"JPMorgan derivatives analysts estimate that nearly $1.1 trillion of S&P 500 options are set to expire on Friday morning, about 60 percent in put options, typically used as portfolio hedges. In case of an adverse reaction in stocks, the accumulation of large blocks of open SPX put contracts at the 2,000, 1,950, and 1,900 levels, could force more selling. Market makers who have sold those contracts would be forced to sell equities to reduce their risk. This kind of activity was one of the key reasons for the market selloff in late August, when the S&P entered its first correction in more than four years."
-- Reuters, December 11, 2015
"On one hand, the good news is that a lot of the shorting activity (related to delta hedging) may have occurred last week -- but it is far from exhausted, with a Fed meeting ahead and the 195 and 200 strikes on the SPY potentially acting as magnets in the week ahead. In fact, 195 would not be out of the realm of possibility, especially with a Fed catalyst in the middle of the week…That said, a positive reaction to the Fed, like last year, could be the catalyst that generates a mirror-image rally of the decline that we saw last week…there is the potential of the call-heavy 210 strike acting as a magnet on the upside…"
-- Monday Morning Outlook, December 14, 2015
Ahead of "quadruple witching" last week, which involves the expiration of equity and index options and futures, open interest configuration on S&P 500 Index (SPX – 2,005.55) options seemed to get more attention than usual. As longtime readers know, this is a topic that we explore month after month in the couple of weeks preceding standard options expiration -- but the J.P. Morgan note, as picked up by Reuters, seemed to attract much attention on trading desks, if media outlets such as Reuters and CNBC, and social media platforms such as Twitter, are any indication.
And as we also discussed last week, with a Fed meeting on the horizon during expiration week -- including options on December CBOE Volatility Index (VIX – 20.70) futures on Wednesday -- we speculated that the resolution of Fed uncertainty could generate a sharp, exaggerated directional move. While we were correct about a sharp move occurring, what we didn’t see was two sharp moves occurring, with a pre-Fed and two-hour post-Fed move higher, followed by sharp declines on Thursday and Friday.
The SPDR S&P 500 ETF Trust (SPY – 200.02) 210 strike looked like an increasing probability as the market traded higher after the Fed’s decision to hike the Fed funds rate and plotted a gradual rate increase path for 2016 and 2017. In fact, in the immediate aftermath of the Fed announcement and Fed Chair Janet Yellen’s press conference, the SPY moved back above its 2014 close at $205.54 and its 200-day moving average.
But by Thursday morning, heavy selling came into the market, and by Friday a weekly "round trip" had occurred, with the prior week’s close at $201.85 coming into play, in addition to the put-heavy 200 strike magnet that we discussed prior to last week’s trading. When the dust settled, it was not quite the fireworks that some were fearing, with the SPY closing down 0.9%, just above the put-heavy 200 strike. Moreover, the SPX finished down only 0.3% for the week. The weekly move might be considered puny in the context of four absolute moves of 1% during a week which saw the Fed hike rates for the first time since 2006.
"It is entirely possible that -- with only three trading days before December VIX futures options settlement on Wednesday morning -- the sharp VIX move higher was due to VIX call sellers buying VIX futures and/or selling S&P futures to guard against a further spike in volatility…If you are the aggressive and speculative type, you could short volatility futures or buy shorter-dated VIX futures puts, betting that last week’s volatility pop was helped in part by the mechanics related to expiration of VIX options in the middle of this week."
-- Monday Morning Outlook, December 14, 2015
The short-term direction of the asset "volatility" did play out as we expected. Per the 30-minute graph of CBOE Volatility Index futures (/VXc1) immediately below, after peaking in the 25 area on Monday afternoon, the front-month January futures contract traded as low as 17.55 on Wednesday afternoon and ended the week at 20.40, below the prior week’s close of 23.65. While a strong directional move in equities was a "bust" call, volatility was significantly lower, as many VIX December call buyers were holding worthless options at VIX settlement Wednesday morning, despite many of these options being "in the money" in the days preceding Wednesday VIX expiration.
"Investors have cut their U.S. equity allocation to an 8-year low, reducing risk ahead of the U.S. Fed's December meeting as worries about the impact of a rate rise have mounted, a Bank of America Merrill Lynch (BAML) survey showed on Tuesday…"
-- Reuters, December 15, 2015
A review of the events of last week, whether technically based or the post-Fed reactions, could very well be an indication of what is in store in the days ahead. On one hand, an increasingly popular quantitative analyst at a major investment bank warns of the potential for a major sell-off related to the Fed expiration week selling risk, similar to August expiration week’s 5.7% SPX decline. With this note on the radar of many trading desks, a week that resulted in only a slight loss might be considered a win from the eyes of a bull. However, a bear might argue that with Fed uncertainty lifted and strong December second-half seasonality at its back, the market had an opportunity to rally, but did not.
And so you have it -- a huge tug-of-war between the bulls and bears not only last week, but all year, and perhaps something that may continue into year-end. In all but two months this year, the SPX has touched its 2014 breakeven point of 2,058.90.
Round-number areas have been extremely important, too -- generally speaking, buy SPX 2,000; sell 2,100 (or 2,120). For what it is worth, there have been 244 trading days this year, and 141 of those days have seen closes between 2,000 and 2,100, or 58% of the trading days.
Expand this range from 2,000 to just above 2,000 (2,120), and 79% of the closes have occurred in this range, or 193 out of 244 days. With the SPX managing to close above 2,000 and the SPY above 200, unlike the breach of 2,000 and 200, respectively, during August expiration week, the short-term technical outlook favors the bulls from the perspective that bulls and bears will wager a fierce battle into year-end, just as they’ve done in all of 2015.
Can it really be that simple? Stay tuned. For now, it would appear that the old "80/20" rule puts the risk/reward in the bulls’ favor, with the SPX closing at 2,005.55 on Friday, just above the 2,000 lower boundary.
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