If You Want to Hedge the SPX, Now Is the Time

Contrarian traders should keep an eye on rising call open interest

Senior Vice President of Research
Jan 29, 2024 at 10:00 AM
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Since the S&P 500 Index (SPX — 4,839.81) neared its all-time closing high in late December, a breakout above this level remained elusive...until Friday. a potential tailwind, the short covering that emerged in the second half of December, could help support a breakout.

          -Monday Morning Outlook, January 22, 2024

Last week, I mentioned the S&P 500 Index (SPX—4,890.97) had finally broken out above all-time highs, with the added bonus of strong short covering potential to help support a sustained breakout.

I did not address the historical implications of the SPX breakout but, we covered this in the February 2024 issue of our monthly newsletter, The Option Advisor, published on Friday.

Our own Senior Quantitative Analyst Rocky White looked back at the historical implications of the SPX breaking out to new all-time highs after going more than a year without achieving this milestone. The historical results using data since 1954, per the tables below, are unambiguously bullish over the several time frames measured.

All timeframes had a higher probability than normal for bullish action, with only the three-month time frame seeing a lower return and bigger drawdown than average. Keep in mind that the three-month return saw only one instance of being lower in the 14 signals. 

MMO IOTW

A weekly exercise I have been doing most weeks since the strong rally stemming from the late-October trough is gauging how short-term traders are viewing the momentum. Each Friday, I look at the five-day open interest changes on the SPDR S&P 500 ETF Trust (SPY—487.41) options that are expiring that day, so in this case I looked at Jan. 26 options on strikes in the vicinity of the SPY (475 through 495 strikes).

As you can see, there is not a “the sky is the limit” mentality, with the preponderance of the activity on the put side (as option players look for a reversal lower). There were liquidations, or open interest decreases, at some strikes – all calls.

As such, a potential warning sign from a contrarian perspective is the point at which the activity below is skewed strongly to the call side, as the put activity has been notably evident for weeks.

SPY Put OI

“…a positive is that total short interest on SPX component names hit a multi-year high in mid-DecemberThis implies that there is plenty of short covering potential to keep pullbacks in check and/or a continuation of the rally from the late-October low after about a three week pause.”

            -Monday Morning Outlook, January 22, 2024

Late last week, short interest data on the exchanges as of mid-January was released. As usual, we compiled this data and graphed total short interest on SPX components. The short covering that began in the second half of December continued through the first half of January.

As mentioned in previous commentaries, SPX component short interest hit a multi-year high in mid-December and, even though the SPX is at all-time highs, there is plenty of potential short covering that could occur before short interest levels hit lows that are consistent with major pullbacks. In other words, the decreasing short interest from a relatively high level is bullish in its implications.

SPX SI MMO

“…note that the 30-day moving average marked last week’s trough before a short-term, “cup-and-handle” breakout to new all-time highs. As such, the 30-day moving average might be of significance in the days and weeks ahead, just as it was in mid-October when it capped a mini-rally prior to the ultimate low in late October.”

            -Monday Morning Outlook, January 22, 2023

At the very least, continued short covering could keep pullbacks to a minimal level if buyers suddenly go on strike, albeit bulls would love to see continued short covering drive the SPX higher.

That said, the SPX entered a short-term “overbought” condition early last week, according to its 14-day Relative Strength Index (RSI), and active fund managers increased equity exposure to a near “fully invested” allocation. This comes prior to a Federal Open Market Committee (FOMC) meeting this week. After the November and December meetings, stocks exploded higher.

As such, a short-term scenario is price action that isn’t necessarily bearish, but looks like that of late-December through early-January; a pause with minimal drawdown before the next leg of the rally.

One level I am watching overhead is 4,940, which is 20% above the October closing low. If a pullback occurs, the first level of potential support is around 4,800, the area of the all-time high in January 2023. The important and rising 30-day moving average is currently just under 4,800, and based on the current slope, will be situated at 4,815 at this time next week.

Stay the bullish course. If you want to hedge FOMC risk, now is the time to do so, ahead of the meeting and with the CBOE Volatility Index (VIX - 13.26) just above its 52-week closing low that occurred in mid-December.

SPX Backdrop MMO

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

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