"... given that there is still a large short position among VIX futures players, plus the early stages of a build-up in VIX call open interest to protect these short positions after June VIX expiration -- and potentially thin volume during a holiday-shortened week, with a plethora of macro events and two expirations -- one could easily argue that the market is at a heightened vulnerability to a volatility pop that we haven't witnessed this year. So again, we advise having short exposure of some kind along with your long exposure."
-- Monday Morning Outlook, June 29, 2015
The volatility that we anticipated last week arrived, as
Chinese stocks continued to sell off sharply and
Greece defaulted on a loan payment due to the International Monetary Fund (IMF). U.S. stocks were not oblivious to the news and, as such, the CBOE Volatility Index (VIX - 16.79) skyrocketed to its highest level since early February,
increasing 34% in only one day. It was its eleventh biggest single-day move dating back to 1990, easily taking out the significant 15.50 area that had capped multiple advances since March.
In fact, the 15.50 area marked a low on Friday morning, as the VIX pulled back from Tuesday's high near 20 and its 2014 close (19.20) on news that Greek Prime Minister Alexis Tsipras sent a letter accepting some of the conditions for extended credit. But, the conditions agreed to were not enough, so the July 5 referendum in Greece remained on the schedule -- and we again headed into a (long holiday) weekend in which Greece voters will dictate the direction of this morning's market.
For now, the area around 15.50 and 19.20 can be keyed on as to what might occur next with respect to volatility. A close above 19.20, for example, would heighten the probability of a move into the 23-to-24 range, with the 23 strike the site of the huge call open interest in the July series, and the 24 area double this year's VIX low. And if the VIX closes below 15.50, the probability of the VIX moving back to its 2015 lows increases.
Another way of viewing the significance of 15.50 is that for months, this level was viewed as "too high" when it reached 50% above last year's low. Last week, the anchoring mindset changed, as one-half of 2014's VIX peak is viewed as attractive for buying volatility.
July VIX Open Interest Configuration -- 23 strike a potential magnet
CoT Report -- VIX futures (data as of June 23)
"... many investors fixating on June 30, the deadline for Greece to meet its IMF obligation … a negative outcome could push the SPY down to 205 relatively quickly, which is around its 2015 breakeven mark of 205.54. Both overseas and domestic events, compounded by two expirations within a week and a quarter-end, could spur a lot of volatility this week."
-- Monday Morning Outlook, June 29, 2015
As you can see on the chart immediately below, the heavy put open interest for those options expiring on June 30 and July 2 at the SPDR S&P 500 ETF Trust (SPY - 207.31) 205 strike arguably acted as magnet in the first couple trading days of last week, as the SPY quickly traded down to this area. However, year-to-date breakeven support ultimately prevailed, and as June 30 options got ready to expire, there may have been some short covering related to the 205-strike puts that were about to expire. We would be remiss to mention that the SPY's 200-day moving average is in the area of last week's lows, further strengthening the potential support area we identified last week in the event that heavy selling occurred. As contrarians, though, bounces from "obvious," well-known support might be viewed as suspect.
So, the question moving forward is, "Will last week's lows be revisited?" As we have mentioned in the past, the bigger the open interest at a put strike, the more likely it is to behave like a giant magnet when price action isn't exactly strong -- which has been the case in recent days. In looking ahead to July standard expiration, which is now only 10 trading days away, put open interest currently exceeds 300,000 contracts. This is unusually large, and the last time I can remember put open interest being this large at a particular strike was back in October, when the 190 strike exceeded 500,000 contracts -- leading to sharp, accelerated selling to strikes with less, but still healthy, put open interest that also acted as magnets.
Therefore, it will be key in the weeks ahead for the SPY to remain above the 205 strike, as a break below could lead to accelerated selling that pushes the SPY to the 200 or 202 level. If the SPY can hold 205, we might see short covering into expiration that pushes the SPY back to its recent highs.
"The STOXX Europe 600 index ... is up 12% for the year ... The yield on 10-year Spanish government bonds, at 2.218%, has risen from 1.517% at the beginning of the year, but remains well below levels that exceeded 7% three years ago. Italian government bond yields have also risen, to 2.244% from 1.727% at the beginning of the year, but they are likewise below levels that exceeded 6% three years ago. Yields on Portuguese government bonds are near 3%. In short, countries prone to fallout from a Greek default appear to be in a position to continue to fund themselves."
--
The Wall Street Journal, July 1, 2015
One scenario is stocks breaking down sharply below support, with the help of big put open interest strikes on key exchange-traded funds and indices acting as "magnets" -- such as the 200 through 205 strikes on the SPY. The decline might also be helped along by those that focus on the popular 200-day moving average. However, if such a sell-off occurs, it will be short-lived, as various indices put in lows by July expiration at levels in which few investors would anticipate.
Whether it is China, the Fed, or European headlines, longer-term investors should seriously consider that the choppy behavior in U.S. stocks this year is just short-term noise, within the context of longer-term bull market. Certainly, on a day-to-day basis, U.S. markets are trading based on what is occurring overseas, especially in Europe. But, there is evidence in various bond and stock markets in Europe that risks of a contagion related to Greece are currently low.
And with respect to the U.S. market, bulls should be encouraged by the S&P 500 Index's (SPX - 2,076.78) monthly close above its
10-month moving average last week. And, despite the fact that major indexes in the U.S. recently logged all-time highs, sentiment is negative, which means if "this too shall pass," there is serious sideline money and short-covering potential that could drive a major rally by year end. For example:
- There is a big short position on SPX component names, which represents future buying power.
- Retail investors still have doubts, with the percentage bearish in the American Association of Individual Investors (AAII) weekly survey at the highest level since August 2014.
- Active investment managers have their lowest exposure to equities since November 2014.
- Equity option put buying (bearish bets or hedges) to call buying (bullish bets) is nearing highs that have typically come at or near market bottoms, and unwind of which would have bullish implications.
The bottom line is that as July expiration nears, equity and volatility futures and options traders could exaggerate downside moves related to Greece. But, from a longer-term perspective, short-term swings may prove to be noise within a bullish, longer-term uptrend.
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