The Best Way to Manage Volatility Risk Right Now

Why now is a great time to consider calls on the heavily shorted small-cap ETF

by Todd Salamone

Published on Dec 2, 2019 at 8:18 AM
Updated on Dec 2, 2019 at 10:50 AM

With President Donald Trump signing the Hong Kong Human Rights and Democracy Act just ahead of the Thanksgiving holiday, equities pulled back on Friday, as some viewed this act as threatening the first phase of a U.S.-China trade deal. However, as we have seen with respect to negative trade headlines recently, Friday's pullback in stocks was modest and came as the S&P 500 Index (SPX - 3,140.98) ended November up more than 100 points, or 3.4%.

Stocks last month rode the wave of the Fed's third rate cut in late October and an assurance from Fed Chair Jerome Powell that the central bank would need to see a persistent move higher in inflation before raising rates again. In other words, the perception that the Fed will not raise rates amid lingering trade uncertainty has been supportive of stocks, unlike last year at this time when the Fed was raising rates into trade uncertainty.

"One thing that stands out about last week is the SPX's weekly high, which occurred around 3,128. Per an observation I made on Twitter last Tuesday, this high was two points shy of the 3,130 level, which is roughly double the peaks that preceded two memorable bear markets, beginning in 2000 and 2007... Noteworthy, too, was the inability of the S&P MidCap 400 Index (MID - 1,985.87) and Russell 2000 Index (RUT - 1,588.94) to take out the 2,000 and 1,600 levels... even though they acted as resistance again last week, patterns are evident on both indexes that are bullish in the intermediate term."
-- Monday Morning Outlook, November 25, 2019

Prior to Friday's decline, multiple equity benchmarks broke out above resistance levels that I discussed last week. For example, the SPX took out 3,130, but was unable to sustain a move above the 3,150 half-century mark. For what it is worth, the SPDR S&P 500 ETF Trust (SPY - 314.31) 315 strike is call-heavy in the standard December options series, and this strike equates to SPX 3,150 -- so this will potentially be a key strike to watch as December expiration approaches in a few weeks.

"The RUT's price action mirrors both the MID and SPX, recently breaking out of a descending triangle pattern (like the SPX) as it looks to take out the 1,600-century mark that has acted as resistance on multiple occasions since January 2018... The RUT's descending triangle breakout two weeks ago targets a 7.5% move higher during the next four months to the round 1,700 level. With some technicians voicing concerns about few stocks participating in the rally, a 7.5% jump might take many by surprise. And, in fact, short covering could be a driver of small-caps too, as short interest on Russell 2000 components is barely below a record high."
-- Monday Morning Outlook, November 18, 2019

Small-cap and mid-cap stocks experienced breakouts of their own, with the Russell 2000 Index (RUT - 1,624.50) advancing above the round 1,600 century mark for the first time since May, following a retest of the channel line that defined its descending triangle pattern. And the S&P MidCap 400 Index (MID - 2,010.15) rallied above the 2,000 millennium mark for the first in more than a year. Moreover, both indexes closed November above levels that mark a round 20% above their respective 2018 closes -- levels that turned back rallies previously this year. The RUT's breakout above 1,600 paves the way for a rally to the next potential resistance area in the 1,700 zone over the next few months.

rut stock chart daily 1129

"The VIX futures 'premium' over SPX HV is now rising to levels from which stocks have experienced corrections in the past, with the one exception over the past couple of years being 2017, when short covering helped drive a second-half rally. Therefore, if the final quarter of 2019 and first quarter of 2020 resemble the second half of 2017, it could be short covering that keeps volatility compressed during the next few months."
-- Monday Morning Outlook, November 18, 2019

"...this VIX floor in the 12 region poses upside volatility risk, which equity market bulls should continue to take into account. A potential bullish scenario is the VIX continuing to work higher amid little to no damage in the equity market, giving it room to work its way lower back to 12 amid a breakout from a range."
-- Monday Morning Outlook, November 25, 2019

After a pre-holiday plunge below the 12 mark that has been supportive of the Cboe Volatility Index (VIX - 12.62) this year, Friday's retreat in stocks came with a small volatility pop back above the 12 level. With trade uncertainty lingering -- particularly ahead of the mid-December date when previously announced tariffs are set to take effect -- and historically wrong-way Commitments of Traders (CoT) large speculators still carrying an extreme net short position on VIX futures, a volatility pop is the biggest risk to equity market bulls.

But as I have discussed here recently, short covering could keep volatility compressed for the next several weeks. In fact, short interest data as of mid-November came out last week, and I was surprised to see little change in the data from the previous report at the end of October. In fact, SPX component short interest increased slightly in the first two weeks of November, as short interest remains at a multi-month high. And RUT component short interest decreased by a minor amount, as short interest lingers at multi-year highs on small-cap equities.

spx component short interest as of 1115

rut component short interest as of 1115

So bullish technical patterns in multiple equity benchmarks and short covering could be drivers of momentum higher in the weeks and months ahead. But trade uncertainty lingers amid risk of a volatility pop, for reasons outlined in this space commentary during the past couple of weeks. So how can one navigate these opposing factors that are in play?

One idea is to de-risk by lightening up on long equity exposure, but maintaining exposure to an advance by purchasing two- to four-month call options on exchange-traded funds (ETFs), such as the iShares Russell 2000 ETF (IWM - 161.77). With implied volatility on IWM and SPY options recently hitting 52-week lows, you can better leverage an upside move driven by short covering, while also managing the volatility risk that equity bulls are facing at present.

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

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