“The idea is to have a short leash with respect to the lower volatility, higher equities trade. While this trade got off to a good start last Monday, it is not yet broken. But then again, it is not looking as promising either.”
- Monday Morning Outlook, October 19, 2020
“The Cboe Market Volatility Index (VIX -- 27.55) remains above two key short-term (30-day) and long-term (252-day, or one-year) moving averages as we enter this week’s trading…there has more been more back and forth above and below these trendlines than in the past, suggesting traders should still be on the alert for higher volatility, but also look for a confirmation. One confirmation measure I said could be viable is the VIX trading above a trendline that has been connecting lower highs since mid-September.”
- Monday Morning Outlook, October 26, 2020
With the election on Tuesday, earnings reports due out over the next few days, and a lot of discussion in the media about how traders are positioning themselves on the volatility front, I am going to stay on the volatility theme once more this week.
Only hours after last week’s commentary was posted on our website, the Cboe Market Volatility Index (VIX - 38.02) reading confirmed what it was indicating on Oct. 19, when it closed above its 30-day and 252-day moving average; a potential signal for higher volatility ahead. However, there were short-term movements above and below these moving averages earlier in the month, so the signal was not as clear it had been throughout 2020.
I advised looking for a confirmation for potential heightened volatility. One way to confirm, for example, was to look for a noticeable VIX close above a trendline connecting lower highs since mid-September, which had been marking short-term VIX peaks in prior days. A significant close above is exactly what occurred last Monday, when the VIX closed at 32.46, with the short-term trendline connecting lower highs sitting at 28.35. The confirmation signal was prescient, as an intraday of 41.16 was observed in Thursday’s session, and marked last week’s high.
“… I do not see market participants positioned for such (higher) volatility, at least not as the media has suggested. For example, total put open interest on SPY options, which fund managers can purchase to hedge equity exposure in anticipation of increased volatility, is around 13.7 million contracts, down from the 15.4 million contracts one month prior to the November 2016 elections….”
- Monday Morning Outlook, October 12, 2020
“On Monday, as U.S. stocks fell sharply and the Cboe Volatility Index, or VIX, climbed, some investors positioned for its fall through bearish options on the gauge. A bearish bet on the VIX is akin to a bullish bet on the S&P 500 because the two tend to move in opposite directions.”
- The Wall Street Journal, October 27, 2020
“…the 10-day moving average of total put volume relative to total call volume for the gauge -- a measure of demand for short volatility bets -- extended its recent rise to the highest in 14 years, according to data compiled by Bloomberg.”
- Bloomberg, October 27, 2020
What I find interesting is the timing of the sharp volatility spike. For one, it is a pre-election spike that is being blamed on the rising number of COVID-19 cases around the world, which has created a second round of lockdowns in Europe and, in San Francisco, a delayed reopening.
Additionally, the volatility spike occurred on the heels of the financial media discussing how traders are now bracing for lower volatility, allegedly due to fears of a long-awaited election result now fading. This echoes the above discussion points I made on Oct. 12 and last week.
So, now what? If you are looking for more clues regarding the direction of the next big volatility move, you can key to the levels I identified on the VIX graph above. In other words, I could see the June high in the 41.85-42.70 area as a potential volatility peak, since these levels represent one-half the March closing high, and double the August closing low, respectively.
And if the VIX moves back below 36.30, or three times the January closing low, this could be indicative of volatility heading lower. Note the importance of this level as support in late April, and as resistance in late June and early September.
As I stated last week, put buying on VIX futures options has historically tended to precede a bullish equity environment and lower volatility. There is still a chance that these buyers will be proven correct on the direction of volatility, but they may have been premature or too aggressive in their bets, and many may risk losing their entire investments -- even if they are correct about a post-election volatility contraction.
As you can see on the graph below, most of the put open interest resides between the 20 and 30 strikes. The November VIX futures contract closed at $33.91 on Friday. Looking ahead, if the contract drifts lower between now and mid-November, to around the 30 area, this is when both put and call buyers would feel maximum pain, based on the current open interest levels. This is also a scenario bulls would welcome, when looking ahead to the next couple of weeks.
Coinciding with the volatility few anticipated, the S&P 500 Index (SPX - 3,269.96) broke below its February high last week. After peaking at a level in mid-October that is 10% above its 2019 close -- a failure in this area for the second time in as many months -- the SPX is now just above potential support from said close, at 3,230. Also of note, just below the 2019 close is 3,220, which is 10% below the SPX’s 2020 closing high.
The top pane in the chart below is a nice visual of how the round 10% SPX return and its year-to-date breakeven levels have acted as both support and resistance in 2020. The circles highlight how the SPX has behave around its 2019 close. In simpler terms, it would be notable for the SPX to hold the 2,220-2,230 area on a closing basis during the next few days.
A break from that area along with a VIX move above the potential resistance levels discussed above would be worrisome for bulls, as short interest on SPX components is in the lower 5% of its annual range, and the equity-only, buy-to-open, put/call volume ratio remains at historically low levels. In other words, there is potential for optimism in this area of the market to unwind, if bears see opportunity in a break from these levels.
There will be more to say about the sentiment indicators I alluded to above next week, either on Twitter (@ToddSalamone) or in Rocky White’s Indicator of the Week column, which is available each Wednesday.
Todd Salamone is Schaeffer's Senior V.P. of Research
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