The "Fear Gauge" Signal to Keep an Eye On

Options sentiment has shifted drastically in recent weeks

Senior Vice President of Research
Oct 5, 2020 at 8:39 AM
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In the interest of keeping it simple, I think a decisive move back below the VIX’s 252-day moving average would signal that lower volatility is ahead, which would allow equities to finally stabilize after sellers emerged at the beginning of the month…If more volatility is on the horizon, I see lower probability of a volatility event like we saw earlier in the year, as Large Speculators are not nearly as net short volatility futures as they were before the VIX soared into the 80 area.”

            - Monday Morning Outlook, September 21, 2020

Last Thursday’s trading session stood out to me, as the S&P 500 Index (SPX – 3,348.44) gapped and closed higher in a choppy session. I noticed that the CBOE Market Volatility Index (VIX – 27.63), after trading below two key moving averages that I have monitored closely – specifically the 30-day and 252-day moving averages – closed the day above both trendlines. My immediate thought is that no matter what equities do in the month ahead, volatility due to election uncertainty will remain elevated. 

I also thought that chances were pretty good that Friday’s opening could be weak, as the VIX had a chance to close below its 252-day moving average, but it did not, despite the market finishing the day fairly strong. It was overnight news that U.S. President Donald Trump and First Lady Melania Trump tested positive for COVID-19 that sealed the deal for a weak Friday opening, and calls for higher volatility amid more uncertainty.

Since late last year, I have been focusing on the VIX’s 252-day moving average. Crosses above and below this trendline throughout much of 2019 provided good buy and sell signals, including the cross mentioned above in late January that hinted at a volatility pop.   

Plus, a cross below its 252-day moving average at the end of July signaled a strong August, and the VIX’s cross above its 252-day moving average on Aug. 31 again signaled weaker equity prices and higher volatility in September. 

A two-day close back below the 252-day moving average on Sept. 15 and Sept. 16 was short-lived and supported by its shorter-term 30-day moving average, before the VIX climbed back above the 252-day moving average on September 17, when the SPX closed at 3,357. 

In other words, VIX crossovers above its 252-day moving average continue to serve as a warning signal, and investors should approach the market with more caution than usual if the VIX remains above these trendlines. If the VIX crosses back below these moving averages, it could be hinting at higher stock prices and lower volatility in the immediate days ahead.

If the VIX strays too far from these moving averages, levels to watch are the 20 area below, and the 36 area above. The 36 area is roughly three times the 2020 closing low, and has acted as “volatility resistance“ since May. Meanwhile, the 20 area, or one-half the VIX’s June closing high, acted as “volatility support” when the SPX peaked in August.

VIX Chart 252 MA

“… last Wednesday, the 10-day, equity-only, buy (to open) put/call volume ratio hit 0.42, or 0.10 above its recent low at 0.32.  The sharp move higher in the ratio from a low relative level prompted our Quantitative Analyst, Chris Prybal, to research previous instances in which this ratio turned 0.10 points higher from a relatively low reading… in these instances that bulls are most at risk of seeing a lower SPDR S&P 500 ETF Trust (SPY) in the 10 days that follow. In fact, in three of the four past instances, the SPY was lower by 1%, 4% and 16.7%... It is usually sometime after that two-week period that the remaining bulls are flushed, setting the market up to rally by day 21 after the signal.”

            - Monday Morning Outlook, September 21, 2020

The Sept. 16 sell signal that occurred due to a sharp spike in the 10-day, equity-only, buy (to open) put/call volume ratio lasted ten trading days and, as such, ended on Wednesday, Sept. 30, with the SPX lower by 0.6% from the signal date.  

Now, there are a couple of encouraging signs for the bulls from an options perspective.  First, the rampant 10-day buy (to open) call speculation that peaked early last month is down roughly 25-30%. Meanwhile, cumulative 10-day buy (to open) put volume peaked in mid-September more than 30% higher than the late-August low.

In other words, the excessive optimism among equity option speculators that we witnessed heading into September has faded, with 10-day cumulative buy (to open) call volume at its lowest levels since July. However, while the optimism that prevailed ahead of the near 10% pullback in the SPX has faded somewhat, I would not label current sentiment in the equity options market as excessively negative. I would grade the current sentiment as “not as bearish” from a contrarian perspective, when comparing to last month at this time.

cp ratio spx overlay

With a retreat in put buying from the mid-September peak, the 10-day, equity-only, buy (to open) put/call volume ratio is rolling over. In fact, the ratio looks much like the rollover that occurred in late-June and preceded the July-August rally.   

The peak in this ratio is encouraging for bulls, especially since the September 16 sell signal is over. But since the ratio peaked at a relatively low level, there is not as much bearish sentiment to unwind relative to peaking at a relatively high level, implying an advance in equities may not have the staying power like other rallies we have witnessed in which an extreme in bearish sentiment is unwound. 

Keep in mind that the risk of this ratio turning higher, which would likely be consistent with lower equities, increases when the VIX remains in an uptrend, as defined by trading above the shorter-term and longer-term moving averages discussed above.

SPX 10day pc ratio

Finally, key levels on the SPX that we are watching came into play last week as well as this week. Per the chart below, note how the SPX’s 2019 close in the 3,230 area was in the vicinity the closing low on Sept. 23. The Intraday low the following day was just below 3,222, which is a round 10% below the early-September all-time closing high.

With support clearly in place around the 3,220-3,230-mark, overhead resistance throughout most of September is at the mid-February closing high of 3,386 that preceded the near 35% pullback into late March. While the 50-day moving average is on the radar of many investors, I have been following the SPX’s 30-day moving average, which is situated at 3,388, or around the February 2020 closing high. This trendline is still downward sloping, and marked resistance on a closing basis in mid-September after two closes above the February closing high. It also acted as support on three of four pullbacks from May through July. A move above or below these resistance/support levels may determine the direction of stocks into and after the election. 

SPX Daily 200day

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

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