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How Unwinding Pessimism Could Push Stocks Higher

The SPX closed last week above a significant Fibonacci retracement level

Senior Vice President of Research
Jun 10, 2019 at 8:29 AM
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"In a worst-case scenario, a move down to the SPY 245 strike, or SPX 2,450, remains a possibility into June expiration, as the SPY 245 strike is the last of several heavy put open interest strikes below the market... A move below the 270 and 275 strikes would further increase the possibility of a sharp sell-off by June expiration. With that said, the bulls can hold their breath for now, as the SPY 275 strike held in last week's pullback, which is equivalent to the 2,750 half-century mark on the SPX... The SPX 2,750 area is just below the unpopular -- but sometimes significant -- 320-day moving average, which acted as support in March."
-- Monday Morning Outlook, June 3, 2019

"Fed Chairman Jerome Powell signaled an openness to cutting interest rates, pledging to keep a close eye on trade fights between America and its largest trading partners. Powell, under pressure from President Donald Trump to ease borrowing costs, said "we do not know how or when these issues will be resolved."
-- Bloomberg, June 4, 2019

"Several big asset managers, including Morgan Stanley and T. Rowe Price, said they are reducing their holdings of U.S. shares. Altogether, individual investors in May pulled $44.2 billion from mutual- and exchange-traded funds that invest in stocks, the biggest month of outflows all year, according to data from Lipper."
-- The Wall Street Journal, June 5, 2019

In last week's commentary, amid a market sell-off that began in early May as trade tensions ratcheted higher between the U.S. and its major trading partners, I discussed the increasing possibility of a rout on par with that of December, as heavy put open interest strikes on the SPDR S&P 500 ETF Trust (SPY - 287.65) down to the 245 strike could act as magnets, like we saw in December.

The outlook for stock investors grew dimmer to begin the week, with the SPY breaking below the 275 strike on Monday, but things quickly changed in the bulls' favor. An influx of dovish talk from multiple Fed officials was the catalyst. Essentially, many central bankers suggested they would do what is necessary to combat any negative consequences of a trade war, moving more in line with fed futures traders that were anticipating interest rate cuts by year end. With the Fed "on board" with the market's trade war fears, investors saw this as the green light to support the market.

Coincidentally, the accommodative "Fedspeak" occurred just as the SPX had declined to the area of its 320-day moving average -- a long-term trendline that we monitor closely, which had previously acted as support in March. Additionally, like the March low, the closing low last week occurred at the year-over-year (YoY) breakeven on the S&P 500 Index (SPX - 2,873.34), around the 2,745 level. In the top pane of the chart immediately below, a rolling year-over-year percentage return on the SPX is displayed.

spx daily 320-day moving average yoy returns

With a bullish catalyst in play, the SPY gapped back above the put-heavy 275 strike. It is likely that the increased shorting activity that followed the breaks of the put-heavy 280 through 274 strikes quickly turned into short covering as the SPY rallied back above these strikes on Tuesday and Wednesday.

So now what? A full-fledged V-rally would push the SPX back to highs in the 2,950 area, but during the next two weeks -- up until June standard options expiration -- the SPY must first overcome peak call open interest at the 290 strike, which is equivalent to SPX 2,900. Many of the SPY 290-strike calls were bought to open, which means this strike could be a magnet like the put-heavy strikes, and a move through the 290 strike could generate additional futures buying as the call sellers look to hedge.

spy june open interest by strike

Even without considering the influence of options open interest as June expiration nears, with the SPX breaking out above a short-term trendline connecting lower highs in place since the May closing high and now just over 2% from the all-time highs, trade worries and the May pullback generated a spike in pessimism that, if unwound, could spark a move through the September 2018 and May 2019 highs.

For example, note the spike in equity put buying relative to call buying, as the 10-day, equity-only, put/call volume ratio is now just below the peak that we saw in December. This is a good indicator of short-term trader sentiment, which, as you can see on the chart below, is near an extreme in pessimism. If the negative sentiment is unwound during the upcoming quiet period for Fed governors ahead of the June 18-19 Federal Open Market Committee (FOMC) meeting, we could still be in the early innings of last week's rally.

10-day equity put-call ratio spike 0607

I am anticipating that with the SPX retracing more than half the losses from peak to trough last week, a slowdown in put buying in the weeks ahead -- and perhaps a massive slowdown in fund outflows -- will remove a headwind that was pressuring stocks. In fact, the SPX closed above the 2,865 area last week, which is a 61.8% Fibonacci retracement of the late-April peak and last week's low.

The market is still susceptible to trade headlines determining the action of the day, but as long as the SPX holds above 2,800, an immediate December-like meltdown of the type that I was concerned about last week is no longer a major concern at this time.

"With an increasing risk of the current pullback extending into June expiration, traders should have exposure to puts to either hedge long positions or for speculative purposes. This does not mean to ignore the long side via call trades, as a surprise positive headline on trade could halt the market's current slide, and short positions related to the put open interest on the SPY would be unwound, helping support the market. Nonetheless, options continue to be an outstanding way to navigate the uncertainty and various risks in the market, as they allow you to limit your risk to the premium paid. And the leverage options provide you still allows for excellent profit potential."
-- Monday Morning Outlook, June 3, 2019

Finally, my concluding remarks above from last week's commentary should serve as a reminder that:

  1. Buying options can be a very effective tool to manage risk, whether they are used for hedging or speculating purposes, as your risk is limited to the premium paid and the leverage affords you huge profit potential.
  2. A huge build in options open interest on broad-market exchange-traded funds like the SPY can potentially magnify short-term upside or downside moves, so it pays to have exposure to both sides of the market via call and put options when this open interest is "in play" as it was coming into last week. This is especially true when there is little to no edge in predicting the next major headline out of Washington that will impact market direction.

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

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