How to Regroup After Last Week's Pullback

Keeping an eye on SPY skew as year-to-date breakeven levels come back into play

Senior Vice President of Research
Mar 9, 2015 at 8:24 AM
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"One short-term risk we see is that on Wednesday, the SPY experienced a candlestick 'doji,' in which the open and close were nearly the same. Such candlesticks will sometimes indicate increasing risk of a reversal. So, from this perspective, bulls beware. If recent support from the SPY's 10-day moving average at 210.79 is broken, look for a move back to the December highs in the 209 area... In fact, in looking at each expiration series through mid-April, the SPY 3/6 weekly option expiration series has the lowest ratio of put open interest to call open interest. From this perspective, this suggests that there is more optimism than usual for the immediate days ahead, which may put the market more at risk of an early March pullback..."
-- Monday Morning Outlook, March 2, 2015
"Fed funds futures, used by investors and traders to place bets on central bank policy, showed Friday that investors see a 21% likelihood of a rate increase in June, compared with 16% a day earlier, according to data from CME."
-- The Wall Street Journal, March 6, 2015

Last week's pullback was not a major surprise, with the majority of the downside occurring on Friday, following a stronger-than-expected employment report. Overall, it was a busy week, punctuated by the release of multiple economic reports -- highlighted by slowing wage growth and weaker-than-expected consumer spending and factory orders. However, on Friday, the focus was the larger-than-expected job creation in February, causing investors to raise their expectations for a June rate hike, and sending bond yields and the dollar significantly higher.

That said, the magnitude of last week's pullback was larger than we expected. After the SPDR S&P 500 ETF Trust (SPY - 207.50) bottomed Wednesday morning in our anticipated support area around $209, it stalled on Wednesday afternoon and Thursday at repeated attempts to rally above the prior week's close at $210.66. Finally, on the heels of the Friday morning employment number, the exchange-traded fund (ETF) broke below several heavy put open interest strikes (209, 209.50, and 210) in the 3/6 weekly options expiration series. Moreover, there was a frenzy of put buying on the weekly 3/6 SPY 208-strike put, perhaps adding to the weekly expiration-day selling.

30-Minute SPY since 2/27

Regardless, the SPY broke below its December highs, which we were anchoring to as a potential support area last week. Now, the January highs in the $206 area -- which is also home to SPY's 40-day and 80-day moving averages -- become a potential support zone in the days immediately ahead. Also, note that SPY's Dec. 31 close is at $205.54, adding an additional layer of support, from a technical perspective.

Daily SPY since October 2014

In the middle of last week, we observed that multiple equity benchmarks we monitor were pulling back to round-number areas. However, on Friday, these indexes broke south of their respective round-number levels, following the Nasdaq Composite's (COMP - 4,927.37) decline back below 5,000 earlier in the week. The fact that multiple indexes quickly became unstable after short-lived advances above round-number levels would suggest the market is now more susceptible to a period of choppiness, with the recent highs now becoming potential resistance areas for these indexes in the weeks ahead.

The jury is out as to the immediate impact that weekly option expiration mechanics had on Friday's trading. Outsized movements in the dollar and the bond market would suggest that option mechanics played a small part, and the employment report could indeed be enough to stoke caution among traders and investors in the weeks ahead. This would be a change from the apparent shift from caution to optimism, as we discussed last week.

"Skew on the SPDR S&P 500 ETF has increased over the past few weeks. But the SPY also rose in that period, suggesting that investors were accumulating stocks and hedging those positions at the same time, says Todd Salamone, senior vice president of research at Schaeffer's Investment Research."
-- The Wall Street Journal, March 6, 2015

One of several indicators that we are keeping a close eye on is the skew in SPY options, or the ratio of implied volatility of out-of-the-money put options (usually purchased as portfolio insurance) relative to out-of-the-money call options (options used to make upside bets). When put options are getting more and more expensive than usual relative to call options, amid rising stock prices, it is usually an indication that hedged players are in accumulation mode.

However, note on the chart below that when the ratio of put implied volatility to call implied volatility is relatively high or near an extreme after a run higher in stocks, the market becomes vulnerable to a decline. We prefer to wait for a rollover before becoming seriously concerned, as this would suggest that the accumulation phase among hedged players has peaked.

As such, we are monitoring this indicator closely, after it rose considerably last week. The direction of this ratio and the SPY look similar to that of the August-September 2014 period, and the eventual rollover in the skew preceded a 10% pullback in stocks during that period. So far, we have not seen a rollover in this ratio, making it premature to call for such a significant pullback. But, after buy-to-open put and call volume dried up last week on the ETF hedging vehicles we follow, such as SPY, we are open to the growing possibility that Friday's action will give way to more weakness in the weeks ahead -- especially if SPY breaks below its January highs and its year-to-date breakeven mark.

Therefore, for those of you with a time frame of six weeks or less, we recommend a decent balance of long and short exposure. Or, if you're trading options, maintain a healthy mix of call and put exposure, given the growing risk to the bullish outlook we discussed for the month of March in last week's commentary.

SPY and 10-day put-call skew

Read more:

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