How the Equity Benchmarks Cleared Historical Resistance

There has been a drop off in buy-to-open VIX put volume since November

Senior Vice President of Research
Nov 30, 2020 at 8:37 AM
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…the SPX closed back below 3,580 on Friday. In fact, since the mid-August breakout above the February closing high of 3,380, most closes have been between 3,380 and the early-September 3,580 peak, implying we are entering the Thanksgiving holiday week nearer the top of a three-month trading range. Similarly, the Nasdaq Composite (IXIC – 11,854.97) has been locked in a range during the same period, with the bottom of the range at the 11,000-millennium mark, and the 12,000-millennium level defining the top. Sellers do not appear to be as powerful relative to past trips up to 12,000, however, which is perhaps indicative of a breakout.”

          - Monday Morning Outlook, Nov. 23, 2020 

In last week’s commentary, I discussed how two equity benchmarks – the S&P 500 Index (SPX – 3,638.35) and Nasdaq Composite (IXIC – 12,205.85) – were coming into Thanksgiving week near the top of a multi-month trading range, and displaying stronger price action relative to previous ventures into the 3,580 and 12,000 levels, respectively. With the uncertainty of the presidential election now behind us, and positive news on the vaccine front, I speculated we could be on the verge of a breakout.

This is indeed what happened, with the SPX taking out 3,580, notching three consecutive closes above the round 3,600 mark, and nabbing its first weekly close above this century level. These three closes above 3,600 improve on the two back-to-back closes above that level in mid-November. What’s more, the IXIC closed above the 12,000 level for only the second time in history, and also scored three consecutive closes, as well as its first ever weekly close, above that level. Also worth noting is there have been bullish 14-day relative strength index (RSI) divergences since mid-October, amid the higher IXIC closes.

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Behind Dow 30000: A Self-Perpetuating Upward Spiral.”

          - The Wall Street Journal, Nov. 25, 2020 

Dow’s Rise to 30000 Heralds a Broader Stock Rally.”

          - The Wall Street Journal, Nov. 25, 2020 

The benchmark that attracted the most headlines, however, was the Dow Jones Industrial Average (DJI – 29,910.37), which touched and closed above the 30,000-millennium mark for the first time on Tuesday. However, the DJI retreated below 30,000 on Wednesday, and ultimately closed the week below this level.  

Schaeffer's Senior Quantitative Analyst Rocky White will soon discuss the history and implications of the DJI touching this new millennium level in his Indicator of the Week. But for what it is worth, the 10,000 level was taken out in April 1999, and the 11,000 level was touched the following month. There were multiple retests of the 10,000 area through 2001, with massive selloffs in September 2001 and June 2002, following breaks back below the 10,000 mark. 

Then, the 20,000 level was taken out easily and quickly in early 2017. But unlike the 10,000 area – which was revisited multiple times beginning just a few months after the breakout – the DJI left 20,000 behind for a few years. That level was finally touched again earlier this year, following the massive February-March selloff driven by the COVID-19 pandemic and the government’s response to it.

If the SPX and IXIC are on the verge of a breakout, it will have to come as market participants grow even more bullish, as such bullishness represents growing market risk.”

          - Monday Morning Outlook, Nov. 23, 2020 

As I mentioned last week, we are seeing optimism creep into the market, which presents a risk from a sentiment perspective. But the price action up until this point is confirming that this increasing optimism was needed for a breakout to occur. In other words, hedging long positions with the CBOE Market Volatility Index (VIX – 21.93) around a multi-month low might be the most prudent course of action to manage risk.

But in no way should you reduce your exposure to the long side, as equities have not yet behaved in a manner that suggests bulls will unwind their long exposure. The SPX might have to incur a move back below the October closing high of 3,534, or experience a decline below 3,500, before bullish market participants revisit exposure and consider taking action to reduce it.

One market area that continues to show increasing optimism among short-term traders in the equity option world, is the 10-day, equity-only, buy-to-open put/call volume ratio -- though it continues to fall. In general, you want to be long when this ratio is declining, as it is now. But the best opportunities appear when this ratio is decreasing after hitting a relatively high level, which is not the case of its most recent peak. This means there is room for this ratio to retreat to its late August lows, which preceded a period of weakness for equities in September and October.

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This Wednesday, both Fed Chairman Jerome Powell and Treasury Secretary Steve Mnuchin will testify to the House Financial Services Committee on the pandemic response. Note that only a couple of weeks ago these two seemed to diverge on the specifics of how to address the pandemic going forward. With that on the radar, one thing I am noticing is a change in how options are being played on VIX futures, specifically those playing puts, per the chart immediately below.

There has been a drop-off in buy-to-open VIX put volume since early November, but the sell-to-open VIX put volume continued to surge. Due to option mechanics and hedging, the sell-to-open volume tends to create a floor at the relative strikes that are being sold, and there is significant put open interest at the 20-23 strikes on December VIX futures options (per the second chart below), with that contract closing at 22.80 on Friday.

After the surge in put buying that occurred in October proved to be smart money, and these put buyers disappeared, one could make the case that a VIX floor is close. However, I am not seeing an alarming amount of VIX futures call buying relative to put buying to suggest that a massive VIX advance is on the immediate horizon.

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

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