Monday Morning Outlook: Will VIX Call Buyers Finally Be Rewarded?

Key CBOE Volatility Index (VIX) levels to watch during what should be an 'interesting' options expiration week

by Todd Salamone

Published on Dec 13, 2014 at 8:52 AM
Updated on Apr 20, 2015 at 5:32 PM

It was a rough week for stocks -- the worst for the Dow, in fact, in more than three years -- but it was a banner five days for the CBOE Volatility Index (VIX). The "fear index" ripped more than 78% higher by Friday's close, while the S&P 500 Index (SPX) slipped less than 2%. As we head into December expiration week, Todd Salamone explains the market mechanics that should make this a very "interesting" week of trading.

  • How a rush to hedge could keep stocks under pressure.
  • Key VIX levels to watch as Wednesday's VIX expiration approaches.
  • Rocky White explains how window dressing takes an unexpected turn in the fourth quarter.

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.

Notes from the Trading Desk: How Hedging Activity (or the Lack Thereof) Affects Stocks
By Todd Salamone, Senior VP of Research

"... [W]e still have not lost sight of the fact that the 'higher volatility ahead' trade -- via the purchase of CBOE Volatility Index (VIX - 11.82) calls -- has deteriorated significantly in recent weeks ... But we know the market could succumb at any moment to 'known' or 'unknown' issues or events ... Nonetheless, volatility players and/or those that typically buy portfolio insurance through the purchase of VIX calls have essentially left the building ... Therefore, with VIX futures relatively low -- plus major equity benchmarks around the world trading near potential millennium resistance levels -- it might be prudent to add VIX calls as a portfolio hedge before something emerges that sparks renewed interest in the once-popular volatility trade."
- Monday Morning Outlook, Dec. 6, 2014

"$VIX up 70% from last week's close of 11.82. Double 11.82 is 23.64 and potentially a key area heading into Friday's trading. $SPX"
-@ToddSalamone on Twitter, Dec. 12, 2014

"Investors watching oil plunge day after day are growing concerned the decline will destabilize financial markets and that's boosting demand for hedges ... Signs abound that investors want to lock in equity gains or protect against sudden losses."
-Bloomberg, Dec. 12, 2014

Volatility, as measured by the CBOE Volatility Index (VIX - 21.08) and VIX futures, exploded higher last week, amid multiple headlines ranging from political uncertainty in Greece, to a continued plunge in crude, mounting worries about slowing growth in China, and speculation that the Fed might change its wording to imply a rate hike is getting closer next week.

The volatility was especially explosive considering equity benchmarks experienced only a modest retreat. For example, the VIX rose about 70% from Oct. 3 to Oct. 13 during a 4.8% S&P 500 Index (SPX - 2,002.33) decline. Similarly, the VIX rose 70% from the Dec. 8 close to Thursday's close, but the SPX decline during the same four-day period was only 1.2%.

Put open interest on the SPDR S&P 500 ETF Trust (SPY - 200.89) grew by 1.1 million contracts last week, 37% above the week prior. However, total SPY put open interest of roughly 15 million contracts is more than 15% below its September peak of 18 million contracts.

Meanwhile, VIX call open interest increased by 300,000 contracts, after traders reduced outstanding calls in the prior week. But VIX call open interest stands at only 4.25 million contracts, lower than 94% of the daily readings during the past 52 weeks, and more than 50% below the 2014 peak of more than 8 million contracts. Moreover, over half the current outstanding VIX calls will expire in the middle of this week, hours ahead of the release of the Federal Open Market Committee (FOMC) policy statement.

Put another way, even though hedging activity increased this past week, as noted in the Bloomberg excerpt above, it remains relatively low when compared to what we have observed during the past several months. As we discussed last week, those utilizing hedging activity in their portfolios might be accustomed to seeing their option hedges expire worthless month in and month out, or do not see the need for portfolio protection during a strong seasonal period for equities. Regardless of why hedging activity has dried up in recent weeks, stocks are more vulnerable than usual to panic-selling or headwinds stemming from a sudden increase in hedging activity driven by negative headlines.

VIX call open interest has fallen off a cliff, ahead of a major VIX pop last week

VIX Daily Open Interest since January 2014
Chart courtesy of Trade-Alert

Despite the shallow pullback in equities up to this point, potential short-term support levels did not hold. For example, the SPX broke below the 2,033 level, which represents a 10% year-to-date (YTD) gain. Moreover, the SPX fell below: 2,049, which is 10% above its recent closing low; its 30-day moving average, a trendline that marked support during the May-July rally earlier this year; and the 1,916 level, which is 10% above the 2014 low. The next layer of support is at the round 2,000 millennium level, site of its 80-day moving average and heavy put open interest in the standard expiration series that expires this coming week.

