Key VIX Levels In Play Ahead of the Fed

CoT large speculators are near their largest net long position ever on VIX futures

Senior Vice President of Research
Mar 19, 2018 at 8:27 AM
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"The SPY again comes into the week just below resistance -- this time from the late-February high, with the round $280 level, which corresponds with the S&P 500 Index (SPX - 2,786.57) 2,800 century mark, residing just above that.

"The $280 level is also interesting from an options perspective, as we embark upon March expiration week. There are heavy calls at the SPY 280 strike, but most of these calls were sold to open. Since they were sold, there is a dampening effect on the underlying as it approaches that strike."

-- Monday Morning Outlook, March 12, 2018

Unfortunately for bulls, per the excerpt above, the equity market was not exactly positioned to rally last week. In fact, the SPDR S&P 500 ETF Trust's (SPY - 274.20) high last week occurred just after the opening bell on Tuesday morning at $280.41. The $280 area was actually approached on both Monday and Tuesday, but as I cautioned last week, heavy call open interest at this strike was liable to impede any rally attempts, as shorting activity would likely greet moves into that strike since the calls were sold to open.

Combine this with the fact that the SPY 280 strike coincided with the round 2,800 mark on the S&P 500 Index (SPX - 2,752.01), a century level that has proven to haunt bulls both last month and in March after the index sliced through it like a warm knife through butter during January. Later in the week, traders would experience another round-number failure as the Nasdaq Composite (IXIC - 7,481.99) was turned away from the 7,600 area, which is a round 10% above 2017's close.

I did not mention that another key equity benchmark, the Russell 2000 Index (RUT - 1,586.05), entered last week trading just below the 1,600 century mark, an area that marked its January high ahead of a 10% pullback.

As it turned out, sellers were in abundance relative to buyers, but now we enter this week with more breathing room to retest these resistance zones. In fact, the SPX, SPY, and IXIC are nearer to potential round-number support, with the IXIC perched around 7,500 and its January high, and the SPX around the 2,750 half-century mark. Long-time readers know the historical importance of half-century levels marking important pivot points.

SPX 2,750 corresponds with the SPY 275 strike, and the leveling off at $275 on Thursday and Friday was likely related to the options market and expiration week, with healthy put and call open interest residing at this strike price, per the open interest graph below. Buying and selling of an equal number of S&P futures related to high open interest at this strike likely led to the SPY settling near this strike at Friday's close.

spy 30-minute chart March 12-16

If the SPX can mount a rally, the obvious resistance level is last week's high in the 2,800 area, which corresponds to SPY $280. This remains an important psychological resistance zone; however, unlike last week, a plus for the bulls is that they won't have to encounter heavy selling of S&P futures related to heavy SPY 280-strike call open interest, since standard March options expired last week.

spy march open interest configuration

If you draw trendlines connecting the SPX lows in February and early March, and the late-January and late-February highs, both are converging at 2,740 to begin the week. If the SPX breaks below this level, the risk increases of a move down to this month's low just below 2,700.

The unwinding of pessimism amid equity option buyers is a plus for bulls heading into this week, as the 10-day buy-to-open put/call volume ratio is heading lower from a multi-month high. A bear might point out that the broad market has been unable to mount a rally amid the unwinding of this fear. This is a fair point, but at the same time, it's more constructive when this unwinding occurs with indexes trading closer to potential support than resistance.

10-day equity put-call ratio

"... VIX 13.72 is 50% above this year's closing low, and VIX traded south of here on Friday before closing the week at 14.64. Moreover, standard March VIX futures options expiration occurs on March 21, which is now less than two weeks away. With heavy put open interest in the 12 through 14 strikes, and heavy call open interest at 20 and above, it would not be surprising to see the VIX trading between 14 and 20 on the morning of March 21 settlement. This implies, from a very short-term perspective, that there may not be a lot left to the volatility decline we have seen since the highs earlier this month."
-- Monday Morning Outlook, March 12, 2018

Indeed, there was not a lot left in the volatility decline that we saw in the week prior to last. Looking ahead, standard Cboe Volatility Index (VIX - 15.80) futures options expire this Wednesday morning, March 21. Wednesday may also be on your radar because the Federal Open Market Committee (FOMC) is scheduled to announce its decision on interest rates. According to the CME Group website, fed funds futures speculators are pricing in a 94% probability of a 25-basis point hike at this meeting. With a rate hike widely expected, investors may focus more on the release of the committee's projections for the economy and the path of future rate hikes.

Therefore, the first couple of days of this week are likely to be highlighted by directionless trading and low volume. However, expect volatility (as measured by the VIX) to be elevated heading into the meeting, given the Fed uncertainty -- particularly as it relates to the committee's interest-rate projections for the rest of the year.

I would not be surprised to see March futures VIX settlement on Wednesday morning between 16 and 18, as this is the area in which option sellers would stand to benefit the most, per the open interest graph immediately below.

VIX march open interest configuration

The VIX is trading around key levels heading into the Fed meeting. For example, 16.04 is last year's closing VIX high and half the 2016 intraday high. This level has marked VIX lows since late February. Additionally, 16.56 is 50% above VIX's 2017 close, and therefore a level that some might focus on as "high" when comparing to its level at the end of 2017.

At the same time, 13.83 is 50% above this year's January lows and the area of the November/December highs. Bulls would like to see the VIX move below this level once again, especially as many foresee a higher-volatility environment in the months ahead. A surprise -- amid Fed uncertainty, yield curve worries, inflation fears, and White House staff shake-ups -- would be a continued decline in volatility.

A group that continues to bet on higher volatility are the "large speculators" in the weekly Commitments of Traders (CoT) report. As I have said before, this is a group that has been caught on the wrong side of major volatility moves. Note in the graph below that they had their biggest net short position on VIX futures just ahead of a huge volatility explosion in late January and early February.

Now, large speculators are close to their largest net long position on VIX futures ever, after massive short covering last month. With the VIX more than 50% below this year's high, will traders be tempted back into the short volatility trade? Stay tuned, as this could take weeks or months to play out.

cot large specs net long VIX futures

And as I said a few weeks ago, just as the large short position on volatility futures was a major risk to bulls that I had highlighted last year, the current net long VIX futures position by large speculators could be an opportunity for stock market bulls. In other words, this long position in VIX futures is likely representative of caution among market participants, and such caution represents future buying power in the months ahead.

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