2 SPX Moving Averages to Monitor as Shorts Gain the Upper Hand

Delta-hedge selling could spark more downside than some bulls can stomach

Senior Vice President of Research
Mar 26, 2018 at 8:21 AM
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"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.

"...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...

"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."

-- Monday Morning Outlook, March 19, 2018

At the beginning of last week, two days prior to March Federal Open Market Committee (FOMC) meeting in which the Fed raised rates by a quarter-basis point and projected a steeper rise in interest rates in 2019, the S&P 500 Index (SPX - 2,588.26) was trading just above a potential support level at 2,740 but right at the 2,750 half-century mark and still more than 100 points below the January peak.

Moreover, the Cboe Volatility Index (VIX - 24.87) came into the week at 15.76, perched around its 2017 closing high, but also significantly below the 18.30-18.65 area -- double this year's VIX closing low and half its closing high, respectively.

As expected, volatility as measured by the VIX rose heading into the FOMC meeting, with the Wednesday morning settlement occurring between the strikes I had anticipated. However, instead of a post-FOMC volatility expectations decline, volatility ramped significantly higher just one day after the expiration of March VIX futures options.

The volatility surge occurred on the heels of: 1) a rout in technology stocks after it was revealed Facebook had failed to protect its users' personal information; and 2) President Donald Trump announcing his administration would take a hard line on China, with as much as $60 billion in tariffs. The two headlines unnerved investors, sparking a sell-off in equities, and a post-VIX expiration surge driven by uncertainty tied to potential new regulations in the tech sector and the economic repercussions of a trade war.

The VIX burst through the 18.30-18.65 area and by late in the week, was trading at potential resistance, as I observed Friday morning on Twitter. For what it is worth, the 25.15 level marked the high earlier this month. But while the VIX moved above 25.15 intraday Friday, it closed below this level.

To my surprise, there were not a huge number of VIX call buyers after the expiration of VIX futures options. This could be because you don't have the natural call buying related to hedging of massive short volatility futures trades, with the Commitments of Traders (CoT) large speculators group in the unusual position of being net long volatility futures. Nonetheless, one would think a spike in call buying is needed for the VIX to ultimately peak. But for now, bulls should be happy the VIX is below the 25.15 level, although a close above 25.15 would likely set the table for a move into the high 30s, its 2018 closing high.

Meanwhile, after gapping below support at 2,700 on Thursday morning, the SPX bounced above and below its 2017 close at 2,673 for a few hours. The sell-off continued into Thursday's close, and ultimately carried the SPX below the 2,650 half-century mark, which marked support after a brief pullback early this month. The sell-off resumed late Friday morning after the SPX failed to get back above the 2,650 level, and by late Friday the index was flirting with yet another century mark, 2,600.

With the SPX last making a high in January, and unable to recover fully from the correction earlier this year, multiple resistance levels now lie overhead, which reduces the appeal of stocks at this moment. For example, there is the SPX 2,650 level that gave it trouble last week on rally attempts, and the year-to-date breakeven level at 2,673 that acted as support in early March but could now act as resistance on rallies.

With the SPX nearly 10% below its January high and negative year-to-date, those who initiated short positions this year are feeling a lot better now than just two months ago. Short interest on SPX components has increased more than 7% in 2018. With many of those shorts likely in winning positions now, they are less prone to short-squeeze situations, which was a strong theme throughout the last couple of years. In fact, the shorts may become bolder by shorting into rallies, because for the first time in a long time they are now in a position of strength.

With volatility picking up and momentum to the downside, I thought it would be of value to add up all weekly and standard expiration options open interest on the SPDR S&P 500 ETF Trust (SPY - 258.05) through April 20 standard expiration. As we break though one heavy open interest put strike after another, it is not out of the realm of possibility that these major put strikes are acting as magnets as delta-hedge selling occurs. There is rather large put open interest down to the 245 strike, which is around 2,450 on the SPX, and this stood out to me as a potential area of put-related support if the selling continues this week.

The 270 put strike is on the far right, and SPY's gap below the put-heavy 270 strike likely got the ball rolling for delta-hedge selling. The short-term risk to bulls is that we're only in the middle of this process.

spy open interest by strike 0325

Before acting too much like "Debbie Downer," there is one small glimmer of hope for bulls from purely a technical perspective. As you can see on the chart below, the SPX comes into the week sitting near the round 2,600 level, which is also an area that is: 1) 10% below the 2018 high; 2) site of its 200-day moving average; and 3) home to a trendline connecting higher lows since this time last year. No doubt, we enter the week at a major pivotal level.

spx 200-day moving average

If buyers step in early this week, short covering from heavy put strikes below the market could fuel a V-rally. However, given smaller put open interest in the weekly options relative to the standard monthly options that expire on April 20, it won't be the expiration of weekly put options that has a big impact. If the market falls below the aforementioned support, those who bought around these levels last month are prone to sell, and this could help fuel a further delta-hedge sell-off down to SPX 2,450.

Be prepared for both scenarios, and be wary of SPX bounces that are not able to take out 2,650. If you are a longer-term investor, now may be the time to think about how much additional downside you can stomach. For example, I have observed the importance of the SPX's 36-month moving average, which is the average of three years' worth of monthly closes on the SPX.

I bring this moving average to your attention because of its historical importance. In early 2010, the SPX stalled at this long-term trendline for a few months coming out of the 2009 bottom. A cross-over proved bullish, and there have since been two "retests" of this moving average (in 2011 and 2016). There has not been a monthly close below this trendline since the bullish cross in 2010. At present, the 36-month moving average is still rising and is situated at 2,262, or 13% below Friday's close.

spx 36-month moving average

Long-term investors who can stomach the possibility of a decline to this trendline can use this as a demarcation point between staying the bullish course or moving to the sidelines. For what it is worth, monthly closes below the 36-month moving average in 2001 and 2008 signaled significant downside in the months and years ahead.

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