Tracking two key moving averages for the S&P 500 Index (SPX)
"...a majority of the recent short positions were put on when the SPX was between 1,900 and 2,000... many of those who recently added short positions are still sitting on losing positions, and this is a potential source of support for the market if they use pullbacks to cut losses on losing short trades. However, there is a caveat... The first is that deep-pocketed market participants, who are likely to buy puts on index or exchange-traded equity funds as a hedge during times of increasing market exposure, appear to be shying away from committing dollars to the market on retests of the highs..."
"If major equity benchmarks stage an extended decline beneath the key technical levels breached amid last week's rout, the options crowd will likely see a growing number of put buyers, which coincidentally is a market headwind. Moreover, the shorts would likely have increasing confidence to stick with those losing short positions..."
--Monday Morning Outlook, November 16, 2015
Last week we mentioned two risks to our bullish stance, both of which were based on our analysis of option activity, following a week in which stocks underwent significant selling pressure. The first is excerpted above, relating to evidence that big-dollar market participants who usually hedge with index and exchange-traded fund (ETF) puts when accumulating stocks were showing evidence of continuing to shy away from big purchases when the S&P 500 Index (SPX - 2,089.17) was trading at 2015 highs. Nothing has changed with this indicator, but as we also noted last week, "While the current direction of this ratio is a threat to the bullish case, the good news is that it is back at levels where it has turned higher, from a historical perspective."
The takeaway going into this week is that with this ratio significantly lower relative to past instances when the SPX was trading in this area on the charts, there is more sideline money to put to work. While there is no guarantee that this sideline money comes into stocks now, it is a building block for an eventual breakout. It might also suggest that short covering, as reflected in the second chart below, is continuing -- a source of market support that we discussed last week.
This ratio hints that hedged players who typically buy index and ETF put options as hedges when accumulating stocks are not in accumulation phase, but overall domestic equity exposure may be relatively low.
Short interest began rolling over from multi-year highs in October; updated data as of mid-November is released this week.
We noticed early last week that from a technical perspective -- despite the SPX trading in the red for 2015, and below lows from earlier in the year -- it was attempting to "carve out" (Thanksgiving pun intended) support from multiple perspectives. This includes intermediate-term moving averages that we track closely; specifically, the uptrending 40-day moving average and its flattening 80-day moving average.
In fact, whereas the 40-day moving average (thick red line in chart below) served as resistance in mid-September when it was sloping lower, it proved to be supportive last week as it sloped higher. For Fibonacci followers, this area was also a 38.2% retracement of the late-September and early November closing low and high. The takeaway is that short covering could be emerging on relatively mild pullbacks.
SPX found support from multiple perspectives early last week, but now 2015 resistance lingers just overhead (yet again).
Now, the "obvious" risk to all technicians is this year's resistance immediately overhead. In fact, Friday's rejection at 2,100 was notable -- as was the SPDR S&P 500 ETF's (SPY - 209.31) rejection at the 210 strike, where heavy November call open interest resided (first chart below). The rejection at the 210 strike was likely driven by November option mechanics, as this open interest was mainly seller-generated, according to data that we receive from the exchanges. Without getting into the details as to why, trust that "capping" action tends to occur when an underlying approaches a call-heavy strike in which the calls are seller-initiated.
Friday's SPY November open interest configuration, with 210-strike "call wall."
SPY 5-minute chart on Friday, Nov. 20. Horizontal line at 210 strike; risk in immediate term that Friday's gap higher is filled.
For bulls, the encouraging news is that a pattern we have seen from time to time preceding a breakout is a pullback from chart resistance that is supported by an intermediate-term moving average, as shown in the SPX daily chart above. The fact that the moving average served as support increases the probability of a trend being in place, making overhead resistance levels vulnerable to being overtaken.
The continued unwinding of the extremes in negative sentiment from weeks ago is supportive of such a scenario. In fact, the equity-only, buy-to-open put/call volume ratio is headed lower again, which removes a risk to the bull case that we identified last week, when the ratio made a brief turn higher. Moreover, whereas declines in this ratio proved short-lived as the ratio trended higher in the summer and early fall amid a build in pessimism, the short-lived turn higher may be indicative of a longer-term build in optimism that proves to be supportive of stocks.
Equity-only, buy-to-open put/call volume ratio turning lower again after brief upturn; indicative of extreme in negative sentiment continuing to unwind.
The "obvious" trade going into this week is sell. After all, the SPX is again situated just below 2015 resistance, small-caps are still lagging, and the world is back on high alert for more terrorist activity following last week's unfortunate events in Paris and Mali. Some are even bracing for the negative ramifications of a December rate hike by the Fed, even though stocks have fared better when the probability of a rate increase rises.
But bears beware -- the sentiment backdrop and some technical measures suggests an increasing probability of an SPX breakout, with strong seasonality serving as a reinforcement. Skew your exposure to the long side, and hedge with bearish plays on stocks in favor with the crowd but displaying poor price action. Or, purchase puts on lagging indexes like the iShares Russell 2000 ETF (IWM - 116.82) in the event that the simple, obvious trade comes to fruition.
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