Don't Be Surprised If This Selloff Sticks

Delta-hedge selling is in play this month

Senior Vice President of Research
Dec 6, 2021 at 9:33 AM
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Last week was chock-full of headlines, ranging from mixed opinions on whether current vaccines will be effective against the newly identified Covid-19 omicron variant, to the Federal Reserve's pivot during Chairman Jerome Powell’s Senate banking testimony, in which he suggested it was time to retire the word “transitory” when talking about inflation.

With that, Powell and other Fed governors indicated the end of the Fed’s bond purchases would likely conclude before the timeline announced at the Fed meeting in November. If you don’t follow Fed matters closely, if bond purchases tapering ends sooner than originally planned, the implication is that a rate hike in 2022 could come sooner than expected, since the Fed has previously said rate hikes won’t begin until bond purchases have concluded.

The concerns of slowing economic growth related to uncertainty regarding the emerging omicron variant, combined with a more “hawkish” Fed, reminded me of my Nov. 30 observation on Twitter about December 2018. During that period, the S&P 500 Index (SPX — 4,538.43) dropped nearly 15% from the beginning of the month into Christmas Eve. Economic uncertainty persisted, driven by a trade spat between the U.S. and China and a looming government shutdown, but the Fed hiked rates in mid-December anyway. Does this sound somewhat familiar?

"While the decline to the 2,400 area from last week's close at 2,600 may not come as a huge surprise to many of you, the fact that it took only a few days to occur may have been the most surprising. Once again, the accelerated selling may have had something to do with options expiration, in a week that was filled with negative catalysts to get the ball rolling to the downside (a Fed rate hike, Fed Chair Jerome Powell foreshadowing more tightening, the threat of a looming government shutdown, President Donald Trump's trade advisor indicating a deal with China is not likely within 90 days, and so on)."

- Monday Morning Outlook, December 24, 2018

Why would I include an excerpt from a nearly 3-year old commentary? My observation on Twitter the following day is the reason. Concerns about economic uncertainty and Fed hawkishness are parallel to December 2018, but so too is the enormous put open interest on SPDR S&P 500 ETF Trust (SPY — 453.42) at multiple strikes immediately below where the SPY is trading, which is also akin to December 2018. 

Not only could the selling be technical-related — as previous highs in September are breached along with important moving averages that have served as support during previous declines this year — but option-related, as sellers of the current out-of-the money puts that wish to remain neutral are forced to short more and more S&P futures, and the SPY approaches heavy put open interest strikes. This is known as delta-hedge selling.

The open interest configuration has changed since my Twitter observation last week. As we head into the two weeks prior to standard December expiration, the first SPY strike that is both heavy put open interest and outweighs call open interest is at 450, or equivalent to 4,500 on the SPX.

A significant break and close below this level, and the SPX’s 80-day moving average, could easily precede a move down to the 4,300 level on the SPX, or the October lows. Coincidentally, the SPY 430-strike, which is equivalent to SPX 4,300, is home to peak put open interest in the December series. Bulls could get a reprieve around SPY 440, as it does not have a lot of put open interest relative to call open interest, implying a much smaller magnet effect relative to other major put open interest strikes.

If the SPY 430-strike is breached well ahead of December 17 expiration, be open to the possibility of a move down to the 400-strike, or 4,000 on the SPX, which is the last heavy put open interest strike.

Delta-hedge selling is not a slam dunk, but bulls beware that the chances of such a scenario developing have increased considerably. Such market action would be a major hit to those that trade seasonality, with December’s historically bullish bias.

MMO  December OI



"Bulls would like to see the VIX move back below its 2020 close, to be a sign that there is a promising resolution to the headlines from Friday. A move above the intraday highs since May could signal there is still more danger to come, within the respect of selling off equities and higher volatility expectations."

- Monday Morning Outlook, November 29, 2021

There are other clues on my radar for corrective price action like we saw in December 2018, a couple of which I highlighted on Twitter last week.

The first was Wednesday’s SPX candle, known as a bearish outside day, indicating continued selling into rallies. It was the second bearish outside day in a seven-day trading day period. These bearish candles followed the three-day candle pattern I cautioned about in early November, beginning with the two consecutive doji days on Nov. 5 and 8, and ending with the SPX’s close at its low on Nov. 9. Arguably, the early-November three-day candle pattern was similar to the four bearish “tri-star doji” patterns that appeared ahead of noticeable short-term pullbacks this year.  

Another discouraging sign for bulls is the recent action in the CBOE Volatility Index (VIX— 30.67). After peaking the previous week around its May and September highs, Wednesday’s pullback and subsequent low occurred around its 2020 close at 22.78. But that low was intraday, and the VIX closed above its May and September highs. As I said last week, a VIX close above the May and September highs could be a sign that higher volatility expectations and lower stock prices are imminent.

The next lines in the sand for a potential VIX peak are 34.17, which is 50% above last year’s close, and this year’s closing high at 37.21. However, if a delta-hedge selloff emerges during the next few weeks, the VIX could triple from its recent closing low around 15. This would mean a VIX reading of 45, which is double last year’s close. In December 2018, it peaked around 36, tripling from a then recent low in the 12 area.     


Finally, the relatively low 10-day buy-to-open put/call volume ratio on SPX components is a concern now that there has been technical deterioration in the market, amid increasing vulnerability to delta-hedge selling in the near term. In fact, the ratio appears to have troughed, indicating a peak in the growing optimism is in for the time being.

However, this ratio is not yet indicating growing fear, as the ratio of put buying to call buying among equity option buyers on SPX components is not moving sharply higher from its recent low point. This implies that equity option buyers have yet to panic, suggesting there is a segment of the market that still represents considerable selling potential.

SPX pc ratio 10 day

Be wary of buying into rallies unless key technical levels just overhead are taken out. Note that so far in 2021, three-day bearish candle patterns preceded pullbacks this year. Buy signals occurred after the SPX moved above short-term trendlines connecting lower highs during the pullbacks.

A trendline connecting lower highs since the bearish outside day on Nov. 22 begins the week at 4,595, and on Friday will be sitting at 4,525. Since the trendline is steep, a close back above the September high in the 4,535 area might be a “must” before buying the dip in the days ahead. Moreover, a VIX reading below previous highs in the 28-29 area should be considered before going long, or unwinding any of your hedges to long positions.

In the meantime, realize the worst of this selloff may not be over, and that what happened in December 2018 could happen again. For now, the SPX is clinging to potential support, as it closed above the September closing high and its 80-day moving average, which was support at the trough in early March.

Moreover, the SPY closed above that key 450-strike. Dare I say it, the close above SPY 450 on Friday is the silver lining for bulls, since there is bullish unwind potential from short positions being covered related to the put open interest at the 450-strikes and below. This scenario is a possibility, if the SPY remains above this strike into December expiration.  

In other words, big put open interest at multiple strikes at and below the SPY 450-strike either exaggerate a downside move if delta-hedge selling occurs, or are supportive as any short positions related to the put open interest are slowly unwound as expiration approaches.


SPX 80day

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

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