Volatility Gauge Suggests Tactical Trading During Summer Doldrums

Is the July OPEX ringing a volatility bell?

CMT, Senior Market Strategist
Jul 19, 2021 at 8:44 AM
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With July options expiration now behind us, we head into some of the tougher few weeks for the market. We’ve been alluding to a possible uptick in volatility over the last few weeks, so I wanted to put some data behind it for our readers. In simple terms, we seasonally see an increase in volatility following the standard July expiration week, which commonly leads to temporary price declines.

"…With the Cboe Volatility Index (VIX -- 15.62) coming into a new week and quarter around 15 – which was its reading ahead of the early 2020 Covid-19 sharp selloff, and a level from which it has bounced in recent months – a hedge of long positions to protect against mid-summer and/or late-summer surprises could be appropriate."

Monday Morning Outlook, June 28, 2021

The Cboe Volatility Index (VIX - 18.45) spot price had been trading below historical averages for the better part of the spring and summer months. Furthermore, the three-month and six-month VIX Futures contracts have also been trading at a discount relative to their long-term averages. Finally, to reiterate our past few commentaries, the VIX appeared to be finding some level of support at the 15 level, which was the reading ahead of the 2020 Covid-19 pandemic selloff. With pent-up complacency finding support near a significant level, we’ve been potentially brewing a perfect cocktail of volatility that could cause major trends in equities to continue to pull back -- or even potentially break down.

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Let’s take a look at a recent study we did. In the first chart, we compared the 10-year and the 20-year seasonal patterns of the VIX. Over the past 10-years, the VIX has finished up +12.72% from July 1 through the end of August, and over 20 years returned +9.59%. Following the July standard options expiration, the 10-year average low is around -14.33%, while the 20-year average is only down -4.32%. Our low in the VIX so far in July was -4.8%, so we are possibly right on track with the 20-year average. You will also notice in the next two charts that we plotted the S&P 500 Index (SPX - 4,327.16) seasonality next to the VIX. As you can see, the equity market customarily finds a bottom near the end of August, with a low being put it on average around Aug. 25.

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The most reasonable explanation that this seasonal pattern occurs is trading volumes and liquidity are lower, as more market participants are away on vacation. From a psychological viewpoint, it could simply be a self-fulfilling prophecy as traders and investors expect it, so they tend to avoid it by reducing capital at risk and trading less until the end of August, when everyone is routinely back from summer vacations. Whatever the reason, the data doesn’t lie.

mmo3july18

In addition, we have another volatility gauge that is waving a cautionary flag. The Cboe VIX Volatility Index (VVIX - 128.89) simply measures the volatility of the volatility index. Recently, it’s been moving upwards ahead of the VIX, at a steeper slope since the beginning of July, while the VIX remained in a downtrend. What this tells us is VIX premiums are being priced higher by market makers, and this often happens as demand increases when market participants anticipate volatility and want to capture some insurance to hedge their portfolios. Two of the more recent examples where we saw this type of move correctly predict market volatility were February 2020 and January 2018. While this indicator by itself isn’t the most reliable signal that volatility is on the horizon, combining this with a confluence of other volatility and sentiment indicators tends to make it more dependable.

mmo4jul18

“Much like breadth, sentiment readings tell us that market participants are overly optimistic. The NDX buy-to-open put/call volume ratio just put in a seven-year low last week at 0.354, which was the lowest reading since July 8, 2014. What this is telling us is that we are in a higher-risk environment, as we are prone to a pullback. What people often fail to understand when looking at put/call levels is that we usually want to see a confluence of changes before making bearish bets outright. Two things we are looking for in particular is a rotation upwards from an absolute low, and a subsequent technical level breakdown in broad indices.”

Monday Morning Outlook, July 12, 2021

We mentioned last week that one of the things we look for when evaluating sentiment is absolute lows. This week, it appears that the all-optionable, equity-only put/call ratio is doing just that, as it’s trying to flesh out a base with a reading of 0.353 last week, and coming off June’s all-time lows to boot. Furthermore, the SPX Components 10-day buy-to-open put/call volume ratio, albeit not budging much, seems to be trying to round out a bottom with a close last week of 0.347, and with the lowest reading of the year just occurring on July 7 at 0.336.

mmo5jul18

This past week, the S&P 500 ETF Trust (SPY - 431.34) momentarily eclipsed the +100% level for the first time since the pandemic lows. I could not help but think how interesting it is that round numbers seem to work out so well, which is something we’ve been preaching about for years. The SPY peaking at that +100% level coincided with the index nearing the upper end of the 2021 price channel and peak call level at the 440-strike for July OPEX. As we explained last week, this had potential to be an area of resistance.

While we are now on the lookout for increased volatility, let’s look at potential pullback zones for the S&P 500. The first and most obvious area traders will look for an opportunity to buy the pullback will be at the 20-day moving average, which is now only 22 points away at 4,305 on the S&P. Although bulls will certainly fight to hold the 20-day moving average, there are plenty of catalysts to bring the market down further. Another, and somewhat obvious level, is the 50-day moving average, but this area also brings with it a support zone between 4,232 and 4,252, where we broke out to new highs in June from a two-month consolidation phase and right near the lower end of the price channel we’ve been tracking throughout 2021.

newmmospx

Finally, a less evident but significant spot would be the 80-day moving average that is presently at 4,187. This would bring us to the June bottom and the contentious area in May, where we experienced a gap down. Furthermore, the 80-day has marked plenty of important bottoms throughout time, most recently the March 2021 lows, where we snapped back into the price channel.

It’s almost as if July OPEX rings a volatility bell. Therefore, it would be prudent to wade carefully through the next few weeks as a precautionary measure. Adding some speculative put positions or hedges are appropriate actions one can take to stave off any possible short-term headwinds. Although, one should also be ready to shed those positions at potential support zones and be ready to flip long once again, since being tactical has proven to be a profitable dip-buying opportunity as we move through the summer doldrums.

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