Good News for Bulls from SPY Options Pits

Despite last week's surge, the VIX closed Friday below the critical 18 threshold

Senior Vice President of Research
Aug 5, 2019 at 8:14 AM
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" ...round millennium levels on the S&P 500 Index (SPX - 3,025.86) and Dow Jones Industrial Average (DJI - 27,192.45), in addition to the level that represents the SPX's 20% year-to-date (YTD) gain (at 3,008), could act as resistance in the near term. And since rallying up to these levels in mid-July, these popular benchmarks have displayed sideways action, which is a welcome alternative, from a bull's perspective, to a violent sell-off.

"... the S&P MidCap 400 Index (MID - 1,983.14) is currently tucked below the 2,000 millennium level, which it has been doing battle with since January 2018. For what it's worth, the 20% YTD gain level on the MID is at 1,995, which -- in addition to 2,000 -- may tempt profit-taking."

-- Monday Morning Outlook, July 29, 2019

Broad-market benchmarks succumbed last week to the round numbers I have been discussing for weeks, as sellers emerged on poorly received remarks from Fed Chair Jerome Powell. The Federal Open Market Committee (FOMC) cut rates by 25 basis points, but indicated a prolonged easing cycle was unlikely, as market participants were expecting. A second catalyst drove more selling on Thursday and Friday, after President Trump imposed more tariffs on China, beginning on Sept. 1.

Not only did the S&P 500 Index (SPX - 2,932.05) fall below the 3,000 millennium level, but the Dow Jones Industrial Average (DJI - 26,485.01) broke south of 27,000 after weeks of going sideways just above this level. Moreover, the S&P MidCap 400 Index (MID - 1,914.53) and the Russell 2000 Index (RUT - 1,533.66) saw the areas just below the round 2,000 and 1,600 levels, respectively, emerge again as solid resistance, while the Nasdaq Composite (IXIC - 8,004.07) briefly retreated below the 8,000 mark for the first time since late June. (Not helping matters was Apple retreating from the $217 area, which is its round $1 trillion market cap level.)

Just as round-number levels and even round-number, year-to-date (YTD) percentage gains acted as resistance in the days before last week's sell-off, now bulls are hopeful that round numbers -- and, in the case of the Nasdaq, a round-number YTD gain -- act as support in the short term. For example, the Nasdaq 8,000 area could be supportive, with its 80-day moving average sitting just below at 7,968 and 7,962 representing the level that is a round 20% above the 2018 close.

Potential support lies just below on other benchmarks that we follow, as well:

  1. The SPX's 80-day moving average is sitting at 2,915, with the round 2,900 level just below this trendline.
  2. The RUT's converging 160-day and 200-day moving averages sit at 1,515, with the round 1,500 century mark just below.
  3. Finally, the MID is sitting right above the round 1,900 century mark -- a brief support area in early May before 1,800 marked a bottom in late May.

"… in the futures market, historically wrong-way large speculators on VIX futures (as measured by the weekly Commitments of Traders reports) are nearing an extreme net short position, which raises the risk of a volatility explosion... option speculators are seeing higher volatility in the days ahead, as is evidenced by the ratio of buy-to-open call volume relative to buy-to-open put volume on VIX futures during the past 20 days...

"As for the VIX itself, it comes into the week trading below 12.71, which is the level 50% below its 2018 close of 25.42. The 12-13 area has been a VIX floor in 2019, so from this perspective, there is growing risk of a slight (to sharp) uptick in volatility in the immediate days ahead."

-- Monday Morning Outlook, July 29, 2019

At last Friday's intraday high of 20.11, the Cboe Volatility Index (VIX - 17.61) spiked 65% above the previous Friday's close. VIX futures popped, too, although not as much as the index. But suffice to say that large speculators on VIX futures were once again positioned on the wrong side of a notable volatility move.

Before last week's volatility spike, call buying relative to put buying on VIX futures reached a record high at over a seven-to-one ratio. A portion of the relentless call buying could have been the results of investors hedging short volatility futures positions, which could keep volatility spikes in check (as the call hedge reduces the need to "panic cover" a short volatility position). That said, the call buying proved timely ahead of negative reactions to both the Fed and the unexpected additional tariffs on China announced by Trump.

As I noted on Twitter last Friday, the VIX 18 area can provide key clues as to where volatility is headed. Despite spending most of Friday above 18.00, the VIX closed the week at 17.61 -- right below this significant price point. This is something bulls can hang their hat on heading into this week's trading.

Moreover, I find it interesting that the August VIX futures contract remains below 18, too. Note below that a plethora of August call open interest begins at the 17 strike and grows through the 20 strike, where there are more than 400,000 contracts. In most instances, 80-90% of VIX call open interest expires worthless -- so if you are playing history, you would not expect to see a ton of upside in the August VIX futures contract, which closed at 17.74 on Friday.

august vix open interest by strike

In keeping with the open interest topic, we are two weeks away from standard August expiration on equity, index, and exchange-traded fund (ETF) options. This is a period in which options open interest can sometimes exaggerate moves when open interest is big.

august spy open interest by strike

However, I find it interesting that SPDR S&P 500 ETF Trust (SPY - 292.62) put open interest is not that heavy below current levels, which removes the risk of delta-hedge selling exacerbating a continued decline in stocks. The 290 strike is fairly put-heavy, but it is not a huge level by historical comparisons, and put open interest is minuscule at strikes through 281 -- reducing the risk of the "magnet effect" that occurs during delta-hedge sell-offs.

In other words, the option forces related to big put open interest strikes will not be in play if the 290 strike is breached between now and expiration Friday on Aug. 16, reducing the odds of a sharp sell-off driven in part by the options market.

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

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