A Near-Term Risk to Stocks Worth Preparing For

There's a potential upside to the increased equity hedging activity of late

Senior Vice President of Research
May 28, 2019 at 7:48 AM
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"The proportion of investors preparing for equity falls is the highest in the survey's history, BAML said, noting that trade war was seen as the main risk by 37% of participants, followed by a Chinese slowdown which was picked by 16%."
-- Reuters, May 15, 2019

The Reuters excerpt above, also highlighted in last week's commentary, is one that I would like to expand upon this week. One way to prepare for equities to fall is by raising cash. And in the exchange-traded fund (ETF) world, according to data published on May 21 by Investment Company Institute (ICI), investors seem to be doing just that, especially as it relates to domestic equity ETFs.

etf net issuance data ici

"Commitments of Traders (CoT) data shows that large speculators have now covered an additional 60,600 contracts of the net short positions in Cboe Volatility Index (VIX - 15.96) futures, which means they've now covered nearly half of their record short position of just two weeks ago."
-- Monday Morning Outlook, May 20, 2019

"The breakdown in Sino-U.S. talks and the latest targeting of Chinese companies by the White House has economists at investment banks increasingly pessimistic about the long-term outlook. Goldman Sachs Group Inc., Nomura Holdings Inc. and JPMorgan Chase and Co. are among those pricing-in a greater chance of a protracted trade war. One China analyst sees both sides stuck in a cycle of 'fighting and talking' until 2035."
-- Bloomberg, May 23, 2019

"Bracing For A Long-Term Trade War"
-- CNBC TV headline, May 24, 2019

Another way to prepare for a decline is to hedge by buying put options on broad-based equity ETFs, such as the SPDR S&P 500 ETF Trust (SPY - 282.78), or a broad-based index, such as the S&P 500 Index (SPX - 2,826.06). With that said, I noticed that the 20-day ratio of buy-to-open put volume to call volume on the SPY has risen from 1.37 at the beginning of May to the current reading of 1.76. In other words, hedging activity has increased as expectations for a trade deal with China have moved from imminent to, in some cases, years away.

As optimism about a deal has soured, a shift in volatility expectations is taking place, evidenced by the Commitments of Traders (CoT) large speculators on Cboe Volatility Index (VIX - 15.85) futures unwinding their previous bets on a decline in volatility. Combine this with investors raising cash and hedging stock portfolios at an increasing pace, and the headwind we have observed is quite clear.

But, so far, the market has not experienced a significant amount of technical damage. For bulls, this is a plus, as high expectations for a trade deal have been quickly replaced by low expectations -- and low-expectation environments typically lead to positive surprises down the road.

Moreover, one can seriously question if the negative consequences being portrayed daily in the media of higher tariffs and/or a protracted trade war are overblown. For example, the anticipated inflationary implications of higher tariffs are not being reflected in the bond market, as bonds have rallied, nor the gold market, which has been despondent.

"We are definitely at risk to retest the round 2,800 level on the SPX in the next week or two. However, unless we break that support level and the barely rising 200-day moving averages, we should continue to view this move as just a pullback..."
-- Monday Morning Outlook, May 20, 2019

After drawing a trendline connecting lower highs for the SPX since May 6, a pattern of support and resistance area comes into clearer view. Resistance from the declining trendline starts the holiday-shortened week at 2,850 and ends the week at 2,825. Meanwhile, support is around the 2,800 level after a retest of the SPX's 2,800 area last week.

The implications of the hedging activity could create a big directional move in the coming weeks, as the descending triangle pattern is resolved.

spx hourly since april 26

Usually, I post SPY open interest configuration graphs closer to standard options expiration, as the implications of big open interest strikes have the greatest impact nearer to monthly expiration. That's when out-of-the-money options become increasingly sensitive to sharp movements in the market as expiration nears, and the underlying ETF or index approaches a relevant strike.

spy june 2019 open interest by strike

However, with the SPY just above the put-heavy 280 strike, and huge open interest stacked all the way down to the 245 strike -- equivalent to 2,450 on the SPX -- a break of the SPY 280 strike, or SPX 2,800, could set in motion a steady move lower, as these big put strikes tend to act as magnets, especially in instances closer to standard expiration. This is because those short the puts are forced to sell S&P futures as a hedge when these strikes come closer into play. Even though much of this put build-up could be "China-related," it could be any number of catalysts that sets the ball in motion for this to occur between now and June expiration.

This is a near-term risk worth recognizing and preparing for, especially if the SPY breaks below support at $280 and fails to rebound quickly back above this level.

But there is a potential upside to the hedging activity that has created a huge build in put open interest. That is, the longer the SPY holds above $280, additional support will occur from the gradual covering of short positions related to the out-of-the-money put open interest. This is because as time passes, the further out-of-the-money strikes become gradually less sensitive to broad-market moves, and thus short covering slowly takes place. Or, if the SPY moves further and further above these heavy put strikes, short covering will occur. As such, a breakout above the trendline of the descending triangle in the chart above could create a tailwind for bulls from both a chart and options perspective.

The latter scenario would catch equity option buyers off guard, as this group is traditionally buying equity puts at a high relative rate to calls near market bottoms. While the 10-day, equity-only, buy-to-open put/call volume ratio is at levels that marked many bottoms since 2017, it is not yet at the fourth-quarter 2018 high, nor the highs of 2016. We prefer to see a roll-over in this ratio from a high to definitively say a bottom is in, as the roll-over signals that growing short-term speculative pessimism has peaked and is in the process of being unwound, which is a necessary step for a V-bottom to occur.

equity only put-call ratio 0524

Todd Salamone is Schaeffer's Senior V.P. of Research.

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