Making Sense of Last Week's Selloff

With the consensus opinion that volatility will pick up into the elections, volatility pops like we saw last week will be short-lived

Senior Vice President of Research
Sep 8, 2020 at 8:42 AM
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“…former resistance levels have held on pullbacks throughout the trend, so a move back below its February high around 3,400 would wave a few cautionary flags. There is potential support, though, at the SPX’s 40-day moving average, which is currently situated at the 3,300-century mark – roughly 6% below Friday close…Momentum players are sticking with big caps, and the SPX’s next test resides between the half-millennium mark of 3,500 and 3,550, with the round 10% year-to-date gain residing at 3,553. As long-time readers know, round-number year-to-date gains or losses can sometimes be pivot or hesitation areas…If you want to hedge against a pullback to these support levels, or even a decline below these levels, you can use the CBOE Market Volatility Index (VIX) as a trigger. For example, in the fourth quarter of 2019, I advised readers to focus on the one-year (252-day) moving average for clues as to when a volatility increase may be on the horizon, as this moving average had been acting as resistance.”

            -Monday Morning Outlook, August 31, 2020

In reviewing my closing comments from Monday, Aug. 31, we got a little bit of everything in terms of resistance and support levels coming into play, amid a selloff and then an immediate pop in volatility.

Equity market vulnerability, which I have been cautioning readers about since mid-summer, finally reared its ugly head, but only after a long period of impressive momentum to new all-time highs.  The Nasdaq-100 Index (NDX--11,622.13), for example, after closing at an all-time high well above the 12,000-millennium mark on Wednesday, saw a drop of just over 10% from Wednesday’s closing high to Friday’s intraday low at 11,145.  The NDX’s low was just at its 40-day moving average and just above the 11,000-millennium mark. While it is not always clear how action around such millennium marks will behave, make no mistake that it is worth monitoring as a short-term trader, as there are either hesitations, or pivots from these levels, and even instant instability, if and when the level is taken out.  From its closing high last Wednesday to Friday’s intraday low, the, impressive gains the NDX has achieved since August 12 have been wiped out, although support had not yet broken, with neither the 11,000 level nor the July highs being broken to the downside.

And as I mentioned last week, while there were multiple support levels on the S&P 500 Index (SPX--3,455.06) that could come into play in the event of a pullback, too, such support was significantly below last week’s closing level, warranting a potential hedge if there was a clue of a volatility pop - stock drop - being imminent. 

One such clue I offered last week, excerpted above, was if the CBOE Market Volatility Index (VIX--33.60) closed back above its 252-day moving average (first chart below). Coincidentally, this occurred on publication day, Aug. 31, and just three days later marked the beginning of a pullback from the area of the SPX’s level that corresponds to its round 10% year-to-date (YTD) gain (second chart immediately below).   

With the consensus opinion that volatility will pick up into the elections, I think volatility pops like we saw last week will be short-lived. Even with the SPX and Nasdaq hitting all-time highs last week, Large Speculators in the VIX futures market are net at an extreme net short position like one might expect. This should limit surprises like we saw with COVID-19, which generated a VIX pop into the 80 area -- last seen in 2008. Bulls hope this last week’s spike looks more like June than February and March.

9-7 chart 1

9-7 chart 2

The SPX dropped 6.5% from Wednesday’s all-time closing high to Friday morning’s intraday low, somewhat similar to the SPX’s drop of 8.3% over a five-day period back in mid-June, from its closing high to intraday low. 

The jury is out as to whether the SPX’s Friday-morning low at its 40-day moving average marks a trough like it did in June. Coincidentally, the 40-day moving average was in the vicinity of the 3,355 level, which is 50% above the March closing low. In June, the SPX’s round 3,300-century mark held after an intraday break, and, as of the Friday close, the SPX’s 3,400-century mark also held after an intraday break. Additionally, the SPX managed to close the week back above its February closing high after a brief move below this level. 

That said, bulls will breathe easier if the SPX climbs back above the trendline connecting higher lows since the June low, which is around 3,450 as we enter the holiday-shortened week. It battled this trendline into the close on Friday but closed just below it.

9-7 chart 3

The uptick in market volatility could be due to a large number of call options, which confer the right to buy shares, on technology stocks such as Apple and Tesla, according to Saxo Bank. Market makers have been forced to take the other side of such trades, buying the underlying stocks to hedge their position… If shares in a stock fall enough, market makers will unwind their shares, causing a sharp selloff.”

            -The Wall Street Journal, September 4, 2020

One of the more interesting comments that I read in the aftermath of Thursday’s decline was found in The Wall Street Journal. It relates to comments that I have been making for weeks about equity option buyers purchasing a huge number of call contracts (upside bets on a stock) relative to put contracts (downside bets on a stock). 

The ratio of put buying to call buying reached historical lows weeks ago, but the market gave traders no reason to do anything else. One consequence of heavy call buying is that market makers, who are on the opposite side of these trades, get lopsided in their exposure, and thus are forced to hedge these option positions by going long on the stock, especially if the underlying equity rallies after the position is initiated. 

However, if the stock declines and moves further and further below the strike of the call option, they can unwind some or most of the hedge, and the unwinding of the hedge contributes to the selling. The good news is once the unwind is over, which occurs when the underlying is significantly below major open interest call strikes, such selling related to market maker unwinding of long positions disappears, giving the market an ample opportunity to rally as a “buy-the-dip” mentality emerges at support -- as we witnessed on Friday.

The market bent but did not break last week. Unfortunately, going into last week, support was far below the previous week’s close, so a quick pullback to these levels felt painful. But bigger picture, it was contained in that key levels did not break, and many leaders, such as Roku (ROKU), Wayfair (W) and Overstock (OSTK) -- among others -- V-bottomed intraday at key levels of support.  

These situations are worth taking a shot at from the long side, but continue to keep an eye out for a scenario in which support levels break down on a closing basis, as such a change in trend could make weaker hands that have been momentum buyers disappear, creating a shift in sentiment that is more detrimental to the market than we saw in June.

9-7 chart 4

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

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