How to Hedge Against Another Major Volatility Pop

The record-setting large speculator short position on VIX futures remains a risk for bulls

by Todd Salamone

Published on Nov 4, 2019 at 8:22 AM

"A couple of factors that could be supportive of stocks in the weeks ahead is the contrarian implications of low earnings expectations as we move into earnings season. And, since late April, when the SPX was trading around 2,950, short interest on SPX component stocks is up nearly 11%..."
-- Monday Morning Outlook, October 14, 2019

"[F]und manager cash positions are above average, even with the SPX knocking on the door of a new all-time high."
-- Monday Morning Outlook, October 21, 2019

"I was surprised the 10-day moving average of the daily buy-to-open put/call volume ratio rose to 0.60 from 0.56 during the past week. This ratio is now once again at a multi-month high. From a contrarian perspective, with the SPX advancing near a new high intraday last week, the growing skepticism/caution among equity option buyers combined with the strong price action in equities has bullish implications."
-- Monday Morning Outlook, October 28, 2019

Last week's action in equities was supportive of the bullish narrative that I have discussed during the past few weeks, when the S&P 500 Index (SPX - 3,066.91) was locked up in a multi-month range amid growing skepticism from many market participants. In fact, the SPX finally broke out above its previous highs, and did so as we moved through one on the busiest weeks of earnings season. The move through previous highs made a technical risk I sited last week disappear. But as I said a couple of weeks ago, the table was set for the bulls, as earnings expectations were set low, implying disappointments were likely factored in already.

There were macro factors in play last week too. First, the Federal Open Market Committee (FOMC) met and, as expected, reduced the fed funds rate for the third time this year. The Fed meeting was a monetary risk that I sited last week. But whereas the SPX experienced peaks on the day or within one day of the previous two rate cuts, the SPX hit a fresh new high two days after last week's rate cut. 

A second macro factor at play last week was all too familiar: U.S.-China trade. On a day that confirmed that equity risk is low due to the caution we are observing at present -- growing short-term skepticism among equity option buyers, increased shorting activity on SPX components, fund managers raising cash, or 2019's $16 billion in outflows from the SPDR S&P 500 ETF Trust (SPY - 306.14) -- Thursday's headline that China doubts that a comprehensive trade deal with the U.S. will ever get done sent the SPX only 0.3% lower. 

For perspective, Thursday's retreat was peanuts relative to the SPX's May 7 decline of 1.6%, when President Donald Trump threatened more tariffs on China. In early May, equity option buyers perceived little risk in the market, with enthusiasm at an eight-month high, while SPX component short interest was at a two-year low. Going into last week, equity option buyers were displaying a two-month high in caution and SPX component short interest had just ticked lower from an annual high, implying negative headlines can be digested more. 

MMO 1 option buyers 1103

"[M]ost sentiment measures remain supportive of a breakout, which means the risk-reward favors the bulls. A post-FOMC breakout from the ascending triangle would likely trigger an 8-10% rally into the first quarter of 2020, akin to the short-covering rally that occurred in the second half of 2017."
-- Monday Morning Outlook, October 28, 2019

As I alluded to above, the SPX broke out above prior highs, and the breakout from the ascending triangle targets a move to the 3,200-3,225 area sometime in the first quarter. For bulls, the breakout is a positive development, as the sentiment backdrop is supportive of the anticipated rally, whether it is short-covering potential, asset allocation moves from bonds to stocks among investors in exchange-traded funds (ETFs), or fund managers moving back into equities after raising cash prior to the breakout.

Potential support resides at the prior highs, which coincided with the first two rate cuts. If the SPX breaks back below its prior highs, a secondary support area is in the 2,925-2,940 area into November options expiration in two weeks. This support is in line with the important 160-day moving average and a trendline connecting higher lows since the early June trough.

A potential short-term hesitation area is at 3,080, which is a round 10% above the 2,800 century mark that marked resistance in February and support in March and mid-May. 

MMO 2 SPX daily 1103

With standard expiration in November occurring at the earliest date possible, due to the first Friday of November occurring on the first of the month, I will peek at open interest on the SPY, emphasizing this Friday's expiration of weekly 11/8 options and standard options expiration on Nov. 15. The call open interest at the 305 strike, equivalent to 3,050 on the SPX, stands out as a potential options-related resistance level. The risk of a delta-hedge-driven sell-off is small, but the risk grows if a catalyst drives the SPY below the 290 strike by mid-month, which is equivalent to SPX 2,900.

MMO 3 SPY OI

A remaining risk for bulls is the record-setting large speculator short position on Cboe Volatility Index (VIX - 12.30) futures. They have been notorious for being on the wrong side of major volatility moves, as you can see on the graph immediately below. 

With the VIX trading 50% below its 2018 close and a level from which significant volatility pops have occurred twice so far in 2019, one might consider using volatility calls as a hedge to portfolios heavily betting on higher stock prices in the fourth quarter.

MMO 4 - CoT VIX

MMO 5 - VIX daily

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

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