SPY Level to Watch Before March Expiration

Money managers may be perceiving “value” in portfolio protection

by Todd Salamone

Published on Mar 9, 2020 at 8:52 AM
Updated on Mar 9, 2020 at 9:00 AM

In the middle of last week, on the heels of the Federal Reserve’s 50-basis point cut in the Fed funds futures rate, it appeared as if we were on the verge of a V-bottom rally. Stocks had already staged an impressive rally off the previous Friday’s intraday low and buyers continued to step in on Monday. Tuesday saw sellers emerge not long after the rate cut, but quickly recovered on Wednesday, closing at its high of the week. But by Thursday and Friday, as investors fled for the safety of bonds, a rotation out of equities occurred, sending stocks below the previous Friday’s close.

On the morning that the Fed cut rates, volatility, as measured by the CBOE Market Volatility Index (VIX -- 41.94), plummeted. In fact, after hitting an intraday high of 49.48 (quadruple its 2020 low) on the last trading day of February, the Tuesday morning low hit 24.93, which I pointed out the day after on Twitter represented roughly half the recent high. In other words, with option prices about half what they were just two days prior, money managers perceived “value” in portfolio protection amid growing uncertainty about how the spreading coronavirus will impact both he U.S. economy and economies around the world.

In hindsight, even though Wednesday’s rally resulted in the S&P 500 Index (SPX -- 2,972.37) closing around Tuesday’s intraday high when the VIX was in the mid-20’s, the VIX barely budged on Wednesday, closing at 31.99, or 28% above its previous day’s low. The fact that the VIX did not close in the 25 area may have been a tell that more volatility was on the way, as the VIX printed 50 for the first time since December 2018, and only the third time in five years, as it reached an intraday high 53.29 in August 2015. 

Friday’s intraday VIX move above 50 looks like 2015 and 2018 in that the close was back below. Moreover, it was significantly below 49.86, which is double the intraday low last week and below 48, which is 50% above last week’s closing low. 

If you are using the VIX as permission to aggressively seek a trading bottom, I would wait for evidence that it is going to close below its 10-day moving average, which acted as support on a closing basis last week. If you are less aggressive, I would look for the VIX to close below 27, which is half last week’s high of 54.39.

While we have not seen a major spike in put buying on SPDR S&P 500 ETF (SPY -- 297.46) options in recent days, prior to the decline we did see major put buying on SPX options. In other words, hedge fund managers tend to play in the ETF market and may have been getting ready for potential trouble as coronavirus fears mounted. In this case, it is traditional fund manages that usually use SPX options to hedge. 

MMO Chart 1

The chart below shows the ratio of SPX puts bought (to open) versus calls bought (to open) over a rolling 10-day period. In mid-February, the 10-day SPX buy-to-open put/call volume ratio was only 1.87. By March 5, this ratio was at 2.20, a multi-month high. Keep in mind that the increased purchase of put options as likely portfolio insurance occurred at relatively high VIX levels, between 22 and nearly 50, a sign of desperation as stocks plummeted. A potential implication is that if traders are willing to buy portfolio protection at any cost, they may not be contemplating a massive exit from holdings anytime soon.

MMO Chart 2

Staying on the theme of the options market, a risk in the short term is the huge put open interest that has built up on SPY options over the past few months, as reports of the coronavirus in China began surfacing broadly in late January. Hedgers usually buy out-of-the-money puts, willing to take on declines of 5%, 10%, or 20% before protection kicks in. As such, with the current decline that has taken place, many big put open interest strikes have been violated, which further pressures stocks as sellers of the puts are forced to short S&P futures as these big open interest strikes come into play. 

The risk to bulls is that with the giant 300-strike put giving way late last week, there is huge put open interest in five-point increments all the way down to the 270 strike. As long-time readers know, such big put open interest strikes can sometimes act as magnets, especially as we near expiration. Standard expiration is now only two weeks away. If the 290 strike breaks, the 285 strike could come into play. Then say that option becomes more sensitive to SPY declines, forcing sellers of those puts to short more S&P futures to remained fully hedged. This process is known as “delta hedging” and is apt to continue to the last heavy put strike at 270, which is 18% below the January closing high. 

At the same time, if the market stabilizes and expiration nears, short S&P futures positions associated with the out-of-the-money puts will slowly be covered, adding a layer of support into expiration. This could result in an expiration-week rally. 

While the open interest does not indicate market direction per se, it does hint at potential downside risk to bulls in the near term. Specifically, what the bears might be up against if the 290 strike is not taken out, or if the SPY rallies above the 300 strike, where open interest is huge on all option expirations between now and March 20.

MMO Chart 3

The SPY's low last week was intriguing, as it was the site of its 320-day moving average, a trendline that is unpopular but has had significance over the years. In fact, it acted as support during a pullback in May 2019 most recently. Moreover, the 320-day moving average is situated at a previous peak in September 2018 and April 2019. Finally, there is decent-sized put open interest at the 290 strike, which is in the vicinity of this chart support.

Looking ahead to next week, if support above breaks, another potential support level is the SPY’s year-over-year breakeven level as of March 13. On March 13 of last year, the SPY closed at $281.34. This level is in the vicinity of the 280 strike, or round 2,800 level on the SPX. Potential resistance is at 302.46, which was the close ahead of Friday’s gap lower. Note that last week’s high was in the vicinity of $311.50, which was the close ahead of a major gap lower on Feb. 27.

MMO Chart 4

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

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