Wall Street Just Completed This Mirror-Image Selloff

The unwinding of negative short-term sentiment could be supportive of stocks

Senior Vice President of Research
Oct 3, 2022 at 9:20 AM
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“Looking ahead, in two weeks we have a standard expiration that occurs in the final month of the quarter and the regular quarterly expiration on September 30. These end of quarter expiration months (March, June, September and December), from my experience, tend to have the biggest open interest builds relative to months where it isn’t an end of the quarter. The implication is that with more put open interest on equity index and exchange-traded fund options, in periods of market weakness, there could be more selling…As such, in such situations, you can sometimes throw your chart work out the window, as delta-hedge selling knows no chart boundaries... the odds increase that another June ’22 occurs, which was an extremely painful and dangerous few days for bulls.  

            -Monday Morning Outlook, Sept. 6, 2022

Since the beginning of September, the major focus of this commentary from week to week has been how the options market could exacerbate selling into September’s end. Going into the month of September, the market’s technical backdrop had been weakening, and major option expirations were approaching, seriously amplifying market risk. The idea was that the market weakness could snowball into a sharp decline, driven in part by option-related selling, much like we saw in June 2022.

Amid a weakening market, a plethora of market-moving events on the calendar -- and September marking a quarter-end month, multiple expirations with larger-than-normal put open interest builds on index and exchange-traded fund (ETF) options (including those options set to expire month-end last Friday) -- another sharp selloff was a growing possibility. The risk was big put open interest strikes below the market acting as giant magnets due to delta-hedging.

Delta-hedging occurs when sellers of those puts - normally to put buyers seeking portfolio protection – are forced to sell more and more S&P futures to remain market neutral as big put open interest strikes come into play and are eventually broken to the downside, a scenario that can feed on itself. This selling frenzy will manifest until expiration occurs, or there are no longer any big put open interest magnets below the market.

True to form, the September selloff mirrored June’s. In June, the S&P 500 Index (SPX – 3,585.62) declined by 12% from its closing high to closing low in 11 trading days. In September, the SPX closed out the month with a decline of nearly 13% in only 14 trading days. This qualifies for an exclamatory “YES” to the headline from my Sept. 6 commentary, “Could This Be a September to Forget for Bulls?

In fact, per the underline in the excerpt from the aforementioned commentary that I led off with, potential support levels have breached during the selloff, including the June lows being taken out, which is not a huge surprise during delta-hedge selling. 

 

 

Per my post on Twitter last Wednesday, much of the delta-hedge selling risk had dissipated. This isn’t to be confused as disappearing, as we saw late Friday. If delta-hedge selling was a major culprit in the magnitude of the equity market’s decline in a short duration, like June, I would expect that stocks find stability in the immediate days ahead.

mmo1oct2

If the market does not stabilize quickly with the expiration-related selling, this should be considered a major red flag for bulls. It could suggest that momentum sellers could do even more damage to the market in the weeks ahead.

That said, a couple more things are potentially aligning for bulls from a short-term perspective, with the caveat that a short-term bull would at least like to see a close back above the June lows. 

First, the Cboe Market Volatility Index (VIX – 31.62) peaked at 34.44 last week. Per the chart immediately below, peaks in 2022 have generally occurred in this area. Unfortunately, this is one of those scenarios where a short-term bottom may not occur until the VIX makes a brief move above this double low, as it did earlier in the year. But if last week’s peak is like that of June, when the VIX spiked as expiration-related selling occurred as I suspected it would, it may prove to be an excellent short-term buying opportunity. As such, whether you are long-term or short-term oriented and buying options, I would have both put and call exposure here. Especially as the market could be at the mercy of momentum sellers, or V-bottom if indeed much of the selling was expiration related and with quarterly expiration last week, such selling pressure has ended.

mmo2oct2

The second potential measure that could be supportive of stocks is the unwinding of negative short-term sentiment. But I cannot emphasize enough, there must be technical improvements in the major indices for bears to be worried and close bearish positions. Per the chart below, put buying on SPX components is extremely high and a similar level of pessimism marked a major bottom several years ago. Right now, the direction of this ratio favors the bears, which suggest that you too should have bearish exposure if trading. But if the SPX takes out its June closing low, be on guard for a rally into the next resistance zone around 3,800.

mmo3oct2

With both September standard and quarterly expirations now a thing of the past and quarterly options expiring on Friday, one potential salvation for bulls, in the immediate days ahead, is that delta-hedge selling risk that was clearly evident around this time last month has now passed. This could alleviate a giant overhang that has been lingering for weeks. Sure, momentum selling could occur in the days ahead, but most of the option-related selling has passed for time being, which could set the market up for a rally as to begin the last quarter of 2022.

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

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