Did Delta-Hedge Selling Play Into Last Week's Decline?

The S&P 500's 80-day moving average didn't hold, so now bulls hope 5,000 can be retaken

Senior Vice President of Research
Apr 22, 2024 at 8:55 AM
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“... The SPX is now 2.5% below its late-March closing high…  with optimism among active investment managers and newsletter writers in the early stages of unwinding, equity option buyers increasing the number of put purchases relative to call purchases, and shorts building positions in recent weeks, the risk of corrective action is heightened, since quantified momentum measures on the SPX are no longer in place….The SPY is currently sitting in the vicinity of the 510-strike, which is also home to more than 80,000 put open interest in the expiring April series. I point this out because a technical break below this popular moving average could induce selling. Moreover, those short 510-strike puts are likely to hedge their position by selling SPX futures to remain neutral. If an onslaught of both technical-based and option-related selling occurs, big put strikes – such as the peak put open interest at the 500 strike – could become magnets. ”

          -Monday Morning Outlook, April 15, 2024

Last week, I presented the growing risks to equity market bulls. Right after we shared this commentary, the potential scenario I presented for the upcoming week promptly unfolded.

The S&P 500 Index (SPX – 4,967.23) and SPDR S&P 500 ETF Trust (SPY – 495.16) broke below the popular 50-day moving average. Not only did this lead to sharp selling among technicians, but it also coincided with the SPY’s move below the 510-strike, generating option-related selling into the rest of standard April expiration week.

As anticipated, the SPY's 500-strike was in play during Wednesday and Thursday’s trading. By Friday morning, the SPY was below the 500-strike and quickly visited the 495- and 496-strikes, home to heavy put open interest thanks to a buildup during the week.

Last week’s action had the look and feel of delta-hedge selling, which I suggested was a possibility in last week’s commentary. During delta-hedge selling, sellers of the puts at the key strikes noted above sell SPX futures to remain delta neutral, as those strike prices come into view during expiration week.   

Negative headlines throughout the week may have been the lighter fluid that ignited such activity. Multiple members of the Federal Open Market Committee (FOMC), including Chairman Jerome Powell, indicated interest rates would likely stay higher for longer, as inflation has remained higher than anticipated. Plus, the conflict between Israel and Iran did nothing to support stocks. Throw in a negative earnings reaction on Friday from mega-cap Netflix (NFLX), and the fire was stoked.

In Friday’s session, not only did the round 5,000-millennium level fail to hold during the decline, but the unpopular yet sometimes important 80-day moving average – which acted as support in May and August -- did not stop the bleeding.

MMO 0421

It bears repeating that during a delta-hedge selloff, technical levels are not on the radar of those engaging in option-related selling. If indeed delta-hedge selling played a large role in the decline last week, the market should right itself quickly, since this risk is now greatly diminished with standard expiration in the rearview mirror. A start would be the SPX trading north of 5,000, which is also the vicinity of its 80-day trendline.

With the SPX now more than 5% below its late March closing high at 5,254, there is still a downside risk beyond technical support levels being broken.

As discussed in prior weeks, the unwinding of optimism is still a risk to bulls, as option buyers on SPX components stocks continue to buy more puts relative to calls. Per the chart immediately below, this means the 10-day buy-to-open put/call volume ratio on SPX components is continuing its ascent. The direction of this ratio (rising from a relatively low level) is a coincidental headwind that can persist, and there is room for this ratio to move to past highs.

MMO 0421 2

Moreover, it appears active investment managers, who chime in weekly about exposure in the National Association of Active Investment Managers (NAAIM) survey, are in what could be in the early to middle stages of unwinding full exposure to equities just a few weeks ago.

MMO 0421 3

Another notable level to watch for the VIX is 18.68, which corresponds with 50% above the 2023 close. If you follow the VIX closely, you know it tends to respect round numbers that anchor to a key high or low, or a key year-to-date percentage level.

          -Monday Morning Outlook, April 15, 2024

With the Cboe Market Volatility Index (VIX – 18.71) closing last week above 18.68 -- 50% above the 2023 close -- the SPX closing south of 5,000, and sentiment indicators moving in a direction that is unfavorable to bulls, be open to the possibility of the SPX moving to the 4,730-4,770 area, with 4,730 marking a 10% correction off the closing high and 4,770 being the site of the 2023 close.

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

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