Nasdaq Holding Key Level Amid Breather

Call option premiums have become more expensive than puts

by Matthew Timpane

Published on Jul 20, 2020 at 8:26 AM
Updated on Jul 20, 2020 at 10:59 AM

The triangle breakdown in the S&P 500 Index (SPX -- 3,185.04) two weeks ago was indeed a classic bear trap bottom, which likely got many eager bears trying to front-run short positions on a potential breakdown. We subsequently saw the market rally off that round 3,000-millennium level and break above the short-term downtrend to fill the June 11th gap this week and regain the parabolic price channel ... 
- Monday Morning Outlook, July 13, 2020

This past week, our upside objective from the triangle breakout achieved the short-term target that we had noted a few weeks ago, but it looks like we’ve now potentially developed a range over the past few weeks in the S&P 500 Index (SPX -- 3,224.73). Bulls were unable to make a late-day breakout from that range on Friday, setting up a possible ongoing battle between year-to-date (YTD) breakeven resistance and support just above -10% YTD level.

A failure at this level could easily send us back down to the lower end of the range for another test of that support as we would break the recent price channel. But, if bulls can break out of this range early in the week, we could see the market make a strong push to test all-time-highs in the near future. Additionally, we have a golden cross tailwind to make that push, as highlighted in last week’s Indicator of the Week, where our Senior Quantitative Analyst Rocky White put the golden cross to the test, showing that the market outperforms by almost double the market average over a 3-month period.

SPX Golden Cross

Furthermore, last week’s price action was choppy, but when we drill down, it was largely from sector rotation based on positive vaccine news that’s come out the last few weeks. We saw a large shift from momentum-driven virus themed stocks into more value-centric cyclical stocks with industrials and materials both outperforming the broader market up over +3.20% on the week. With that shift, we saw the NASDAQ 100 Index (NDX – 10,645.22), or rather, technology in general, finally take a breather after running along the upper end of the price channel we’ve been discussing. This consolidation looks to be forming a pennant pattern and is still holding the psychological round 10,000-millennium level, which is very constructive for bulls. 

NDX 2yeardaily

Following July standard options expiration, we do typically see some hesitation in the broader markets, but I would attribute that more towards market positioning than anything else, with all things being equal. Also, I suspect we’ll start hearing industry pundits talking about how August is a month to watch out for. Still, what we know is the majority of the time, this “seasonal” volatility doesn’t strike until September when we look back to 1928. But, what really stood out to me when reviewing seasonal trends was that in presidential election years dating back to 1928, it showed that August and September were far more bullish than usual. On average, the SPX is down by -0.56%, whereas in election years, it is strikingly up by +2.56% on average, and it wasn’t until the last week of September that we started to see that dreaded volatility perk up. 

Fed Balance Sheet SPX

So, while seasonality and market rotation appear to have the bull’s backs, under the hood, there are still some concerns we’re paying attention to. As you can see from the chart above, the Federal Reserve’s Balance Sheet was highly correlated to the S&P 500 following the Great Financial Crisis from 2010 until about 2016. In the fourth quarter of 2014, the Federal Open Market Committee (FOMC) announced it would stop purchasing additional treasuries but would reinvest its runoff. As you may know, this caused a 2-year cyclical bear market until market participants became comfortable with the idea that the Fed was no longer taking Quantitative Easing measures. 

Right around the start of 2017, the market decoupled and pulled away from tracking the balance sheet, but then the FOMC announced in September 2017 that it would start normalizing its balance sheet in October. At first, gradual reductions did not spook investors. Still, once the rate of reduction accelerated in 2018, we started to experience much more volatility in the markets, though overall the market has remained in its secular bull market uptrend. 

Now, since the start of the COVID-19 pandemic, the Fed has injected roughly three trillion dollars of stimulus into the bond markets. With the economy still recovering and nowhere near normal, the Fed has already started reducing emergency stimulus to the tune of $210.33 billion in just the past five weeks. Therefore, while it’s hard to tell what exactly will happen this time around -- since there is only one prior example, -- it will be interesting to see how the market eventually reacts. But, I would guess at some point, market participants might get nervous just like before.

SPX pc ratio

This extreme also coincides with the massive surge in options volume as a whole that we’ve seen since the restrictions went in place due to COVID-19. The surge is widely believed to be caused by retail investors coming into the market in response to the lack of sporting and entertainment options available. In the past, it has been well-documented that these are typical signs of euphoria that tend to end badly for some. 
- Monday Morning Outlook, June 29, 2020

Finally, we’ve recently discussed on multiple occasions the 10-day buy-to-open put/call volume ratio, which is still holding in an extreme territory at 0.34. As you know, this near-term sentiment indicator has been sending us red flags that options traders are overly optimistic, which has been a great contrarian indicator in the past. But, the more I think about it, the reason why we may not have seen a reaction to this is partly due to the demand we’ve had in the options market. As we’ve mentioned before, the total option volume surge we’ve seen since the pandemic started has largely been attributed to small speculative retail traders jumping into the options market. The volume surge is only compounded by the fact that trading is now basically frictionless with zero or near zero commissions. 

What I find most interesting about this, though, is that call options premium have been bid up in many stocks where they now are more expensive than put options based on implied volatilities, which is fairly rare. Typically, this will happen in a hot momentum stock or maybe a few at a time, like when Tesla broke out above its overhead resistance in late December last year on its surge to $900. However, right now, we see this in all kinds of names in the market. This is unusual for a bullish trending market, and it’s really upended the historical relationship and possibly distorted traditional analysis, in my opinion. 

One way to cautiously navigate this bull rally as it continues to climb the wall-of-worry would be to trade shorter-term setups to control your risk exposure. Alternatively or in conjunction, you could also utilize pairs options trades or straddles to play upside momentum while reducing the risk associated with any potential near-term pullback.  

Matthew Timpane is a trader at Schaeffer's Investment Research.

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