Daily Chart of SPX Since December 2013 with 30- and 80-day Moving Averages and Lines at 2,033 and 2,049

The Russell 2000 Index (RUT - 1,152.45) failed to sustain a move above 2014 resistance at 1,180, and at week's end fell back into negative territory for the year, with a close below 1,163.64. The YTD breakeven level on the RUT has been a magnet within the scope of a trading range this year. In fact, in 38 of the 241 trading days this year, the RUT has crossed 2013's close -- almost 16% of the trading days throughout the year. Moreover, it has crossed this mark in eight of the last 17 trading days.

The iShares Russell 2000 ETF (IWM - 114.71) enters expiration week trading at the bottom of its range since Nov. 19, but below its YTD breakeven point of $115.36 and below $114.75, which is 10% above its mid-October closing low. More importantly, the IWM is below the put-heavy 115 and 116 strikes.

As we have explained in prior reports, after a break below a major put strike in the days preceding expiration, other heavy put strikes below can act as magnets in a process called "delta-hedge selling." Delta-hedge selling occurs when an underlying approaches heavy put strikes and the options become more sensitive to the movements of the asset, forcing sellers of the puts to short futures to offset losses from the puts they sold to buyers of those options. In this case, heavy put open interest is stacked down to the 109 strike, which is coincidentally around the February and May lows.

Therefore, the IWM's close below the put-heavy 115 and 116 strikes enhances the possibility of delta-hedge selling. That said, a strong rally off the bottom of its short-term trading range could inspire short covering related to the expiring put open interest.

IWM December Open Interest Configuration

Finally, we are closely watching the VIX, which hit a high of 23.06 in Friday's trading, before settling at 21.08. After consecutive months in which 90% to 99% of VIX call options expired worthless, could this be the month that the few who stuck with the higher-volatility trade are rewarded with call options that expire with significant value?

As we head into expiration week, and given the recent trajectory of VIX and VIX futures, sellers of VIX call options run the risk of a continued advance in volatility, so they may be looking to hedge this risk by buying VIX futures, which could drive volatility higher and stocks lower. December VIX futures closed on Friday at 19.58, just below December's peak call open interest. If the VIX surges above 23.64 -- double its recent low -- and December VIX futures move above 20, we could see another sharp increase in the VIX, especially if VIX call buyers suddenly surface again.

But if you think past is prologue, expect to see a VIX settlement price Wednesday morning that is below 16, repeating a pattern where the vast majority of VIX call open interest expires worthless (see second graph below -- December VIX open interest configuration). For those of you not familiar with VIX options, the December series is based on December VIX futures, and the last day to trade December VIX options is Tuesday, ahead of Wednesday morning settlement.

With an FOMC meeting this week, there might be a little juice in SPX option premiums that is driving volatility expectations higher. Stay tuned -- it should be an eventful expiration week.

Daily Chart of VIX since January 2014 with Line at 23.64

VIX Open Interest Configuration December 17 Expiration

Indicator of the Week: Window Dressing
By Rocky White, Senior Quantitative Analyst

Foreword: It is expected that many mutual funds and other portfolio managers partake in a dubious custom called "window dressing." This is when mutual funds buy stocks that have been outperforming near the end of the quarter, just before the reporting period. This way, when they send their quarterly reports and disclose their holdings, it looks as though they had the foresight to invest in these high-flying stocks. Similarly, they sell stocks that have been underperforming to hide the fact they owned market laggards. This is done to fool those who invest or may potentially invest in their fund. It makes their portfolios look stronger than they actually have been. This week, I'm going to see if we can quantify the evidence that window dressing is, in fact, occurring. If it is prominent, then maybe we can predict which stocks will benefit and which will suffer because of this ruse.

Window Dressing Since 2010: To find evidence of window dressing, I went back to 2010 and looked at how all stocks (that met some liquidity guidelines) did in the final two weeks of each quarter. I also found out how each stock did in the preceding six months before those last two weeks. For evidence of window dressing, I determined the best 25 and worst 25 stocks each quarter, according to those six-month returns, and compared this data to the returns of those stocks in the last two weeks of the year.

