Don't Wait -- and Pay Up -- for Protection Right Now

The number of CBOE Volatility Index (VIX) outstanding option contracts will plummet this week

Senior Vice President of Research
Jan 17, 2015 at 9:30 AM
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It was another volatile week on Wall Street, with the Dow exploring a range of nearly 680 points. The blue-chip barometer suffered five straight losses until Friday's relatively modest rebound, due to plummeting crude prices, a shocker from the Swiss National Bank, and disappointing earnings out of the financial sector. Looking ahead, the European Central Bank (ECB) will take the spotlight during the holiday-shortened week, and Schaeffer's Senior VP of Research Todd Salamone expects volatility expectations to remain elevated.

  • The significance of CBOE Volatility Index (VIX) options expiration.
  • The support levels and moving average on our radar.
  • A long-term ray of hope from the VIX futures spread?

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: The Impact of VIX Options and the ECB
By Todd Salamone, Senior VP of Research

"If what lies ahead in the immediate days for the stock market is anything like we observed this past week, expect choppiness to be the order of the day ... Like last year, indexes are respecting round numbers and year-to-date (YTD) breakeven points."

"Next week is expiration for most options ... January SPDR S&P 500 ETF Trust (SPY - 204.25) options ... expire next week. If the market advances, resistance from heavy call open interest relative to put open interest occurs at the 205 and 210 strikes ... Note the enormous put open interest at the 200 strike ... if negative news hits the market, this strike could be a magnet, as short positions would have to be re-established."

"... it appears hedged money could be parking cash elsewhere and taking a 'wait and see' approach, with the SPX trading in the 2,000 area, the official start of earnings season next week, and Federal Open Market Committee (FOMC) and European Central Bank (ECB) meetings scheduled for later this month. Regardless of the motivation for low-hedging activity, we continue to advise having a hedge or short (put) exposure in place, especially with earnings season and the FOMC and ECB meetings just around the corner."

- Monday Morning Outlook, Jan. 10, 2015

"$VIX high today 23.34 (double the 11.82 December low is 23.64)"

"$SPY $200 magnet update: 8 of past 12 30-min intraday bars touch $200 and 16 of past 25 30-min bars touch $200 $PremiumSellerDream"

-@ToddSalamone on Twitter, Jan. 14-15, 2015

Last week's trading played out as we expected -- choppy, as the SPDR S&P 500 ETF Trust (SPY - 201.63) opened the week lower and rallied strongly to the call-heavy 205 strike Tuesday morning, before declining again. The balance of the week was range-trading around the 200-strike "magnet" following the release of poor retail sales data before the market opened Wednesday morning.

Heavy call and put open interest at the January 2015 200 strike was present throughout expiration week, so adjustments by sellers of these options likely influenced this narrow range around $200 (see the SPY January open interest configuration graph below the SPY 30-minute chart).

30-Minute SPY Chart since Jan. 12

SPY January Open Interest Configuration: Options that expired on Friday likely influenced last week's trading activity

SPY January 2015 Open Interest Configuration

Last week, we observed that various equity benchmarks peaked around last year's closing levels, and these are levels that we continue to watch as potential short-term resistance points. This past week can be summed up by round-number century and millennium levels coming into play as supportive. For example, the S&P 500 Index (SPX - 2,019.42), PowerShares QQQ Trust (QQQ - 100.82), S&P 400 MidCap Index (MID - 1,430.89), and Wilshire 5000 (W5000 - 21,244.68) found floors around 2,000, 100, 1,400, and 21,000, respectively.

In fact, it was in late August, or about five months ago, that the SPX first touched 2,000, which is where the index is parked now. Its peak last month was 5% above this major millennium mark, while at its trough in October, the SPX was 7% below the 2,000 area. From this vantage point, using the October and December trough and peak as reference points, there is roughly equal risk-reward.

That said, the SPX must break important support areas that are in play now before the October lows can be tested. For instance, the index comes into this week around the 2,000 millennium mark and its 120-day moving average -- a trendline we discussed last week as being supportive during multiple pullbacks since 2013 (exception being the October decline).

