2 VIX Levels to Buy and Sell Stocks

Volatile trading range action for stocks could continue as December options expiration approaches

Senior Vice President of Research
Dec 10, 2018 at 8:16 AM
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"After Friday's move back below [SPY] $280, bulls should seek a move back above this round number and the FOMC decision-day close of $280.50, before getting aggressive..."
-- Monday Morning Outlook, November 12, 2018

"Despite last week's rally, equities are still locked in an area that is pivotal for bulls and bears alike. In other words, the bulls are not out of the woods, but the bears have to be somewhat disappointed in last week's advance... SPX resistance is in the form of a trendline drawn through the early October high -- one day prior to Powell's 'long way' remarks on rates -- through the mid-November high... Whereas the SPY 265 strike is put-heavy and the SPY 275 strike is call-heavy, amid an environment over the past couple of weeks of negative and positive headlines with regard to the Fed and trade talks with China, it is not a huge surprise to see the put-heavy strike defended and the call-heavy strike posing as resistance."
-- Monday Morning Outlook, December 3, 2018

Monday's session was about the only bright spot for equities last week. The SPDR S&P 500 ETF Trust (SPY - 263.57) gapped above potential resistance at the 275 strike that morning after President Donald Trump indicated progress in trade relations with China after a weekend G-20 dinner. But clouds quickly darkened as reports emerged about the lack of details with respect to this progress.

While it was announced the U.S. and China would suspend additional tariffs for 90 days, investors weighed the uncertainty of the outcome of the trade situation as the yield curve continued to flatten, hinting at slowing economic growth ahead. Talk of a pause in rate hikes ahead of an anticipated increase next week helped build support for stocks, albeit only temporarily. By Thursday and Friday, the SPY and SPX found themselves toying again with their October and November lows in the area of the put-heavy 265 strike that I discussed last week, which is also in the vicinity of the 80-week moving average, the importance of which I discussed in my commentary on Nov. 26:

"Since 1980, breaks of the 80-week moving average have usually preceded tests of the 160-week moving average, which approximates a roughly three-year moving average. With the 160-week moving average currently situated around 2,400, bulls run the risk of at least another 10% pullback if there is a significant breach of the 80-week moving average on a weekly closing basis. A break of the 160-week moving average would likely foreshadow further bear-market action."
-- Monday Morning Outlook, November 26, 2018

The bottom line is the SPY and S&P 500 Index (SPX - 2,633.08) failed at $280 and 2,800, respectively. Last month, I cautioned that you should be wary about rallies that fail to take these levels out convincingly. Within one day of closing around $280, the SPY found itself back below another resistance level at $275 and within one week, both the SPY and SPX found themselves below their respective 80-week moving averages for the second time in three weeks heading into the weekend, albeit only barely below.

Therefore, caution flags are out once again about the increased possibility of bear-market action in the coming months, or at the very least a further correction down to the 2,400 level on the SPX or $240 on the SPY -- site of the 160-week moving averages, also discussed in my late-November commentary.

spx with 80-week and 160-week MAs

The continued technical deterioration in the SPY has occurred in the immediate aftermath of the Fed holding the fed funds rate steady on Nov. 8. In the 22 instances during the current tightening cycle in which the Fed held rates steady at an FOMC meeting, the SPY has rallied 77% of the time in the one month following the pause, with an average return of 1.46%. During the past month, however, the SPY declined an eye-opening 6%. A decline of this magnitude when bullish conditions were in place is another risk for bulls.

An immediate risk to bulls, since we are only two weeks away from standard December expiration and amid the sharp decline last week, is the big put open interest lingering at the SPY 260 strike, a large majority of which was bought to open, according to Chicago Board Options Exchange (CBOE) data.

As long-time readers know, a big put open interest strike like this can sometimes act as a magnet due to "delta hedging," which occurs when sellers of the puts are forced to sell S&P futures to hedge their positions as the SPY approaches a put-heavy strike. Since the put options grow more sensitive to SPY action during the decline, sellers of the puts are forced into selling more and more S&P futures to remain neutral.

Admittedly, this is a tricky situation, as there is a bullish counter-argument to this situation. That is, any short positions associated with the 260-strike put open interest that exists now will get steadily unwound if the SPY remains above $260 and we move closer to expiration day.

spy open interest by strike dec 2018

But if the 260 strike breaks, selling could accelerate as shorting of futures accelerates. However, I would expect any selling related to delta-hedging to stop once SPY 255 and 250 are approached, as many of these puts were sold to open, which effectively dampens volatility -- unlike instances in which the puts are bought to open, which drives volatility.

The bulls do have a few arguments to make their case. The first is a repeat pattern emerging of the February-through-May action, in which the SPY made several lows around the area we have been probing since October. The main difference between these two time periods, however, is that longer-term moving averages did not break down earlier in the year.

vix key buy and sell levels dec 10

The action in the Cboe Volatility Index (VIX - 23.23) last week was also interesting. On one hand, stocks nosedived when the VIX declined to the 16.28 level, which is 50% above the August closing low of 10.85. However, the VIX peaked around 25.15, which is half its 2018 intraday high. If we are still engulfed in a volatile trading range for the foreseeable future, buying opportunities will emerge around VIX 25, whereas bouts of selling will emerge on VIX declines to the 16 area. If my VIX read is correct, it is "advantage bulls" in the very near term. But if the VIX closes significantly above 25.15, watch out below.

Risks are growing for longer-term bulls, unless the SPX can quickly gather steam and rally back above 2,800 convincingly. Until then, the best they can hope for is the volatile range action that we are witnessing now.

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