Why Now is the Time to Hedge With Call Options

There were several macro headlines to sift through last week

Senior Vice President of Research
Dec 16, 2019 at 8:15 AM
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"We have agreed to a very large Phase One Deal with China. They have agreed to many structural changes and massive purchases of Agricultural Product, Energy, and Manufactured Goods, plus much more. The 25% Tariffs will remain as is, with 7 1/2% put on much of the remainder. The Penalty Tariffs set for December 15th will not be charged because of the fact that we made the deal. We will begin negotiations on the Phase Two Deal immediately, rather than waiting until after the 2020 Election. This is an amazing deal for all. Thank you!"
-- President Donald Trump, December 13, 2019

To say that investors around the world had a plethora of macro news to digest last week would be an understatement. The House Judiciary Committee sent articles of impeachment to the House, phase one of a trade deal was reached with China, giving investors a sigh of relief ahead of new "penalty" tariffs set to go into effect on Dec. 15 that will not be imposed. Additionally, British elections resulted in a clear victory for Conservative Party Leader Boris Johnson, implying Brexit will occur by the end of January.    

If that isn't enough, a U.S. trade deal with Mexico and Canada gained support from House Democrats, clearing the way for Congress to ratify a new deal. And there were reports that the Trump administration and House Democrats were nearing a spending agreement as budget talks move forward.

"In December 2018, the Fed raised rates and this got the ball rolling for a massive sell-off December expiration week … 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."
-- Monday Morning Outlook, December 9, 2019

Finally, but far from least importantly, the Federal Open Market Committee (FOMC) met for its final meeting in 2019. The committee made no change to interest rates, and removed a projected rate hike in 2021, according to its updated dot-plot forecast. Whereas stocks were hindered in December 2018 by a rate hike amid trade uncertainty, they were driven higher last week by forward progress on trade amid the absence of a rate hike and the Fed’s outlook being slightly more dovish relative to a prior dot-plot projection.

As the major headlines were mostly backloaded from the middle to the end of the week, equity benchmarks drifted sideways to slightly lower ahead of an explosive rally on Thursday, driven by President Trump's near-the-market open suggestion that a phase one trade deal was near.

The rally drove the S&P 500 Index (SPX - 3,168.80) to new all-time highs above the 3,152 level, which is double its 2007 peak. The S&P 400 MidCap Index (MID - 2,024.72) rallied further above the 2,000-millennium mark, but it did not eclipse its September 2018 all-time high in the 2,050 area.

Similarly, after the Russell 2000 Index (RUT - 1,637.97) toyed with both the round 1,600-century mark and the 1,620 level, which is 20% above its 2018 close, for the past three weeks, Thursday’s rally pushed the index comfortably above these levels. However, the RUT remains more than 100 points below its August 2018 record closing high of 1,740 and below the 1,712 level, which is double its 2007 and 2011 peaks. 

Backtracking to the Fed’s dot-plot forecast last week, it could be anticipating more trade uncertainty for at least a year in taking back a previously anticipated rate hike in 2021. If this is the case, and the Fed is right, investors should prepare for more trade drama in the months ahead, even though there was perceived progress last week.

As we look to expiration Friday, I find it interesting that the SPDR S&P 500 ETF Trust (SPY - 317.32) rallied above the 315 strike, home to more than 100,000 calls outstanding. The big open interest at this strike may have played a part in the Thursday rally, as those shorting those calls were likely pressed into buying S&P futures to remain neutral as the SPY approached this strike. With smaller open interest strikes above, these strikes act less like magnets, creating less incremental buying related to options open interest. This might explain the lack of a big follow-through rally on Friday.

It will likely take another positive catalyst for the big 320-strike calls to become influential. If volume retreats amid fewer macro headlines, stocks could drift lower in the week ahead as long positions related to the big call open interest around current levels is unwound as expiration nears. An important level to watch is the 315 strike, where the heavy call open interest is located. A move below it could lead to the unwinding of long S&P futures positions that were accumulated as the market reacted positively to trade headlines.

spy december open interest

The short-term sentiment picture is mixed. On one hand, the 10-day equity-only, buy (to open) put/call volume ratio is near its September lows and showing very early signs of turning higher. Long-time readers know that a turn higher in this ratio from a low level is a sign of optimism turning into pessimism, which makes stocks vulnerable in the short term. We are monitoring this indicator closely, as this ratio could quickly turn back lower after the market hit highs on Thursday. But buyers beware, a negative catalyst would spark growing pessimism among short-term traders, potentially sparking a pullback in stocks similar to the mid-to-late September pullback.

10daypcratio MMO

"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

On the other hand, short interest data as of Nov. 29 was released last week and, despite the impressive 3.6% SPX rally in November, the shorts didn’t budge. This is pleasant music to the ears of bulls, as the bullish technical patterns that I have discussed in prior weeks are playing out, and this has occurred without a major tailwind of the shorts, who could be supportive of this market in the weeks ahead.

SPX Stocks Short Interest MMO

"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

"Traders Buy Hedges ‘Like World is About to End'"
-- Bloomberg News headline, December 10, 2019

The above headline caught my attention last week. While our quantified options data that measures potential hedging activity suggests hedging using equity exchange-traded fund (ETF) options is less than what we were seeing in October, something that did stick out is the implied volatility skew of 5% out-of-the-money (OOTM) options on the SPY. 

In other words, per the chart immediately below, the implied volatility of put options with strikes 5% below the SPY is roughly double that of SPY call options with strikes 5% above the SPY (this is known as implied volatility skew).  

Translation: hedging is expensive, with the put options trading at an 18% implied volatility, double the current 21-day historical (realized) volatility of the SPY. 

On the other hand, implied volatility on SPY call options at strikes 5% above the SPY is only 9%, roughly in line with realized volatility. Translation: call options are reasonably priced. 

MMO 10Day MA

This observation further supports what I have been suggesting for the past couple of weeks in terms of using ETF calls to manage risks, as the leverage that options provide allow you to put less money at risk relative to buying equities. And if the bullish technical patterns that I have identified in past commentaries during the past several weeks play out and a short-covering rally indeed materializes, the call options give you an inexpensive way to leverage such a scenario. 

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

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