SPY's Next "Lines in the Sand" After the Sell-Off

CoT large speculators were once again on the wrong side of a major volatility move

Senior Vice President of Research
Oct 15, 2018 at 8:40 AM
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"It will be critical for the indexes to mount a bounce this week, as they come into the week at support levels that, if broken, could generate sell-offs like we saw in February and March."
-- Monday Morning Outlook, October 8, 2018

It did not take long. Major equity indices broke below support levels that I discussed last week, and the implications, as I warned, were a major negative for bulls. For example, the S&P 500 Index (SPX - 2,767.13) broke below potential support in the 2,840-2,860 zone, and other equity benchmarks, such as the Russell 2000 Index (RUT - 1,546.68) and S&P MidCap 400 (MID - 1,871.25), breached psychologically important round-number levels and their respective 200-day moving averages, sending bulls running for cover as the action in the stock market looked similar to the February-March correction we witnessed earlier this year.

Many looked for "reasons" -- President Donald Trump questioning the Fed, higher interest rates, valuations, strained trade relations with China, etc. Perhaps it was a combination of "all of the above," but at the end of the day, it cannot be denied that equities are struggling once again in the immediate aftermath of a recent rate hike. This is a pattern that I have observed for months now and, so far, is a pattern that has continued since the Fed’s tightening cycle began in 2015.   

"... it's simply an adjustment to higher risk-free rates."
-- Bloomberg, October 12, 2018

In fact, per the chart below, when the Federal Open Market Committee (FOMC) raised the fed funds rate to a target of 2.00%-2.25%, perhaps investors viewed the most recent hike as an especially opportunistic time to move money out of dividend-paying stocks, as the upper boundary of the risk-free rate moved closer to the SPX’s 2.34% dividend yield at the time of the hike.

SPX dividend yield since rate hike

Regardless of the reason, what can we make of the accelerated selling that pushed the SPX and its related exchange-traded fund, the SPDR S&P 500 ETF Trust (SPY - 275.95), down more than 5% from the prior week’s close into the Thursday close?  Certainly technical selling had a hand in this, as the SPX and SPY broke below their respective January 2018 highs and a channel line connecting higher lows since April, likely stopping out those that bought the late-August breakout and others focusing on channel-line support.  



But as we have seen before, and likely saw again, the options market likely had a hand in some of the selling too. With October expiration just days away, big put open interest strikes can act as magnets when selling is underway, as sellers of the puts are forced to sell S&P futures to stay neutral when these strikes come in view and the option prices grow more and more sensitive to the underlying’s price. This process of put sellers selling futures to stay neutral is called "delta hedging." Naturally, the bigger the put open interest, the greater the number of futures that need to be sold, and the more powerful these magnets become. 

Per my Wednesday observation on Twitter, put open interest at the SPY 280 strike was huge, and a break of this level proved devastating for bulls, as selling accelerated under heavy futures selling. This selling eventually brought other heavy put open interest strikes into play, and made the 150,000-plus put contracts open at the 272 strike a natural "next stop" before delta-hedge selling would likely let up to a degree.  

SPY 30min chart oct 8-12

"[T]he Commitments of Traders (CoT) reports showing that large speculators are in an extreme net short position on VIX futures has been a risk factor for bulls, as this group has long been on the wrong side of major volatility moves for years ... if the VIX takes out … 18.66 -- half the 2018 closing high -- it could be indicative of volatility heading higher in the weeks ahead. That said, I don't expect to see a volatility event like we witnessed earlier in the year, as total open interest in VIX futures positions is 35% below the level of early 2018."
-- Monday Morning Outlook, October 8, 2018




The sell-off in equities was coincident with a surge in the Cboe Market Volatility Index (VIX - 21.31) front-month futures contract, which advanced 50% last week. Yes, in another pattern I have long observed, CoT large speculators were again on the wrong side of a major volatility move.

As for the VIX itself, not only did it advance above 18.66, but it also took out the 21.70-22.50 area by Thursday’s close, which I had listed as potentially important earlier that day. One thing the bulls had going for them at Thursday’s close was the VIX remained below 25.15, which is one-half this year’s intraday high of 50.30, which occurred on Feb. 6, as Credit Suisse terminated its daily inverse fund, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV). Coincidentally, the 25 area is the site of the March highs, which occurred when the SPX and SPY retested the February lows before rallying. Bulls would like to see the VIX close below the 21.70-22.50 area as a first sign that a strong, lasting bounce is underway. 

Meanwhile, equities once again find themselves in an area that they must stabilize, from both an options-related and chart perspective. The SPY is still vulnerable to more delta-hedge selling if the put-heavy 272 strike breaks, but the good news is the biggest wave of delta-hedge selling occurred with the break of the 280 strike and the subsequent move down to the 272 strike. If the SPY remains above 272 and, better yet, 275, time is on the side of the bulls, as short-covering related to put open interest at these strikes and below could serve as a tailwind into expiration. In other words, if the SPY can just stabilize around current levels, the opposite forces that sent equities spiraling lower could be supportive in the week ahead.

From a chart perspective, the RUT comes into the week trading at potential support from its year-to-date breakeven level around 1,535. The SPY 272 level is important not only from an options perspective, but from a chart perspective too, as this was the site of a trendline connecting the January and March highs during the correction earlier this year.  Those that bought this breakout are likely thinking breakeven in this area, and the put open interest at the 272 strike likely represents insurance on a move below this level. If 272 breaks, the next "line in the sand" is the round 270 strike, which equates to the round 2,700 mark on the SPX. Another line in the sand is SPY 267 level, site of the 2017 close and the lows in May and June.

10day BTO pc ratio

There are solid reasons from a technical and options-related point of view on why the market can stabilize and perhaps bounce in the short term. At the same time, the optimism that preceded the rate hike is still being unwound (see the equity-only, buy-to-open put/call volume chart immediately above), and there were some key technical levels that broke down last week that could embolden the shorts and make the longs wary. 

If we bottom, it could be a process like February and March, so continue to be open to opportunities on both sides of the market if you are a short-term trader. If you are a premium seller, amid last week’s volatility pop, now might be a time to sell out-of-the-money index or ETF put options if you can make a strong case for support levels to hold in the coming days and weeks.

SPY chart 2018 MMO

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