Additionally, SPX 1,980 could prove important as we enter the second half of the month, as it is the site of the index's 10-month moving average. Note on the graph below that the SPX has not experienced a monthly close below its 10-month moving average since January 2012, when it crossed back above this trendline. The moving average acted as a cap on rally attempts during the five months prior to the January 2012 breakout.

Monthly Chart of SPX since January 2011 with 10-Month Moving Average

We expect volatility expectations to remain elevated above 20, with monetary policy decisions from the Bank of China and the European Central Bank (ECB) on the calendar next week. With last week's surprise move from Switzerland's central bank to no longer cap-tie its currency to the euro, market participants will be paying close attention to these overseas central bank meetings.

Additionally, January CBOE Volatility Index (VIX - 20.95) futures options expire Wednesday morning, which means the last day to trade January VIX options is Tuesday. Currently, the VIX is trading just below 23.64, which is double last month's low at 11.82. As you can see in the chart below, the "double low" area marked the mid-December peak and, so far, this month's peak. It is likely, especially with a major call influence at the 23 and 24 strikes (see the January VIX open interest graph below the VIX chart), that the VIX settles below 23-24 on Wednesday morning.

Daily Chart of VIX since November 2014 with Line at Double Last Month's Low of 11.82
VIX Open Interest January 21 Expiration

But what happens after Wednesday is up in the air, as the ECB meeting occurs the following day, and could have the biggest impact on world markets, given that there is a lot of speculation on whether or not more stimulus action will be announced.

Additionally, any VIX January calls that are meant to be portfolio hedges will be expired by the time the ECB meets. In fact, of the 3.7 million call contracts outstanding, 2.0 million, or 56%, are due to expire on Wednesday. VIX put open interest will also fall off a cliff, as 1.4 million VIX put contracts, or 63% of puts outstanding, will expire on Wednesday. So, unless the expired calls are immediately replaced, the amount of portfolio protection outstanding will decrease substantially.

Despite reports that market participants are concerned about rising volatility in 2015, and are subsequently buying portfolio protection via VIX calls, we are not seeing such activity. A lack of portfolio protection, either because hedged money is reducing equity exposure or because portfolio protection is viewed as wasteful, is a risk to the market. And such a risk is all the more reason to have portfolio protection in place, as we advised last week, despite equity benchmarks sitting on support levels. If you wait to buy portfolio insurance on a break of support, it will likely be even more expensive than it is currently.

Indicator of the Week: VIX Futures Spread
By Rocky White, Senior Quantitative Analyst

Foreword: The S&P 500 Index (SPX) has pulled back sharply from its peak close reached on Dec. 29. As expected, the CBOE Volatility Index (VIX), which typically moves in the opposite direction of stocks, has spiked. However, the longer-dated VIX futures contracts did not see the magnitude of the spike that the front-month futures contract saw. As a result, the front-month VIX futures contract traded above the VIX futures contract four months away.

The VIX is a measure of how expensive options are for the SPX. When markets are in turmoil and/or there's a lot of uncertainty, then options become expensive (and the VIX increases). Evidently, VIX futures traders are expecting less expensive options in four months. I would conclude from this that they are expecting markets to calm down a bit going forward. This week I'm taking a look at prior times the long-dated VIX futures fell below short-dated futures to see if VIX futures traders have had a tendency of correctly predicting calmer markets going forward.

5-Day Futures Spread Goes Negative: In the chart below, the "5-Day Spread Percent" is a five-day average of the difference in the four-month VIX futures and front-month futures as a percentage of the VIX level. When the red line falls below zero, it means the longer-dated futures contract is below the front-month contract. The yellow circles on the SPX line mark times the spread percent fell below zero, but only if it's the first reading below zero in at least a month.

Taking a quick look at the chart shows the last five signals before the one last week were all at or near short-term market bottoms. However, the market has been strong over that period and any dot you'd place on the chart since 2009 would probably be a pretty good buying opportunity. There were also some signals before 2009 that would have been terrible buying opportunities.

SPX since 2006 with 5-Day Spread Percent

Quantified Results: The tables below summarize SPX results after those signals on the chart above, and then for the index anytime since 2006, for comparison. You can see the average return at two and four months after a signal is lower than typical returns, despite a higher percentage of the returns being positive.

