Last week’s SPX low was the site of its 50-day moving average, as well as its early-May peak
“While we are now on the lookout for increased volatility, let’s look at potential pullback zones for the S&P 500…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.”
- Monday Morning Outlook, July 19, 2021
Just in time for the July 21 expiration of options on Cboe Market Volatility Index futures (/VXc1), the volatility pop that we were expecting came to fruition. We mentioned expiration of options on the July futures contract this past Wednesday because the July futures contract was trading around huge put open interest strikes the week prior, just above 17.00 on July 15.
The Wednesday morning settlement of 18.90 meant that many puts expired worthless, with the 19-strike put only worth 10 cents. It reminds me of a pattern in prior years where there was a noticeable pattern of many calls expiring worthless after being "in play" prior to expiration. Also, for what it is worth, the July contract high on Monday was 24.76, just shy of the huge call open interest at the 25-strike, leaving call buyers at this strike with a worthless trade too at expiration.
As for the Cboe Market Volatility Index (VIX - 17.20), after peaking at its 320-day moving average for the second time since May and closing below its 2020 close following the Monday-Friday spike, it now has a little room to decline to the 15 area, which acted as a floor in the second quarter, but preceded only short-term trading range behavior or a mild pullback.
As we suggested in last week's commentary and on Twitter, a break below the S&P 500 Index's (SPX - 4,411.79) channel could be temporary based on historical action, given buyers usually surfaced at its rising 50-day moving average, which has rested just below the channel during the past several months.
This analysis was spot on, as last week’s low was not only the site of its 50-day moving average, but also its early-May peak, which was the last time the SPX traded above this channel. If the SPX is going to take out channel resistance this week, it will have to close above the 4,435-4,453 range. The bottom of this channel ranges between the 4,300-century mark and 4,320. Meanwhile, the SPX’s 50-day moving average, which has marked troughs in five of the past six pullbacks, comes into the week at 4,256. With the Fed meeting this Wednesday and the heart of earnings season approaching, it is not out of the question for these support and resistance levels to be tested in the immediate days ahead in volatile, choppy trading.
“Record Stock Rally Ignores Wall Street's Phobia About Optimism”
- The Wall Street Journal, July 18, 2021
In addition to fears about the highly contagious Covid-19 delta variant stifling the economy, or “bad inflation” that is more than transitory due to supply bottlenecks, another fear has been the growing optimism among investors. As I have implied many times, such optimism represents a risk, but it is not exactly a great timing indicator when paired with the bullish price action we have observed the past several months.
If a major technical breakdown occurs amid this optimism, investors should take note. But as it stands, perceived risks should be managed with hedges when portfolio insurance is cheap, and/or call options should be emphasized to leverage the current uptrend with less dollars at risk.
However, traders are not behaving in this manner. At the first hint of a selloff, a shift in sentiment occurs, even though the SPX and other indices have not fallen below key levels of support during the various pullbacks this year. For example, the buy-to-open put/call ratio on individual equites tends to increase as stocks drop, even when such declines have proven time after time to be buying opportunities. Moreover, weekly surveys of investor bullishness will see the bullish percentages quickly drop at the first hint of trouble.
In the options market, a rising number of bears was really pronounced on components of the iShares Russell 2000 ETF (IWM - 219.55) during the latest decline. Even though the $210 level has marked support during pullbacks since February, note the spike in the 10-day, buy-to-open put/call volume ratio on IWM components.
While some technicians may view the ETF’s pullback to its 200-day moving average, which is situated at the $208 level, as a buying opportunity, option speculators were heading for the hills instead, even though $210 support has not yet broke and the ETF remains above this long-term moving average. In fact, the 10-day, buy-to-open put/call volume ratio on components of the IWM is now closer to its highs during the past two years.
The fact that a healthy number of traders are panicking before support levels break might suggest that optimism is not as prevalent as perceived. Yes, there will be a time that these support levels break down when few are expecting, and that is when a more pronounced unwinding of optimism could take hold, causing more damage to equities.
But as I have said many times, declines up to this point have not been enough to test the nerves of those that have been long in this market for months, even those labeled as the “weaker hands.” If the indices trade above or around support levels, be wary of trading against the underlying trend. It is one thing to manage risk, but it is another to fight the market and misplace the implications of optimistic sentiment readings in a bull market.
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