Shorts, Fed Could Put a Lid on Rallies

2 major concerns about stock market sentiment right now

Senior Vice President of Research
Dec 17, 2018 at 8:51 AM
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"An immediate risk to bulls… is the big put open interest lingering at the SPY 260 strike, a large majority of which was bought to open… big put open interest strikes 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 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."
-- Monday Morning Outlook, December 10, 2018

We enter expiration week with the SPDR S&P 500 ETF Trust (SPY - 260.47) just above the put-heavy 260 strike that I discussed in detail last week. The significance of this strike has not changed, as you can see in the updated graph below. Normally, other large put open interest strikes could act as magnets too, but in this case, the put open interest at the 250 and 255 strikes was generated by sell-to open-volume, which means buying of S&P futures is likely to occur as those put strikes are approached. 

In other words, as we look ahead to this week from a purely options-related perspective, the market sets up for increased volatility if the SPY 260 strike is violated, but dampening volatility if the 255 strike is approached. On Monday and Friday of last week, the SPY broke below $260, but it was only temporary, as the bulls quickly regained control.

SPY December OI MMO

Bulls should welcome the fact that the moves below the put-heavy 260-strike proved only temporary last week, as technical buying may have overcome delta-hedge selling, with buyers stepping in as the SPY traded around its February and early April 2018 closing lows. Moreover, the $255 area is the next level of potential support from both an options-related and a chart perspective, as this area marked the intraday lows in these same months. 

"[B]oth the SPY and SPX found themselves below their respective 80-week moving averages for the second time in three weeks heading into the weekend... 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."
-- Monday Morning Outlook, December 10, 2018

Unfortunately for bulls, previous 2018 lows holding is about the only thing that gives them hope at the present. It is the bears that have more to get excited about, starting with a brief rally last week stalling at $266.86, last year’s SPY close. 

Additionally, a trendline connecting the various lows since February was violated (see the SPY daily graph immediately below). This trendline was breached intraday on a few occasions, but at Friday’s close, the SPY closed significantly below it. Finally, moving beyond the daily chart, the SPY again closed below its 80-week moving average, after peaking at its declining 80-day moving average earlier this month -- the third weekly close below this important long-term moving average in four weeks.   

SPY daily MMO

In addition to the technical deterioration in the market, monetary concerns come to the forefront this week, as the Fed meets again and is expected to raise rates for the ninth time in this tightening cycle. Per the table below that summarizes SPY action in the month following rate hikes, there is little for bulls to get excited about.

SPY in month after rate hikes

Finally, on the sentiment front, I have two more concerns. The first falls under the headline of equities not doing what they are expected to do when bullish conditions exist. While the buy-to-open, equity-only put/call volume ratio is rolling over from an extreme high -- normally a sign that trader pessimism is exhausted -- stocks have been unable to respond with a V-type rally. Instead, Friday’s SPY close was its lowest since early April. In other words, even as equity option buyers have grown more optimistic relative to a couple of weeks ago, the broad market has been despondent, indicative of major motivated sellers.

BTO pc ratio MMO

Moreover, we compiled short interest data that was made available last week by the exchanges, as of Dec. 1. I was shocked by what I was seeing when looking at S&P 500 Index (SPX - 2,599.95) component short interest, which remains at extremely low levels. In other words, the shorts have not even begun to smell blood. 

A risk to bulls is that the shorts begin to build positions like they have done in the past, which would be an additional headwind. In the past, it was the work of the shorts that helped drive short-term pullbacks. And it was the unwinding of those short positions that helped the market find support and make the V-bottoms we have grown accustomed to seeing -- but have yet to materialize. Now, the tables are turned relative to the recent past, as it is the shorts that could very well put a lid on rallies and drive stocks further lower.

SPX short interest MMO

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