If window dressing had a significant effect on the stocks, you'd see the stocks with the best six-month returns tending to outperform those with the worst six-month returns. Again, this is because portfolio managers are purchasing the outperformers and selling the underperformers just before the end-of-quarter disclosures are released.

The table below shows the results. There is clear evidence of window dressing in these numbers. The best-performing stocks in the preceding six months have averaged a gain of 0.48% over the final two weeks of the quarters since 2010. Meanwhile, the stocks doing the worst over the prior six months have averaged further losses of 1.03% over the final two weeks. Also, 54% of the best-performing stocks were positive in the last two weeks, while less than half (48%) of the worst performers were positive.

Stock Performance in Last 2 Weeks of the Year Since 2010

In Which Quarters is Window Dressing Most Prominent?: I wondered if window dressing was more prominent in some quarters than others. Using the same criteria as above, I found the average return of the stocks depending on the quarter. If window dressing is significant in the quarter, then for that quarter the average return in the "Best Performers" column should be better than the average in the "Worst Performers" column.

From the data below, if you're looking to profit from window dressing this quarter, you might want to reconsider and wait until 2015. During the tail end of the fourth quarter, the worst-performing stocks in the preceding six months have actually done better than the best-performing stocks. Maybe there are other considerations for portfolio managers in the final quarter of the year (tax considerations, perhaps?) that override window dressing. Whatever the reason, it's something we will revisit next March.

Stock Performance in Last 2 Weeks of Each Quarter Since 2010

This Week's Key Events: All Eyes on the Fed
Schaeffer's Editorial Staff

Here is a brief list of some key market events scheduled for the upcoming week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.

Monday

  • The week starts off with a bang, with the Empire State manufacturing index, industrial production and capacity utilization, the National Association of Realtors' pending home sales index, and Treasury International Capital (TIC) all slated for release. FuelCell Energy (FCEL) and VeriFone (PAY) will release earnings.

Tuesday

  • On Tuesday, the Federal Open Market Committee (FOMC) will kick off its two-day policy-setting meeting. Also on the docket is data on housing starts, plus Markit's flash purchasing managers manufacturing index (PMI). Darden Restaurants (DRI), FactSet (FDS), and Navistar (NAV) will report earnings.

Wednesday

  • The latest policy announcement by the FOMC highlights Wednesday's docket, as well as the subsequent press conference from Fed Chair Janet Yellen. Also being released is the consumer price index (CPI) and the weekly crude inventories report. FedEx (FDX), General Mills (GIS), Joy Global (JOY), and Oracle (ORCL) will show their earnings power.

Thursday

  • Weekly jobless claims and the Philadelphia Fed's manufacturing survey come out on Thursday. On the earnings front, Nike (NKE), Accenture (ACN), Cintas (CTAS), ConAgra (CAG), NQ Mobile (NQ), Pier 1 Imports (PIR), Red Hat (RHT), Rite Aid (RAD), and Scholastic Corp (SCHL) will report.

Friday

  • There are no notable economic reports on Friday. BlackBerry (BBRY), CarMax (KMX), Finish Line (FINL), and Paychex (PAYX) will step into the earnings spotlight.

And now a sector of note...

Retail
Bullish

The retail sector has been in the headlines recently, with holiday shopping season getting into full swing. In fact, November retail sales figures topped expectations last week, helping to power a broad-market rally on Thursday. Meanwhile, the SPDR S&P Retail ETF (XRT) looks like an interesting play. The shares are currently sitting atop several layers of previous resistance, including their year-to-date breakeven mark of $88.10, and $90.12 -- a 10% premium to XRT's mid-October closing low of $81.93. What's more, the round-number $90 level is significant, as it's roughly double the exchange-traded fund (ETF)'s 2007 and 2010 resistance level at $45, and could now reverse roles to act as support. That said, this past week's pullback to the $90.50 area provides a potentially solid entry point, especially if retailers continue to benefit from lower gas prices translating into more consumer spending.

Digging deeper, two-thirds of the 73 retail stocks we follow are trading above their 80-day moving average. Nevertheless, the typical short interest-to-float ratio among these equities exceeds 12%, which would take roughly six sessions to cover, given average daily trading volumes. Also, fewer than half of the brokerage firms covering these names have handed out "buy" ratings. All things considered, retail stocks could be poised to run higher on potential short-covering activity and/or a round of analyst upgrades.

Weekly Chart of XRT since January 2007

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