The average negative return four months after a signal is more than 30% in four months. There are only two negative returns, but this explains why the average return is lagging. It looks as though there has been a lot more volatility after a signal, compared to normal -- especially to the downside.

SPX Returns After a VIX Spread Signal vs Anytime

With the signals occurring during different market environments, I'm not sure I would want to conclude much from the results in the tables above. Below is a table showing the returns after each of the signals. You can see the two signals that happened in 2008 led to huge losses.

I also show where the SPX was on the day of the signal, relative to its two-week high. Using this to measure the pullback, it seems the recent signal was on a very minor pullback. I bolded the five signals with the smallest pullbacks (or every one less than 5%, if that sounds better). No huge losses occurred after these particular pullbacks, and each time the SPX was positive four months later. So, at least we have that going for us.

SPX Returns After a VIX Spread Signal

This Week's Key Events: Blue-Chip Earnings, Housing Data in Focus
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.


  • Markets will be closed on Monday in observance of Martin Luther King, Jr. Day.


  • On Tuesday, the National Association of Home Builders will release its housing market index. IBM (IBM), Johnson & Johnson (JNJ), Halliburton (HAL), Morgan Stanley (MS), Advanced Micro Devices (AMD), Baker Hughes (BHI), Cree (CREE), Delta Air Lines (DAL), MGIC Investment Corp (MTG), Netflix (NFLX), Petmed Express (PETS), and Regions Financial (RF) will step into the earnings confessional.


  • The report on housing starts and building permits comes out on Wednesday. American Express (AXP), UnitedHealth (UNH), eBay (EBAY), TD Ameritrade (AMTD), Discover Financial (DFS), F5 Networks (FFIV), Fifth Third (FITB), Kinder Morgan (KMI), Logitech (LOGI), Northern Trust (NTRS), Sallie Mae (SLM), SanDisk (SNDK), United Rentals (URI), U.S. Bancorp (USB), and Xilinx (XLNX) will report their earnings data.


  • Weekly jobless claims, Markit's flash purchasing managers' manufacturing index (PMI), and crude inventories come out on Thursday. Across the pond, the ECB will announce its policy decision. Verizon (VZ), Travelers (TRV), Starbucks (SBUX), Alaska Air Group (ALK), Altera (ALTR), Capital One Financial (COF), Covidien (COV), Cypress Semiconductor (CY), E*TRADE Financial (ETFC), Fairchild Semiconductor (FCS), Huntington (HBAN), Intuitive Surgical (ISRG), Janus Capital (JNS), Johnson Controls (JCI), KeyCorp (KEY), Southwest Airlines (LUV), Skyworks Solutions (SWKS), Travelzoo (TZOO), United Continental Holdings (UAL), and Union Pacific Corp (UNP) will step into the earnings spotlight.


  • Friday's economic calendar includes the existing home sales report and the Conference Board's index of leading economic indicators. General Electric (GE), McDonald's (MCD), Bank of New York Mellon (BK), Honeywell (HON), Kimberly-Clark (KMB), and Rockwell Collins (COL) will release their earnings data.

And now a sector of note...


The utilities sector has been a strong performer on the charts over the long term. Of the 10 utility stocks we follow, eight are currently trading above their 80-day moving average. Even more impressive, these securities have gained, on average, nearly 27% over the last 52 weeks. Nevertheless, just 37% of covering analysts rate these stocks a "buy," suggesting upgrades could be in the cards. What's more, short-term put open interest outweighs call open interest, per the average Schaeffer's put/call open interest ratio (SOIR) of 1.03. A capitulation among these skeptical options bettors could create tailwinds.

In a similar vein, the Utilities SPDR ETF (XLU) has advanced more than 27% over the last year, and is currently sitting atop several layers of potential support. Specifically, the exchange-traded fund (ETF) is north of the $45 level, which corresponds with its 2007 peak. Also, the same area is roughly double XLU's March 2009 low and triple its October 2002 low, hinting at possible triple-barreled technical support. If the shares can sustain their momentum, additional buying power could result from short sellers and/or option bears throwing in the towel. After all, 31.8% of XLU's float is sold short, and its SOIR of 5.29 ranks in the 93rd annual percentile.

Monthly Chart of XLU since December 2007

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