2 Potential Catalysts for a Volatility Pop

The Fed's last meeting of 2019 kicks off on Tuesday

Senior Vice President of Research
Dec 9, 2019 at 8:50 AM
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"...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

"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."
-- Monday Morning Outlook, December 2, 2019

"U.S. Stocks Slide After Trump Signals Further Delays to China Deal"
-- Wall Street Journal, December 3, 2019

Negative trade headlines set the tone early last week, setting in motion a mild pullback in equities and a sharp uptick in volatility expectations, as measured by the Cboe Volatility Index (VIX - 13.62). In fact, as the VIX was approaching the 18 level on Tuesday, I observed on Twitter the importance of the 18 area, referencing the fact that this level is half its December 2018 closing high. What I failed to mention is that just below this critical level was 17.31, which is 50% above the 2019 VIX closing low of 11.54.

On Tuesday, the VIX peaked intraday at 17.99, reaching a trendline marking lower highs in this volatility benchmark since the 2019 peak in August, suggesting volatility is still on the downswing in the intermediate term. Additionally, the Tuesday VIX high was around its year-over-year (YoY) breakeven, as you can see in the top pane of the chart immediately below. By Tuesday’s close, the VIX was at 15.96, below both the 17.31 and 18 levels discussed above, and this preceded a Wednesday rally driven by -- you guessed it -- reports that a trade deal will get done soon.

For bulls, the hope is that last week’s VIX pop was "it" for the time being. With the VIX's weekly close below 17.31-18.00, the intermediate-term trend lower in volatility is on the bulls' side. But equity bears are hanging their hats on a couple of potential catalysts in the days ahead that could drive volatility higher and stocks lower. Specifically, the Federal Open Market Committee (FOMC) meeting is Dec. 10-11, and stocks have declined in the immediate aftermath of two of the past three meetings. Moreover, Sunday, Dec. 15, is when additional tariffs could go into effect -- an event that could spur another volatility pop.

vix daily chart dec 6

If the year-over-year breakeven on the VIX is to be tested again by next Monday, the day after additional tariffs are due to go into effect, we are talking about a VIX reading of 24-25 zone, with the 25 area representing the 2018 VIX close.

As I alluded to above, whereas the VIX advanced more than 50% at its intraday high last week relative to the late-November closing low, the volatility surge was much more prevalent than the equity pullback. The S&P 500 Index (SPX - 3,145.91) experienced one close below the 3,100-century level after gapping below it on Tuesday, but on Wednesday, it gapped right back above 3,100.  

For what it is worth, the SPX found support around 3,070, which corresponded to its round 10% YoY gain. This support came into play after the SPX pulled back from its 20% YoY gain, per the chart below in the first pane. The SPX didn't come close to retesting its late-October breakout level at 3,025.  

spx daily chart dec 6

Similarly, the Russell 2000 Index (RUT -1,633.84) and S&P MidCap 400 Index (MID - 2,021.98) experienced Tuesday closes below 1,600 and 2,000 respectively, with the RUT immediately recouping 1,600 by Wednesday.  It wasn't until Thursday that the MID closed back above 2,000. 

"...both the SPY and SPX found themselves below their respective 80-week moving averages for the second time in three weeks heading into the weekend, albeit only barely below. Therefore, caution flags are out once again about the increased possibility of bear-market action in the coming months, or at the very least a further correction down to the 2,400 level on the SPX or $240 on the SPY...

An immediate risk to bulls, since we are only two weeks away from standard December expiration and amid the sharp decline last week, is the big put open interest lingering at the SPY 260 strike, a large majority of which was bought to open, according to Chicago Board Options Exchange (CBOE) data….As long-time readers know, a big put open interest strike like this can sometimes act as a magnet due to "delta hedging," which occurs when sellers of the puts are forced to sell S&P futures to hedge their positions as the SPY approaches a put-heavy strike. Since the put options grow more sensitive to SPY action during the decline, sellers of the puts are forced into selling more and more S&P futures to remain neutral."

-- Monday Morning Outlook, December 10, 2018

For those of you that remember, stocks experienced a December 2018 that bulls would rather forget. In fact, I can remember highlighting the risks, per the excerpt above, as the SPX was technically weak, and we were just two weeks away from standard December expiration, with a boatload of put open interest immediately below the market that could trigger a "delta-hedge" sell-off, in which those short the puts are forced to sell more and more S&P futures as the big put open interest strikes are violated.

In December 2018, the Fed raised rates and this got the ball rolling for a massive sell-off December expiration week down to 2,350, just below the 2,400 level that I had warned about two weeks prior, with the SPX at 2,633.

With a Fed meeting this week, and two weeks away from standard December expiration, are we at risk of December 2018 repeating itself? From an options-related perspective, the answer is no. To give you a visual, below is the SPDR S&P 500 ETF Trust (SPY - 314.87) open interest configuration graphs from Dec. 7, 2018, and Dec. 5, 2019.

On Dec. 7, 2018, the SPY was trading at $263.57, just above the put-heavy 260 strike, as seen on the first chart below. A break of this strike, as I alluded to in this report last year, would risk a delta-hedge sell-off, since heavy put open interest was stacked at multiple strikes below $260. These heavy put strikes, I advised, could act as magnets, and this is exactly what occurred when the SPY broke $260.

The second chart below is the SPY open interest configuration for this upcoming December expiration. Because the SPY is in much better technical shape, note that there are not as many huge put open interest strikes immediately below that could act as magnets if a catalyst drives stocks lower between now and expiration. A break of the SPY 305 strike could spur heavy selling, but decent call open interest at the 295 and 300 strikes would likely be a support zone. Therefore, from an option-related perspective, an 8%-10% correction risk is much lower at present relative to last December.

3SPY open interest dec 6

4spy open interest dec 6

There is downside to a lack of huge put open interest relative to call open interest immediately below the market. That is, the upside potential from the unwind of short positions related to expiring out-of-the-money put open interest in the next two weeks is not as great as 2018. Translation: from an analysis of the options market on SPY options, we could see little volatility in the SPY relative to what we were vulnerable to last year.

My hunch is the volatility pop we saw last week is it for now. But that isn’t to say other forces that drive volatility higher and stocks lower could be in play in the weeks ahead. Therefore, I continue to recommend using three-to-four-month exchange-traded fund (ETF) calls to manage monetary and macro risks while participating in a potential short-covering rally following the emergence of bullish technical patterns on broad indices that I have observed in this weekly report during the past month.

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

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