"...we are now only nine trading days away from a standard options expiration. And as we alerted you last month, the week before standard option expiration is the window when option mechanics can begin to influence the magnitude of market moves. Specifically, heavy put strikes below the market, especially in the wake of a negative catalyst (Friday's employment report), can act as magnets, as sellers of those puts look to hedge their positions by shorting S&P futures as the options become more and more sensitive to the SPY's downward movement … Note the heavy put open interest at the 180, 183, 185 and 187 strikes. Unfortunately for bulls, this would suggest downside risk during the next two weeks to the $180 level…"
-- Monday Morning Outlook, February 8, 2016
Bulls are likely thinking that they have seen this act too many times in recent months around standard expiration weeks, as a shaky technical backdrop combined with negative news flow is generating huge downside moves in short periods. Our theory is the heavy index and exchange-traded fund (ETF)
put open interest acts as magnets, as we've been alerting you to each expiration week.
Last week, we entered that "window" in which the market becomes most vulnerable to option mechanics acting in concert with negative news flow to push equities sharply lower in short periods. And, sure enough, after
worries about European banks surfaced, the SPDR S&P 500 ETF Trust (SPY - 186.65) found itself down nearly 4% from the previous week's close -- as lower gaps on the open and follow-through selling on Monday and Thursday were responsible for the week's struggles. By late-afternoon Thursday, the SPY found itself hovering just above its 180-strike price, a level that we warned was achievable with standard February expiration only nine trading days away.
The positive news was the late-day Thursday bottom just above the SPY's big put open interest at the 180 strike. The reversal was driven by perceived positive catalysts, the first being news that crossed the wires that an Organization of the Petroleum Exporting Countries (OPEC) oil minister expressed desire for a production cut -- which
stemmed sharp losses in the oil market. Following this was news that Deutsche Bank was buying back debt to relieve liquidity fears and
a "vote of confidence" by Jamie Dimon, CEO of JPMorgan Chase & Co. (NYSE:JPM), who increased his JPM holdings by a sizeable amount.
And, as you might infer from the various observations that I posted on Twitter, the late-week positive catalysts occurred as multiple indices were trading at potential pivot points.
For example, long-time readers are aware of the emphasis we put on round-number year-to-date gains/losses as potential pivot points. The S&P 500 Index (SPX - 1,864.78), for example, toyed with the 1,839.54 level (10% below the 2015 close) most of the week -- with two intraday moves below this level and two closes above it early in the week -- before closing just shy of it on Thursday evening. Friday's rally pushed the SPX back above this level.
"The SPY's price action looks similar to the September period … From a sentiment perspective, a relatively shallow decline from January's close would make sense, as there is not as much optimism to wash out."
-- Monday Morning Outlook, February 8, 2016
Moreover, per the chart immediately below, note how the CBOE Volatility Index (VIX - 25.40) topped out 50% above last year's close. VIX peaks occurred in this area last month, and so far, it appears that this pattern is repeating this month too.
Additionally -- and not mentioned in my various Twitter observations -- there are "flight to safety" assets, such as the SPDR Gold Trust ETF (GLD - 118.36) and the iShares 20+ Year Treasury Bond ETF (TLT - 131.50), which ran into resistance last week. This could spell profit-taking, at least in the short term, on these assets.
For example,
GLD hit $120 -- a round level 20% above its recent low at $100 and site of its 36-month moving average, which marked an important bottom in 2008. A monthly close below this trendline in April 2013 hinted at more troubles ahead. Last week's touch of this moving average is the first since early 2013, and the jury is still out as to whether this marks the end of the GLD rally in 2016 or not. So, if you are thinking about getting long GLD, perhaps best to wait for a monthly close or significant close above $120.
Also, the TLT pulled back on Friday, after hitting a level that marked 10% above its 2015 close and an important high in 2012.
With gold and bonds trading at potential resistance, the SPY experiencing a nasty decline to potential chart and options-related support the week prior to this week's standard February expiration, and perceived positive catalysts at the end of the week -- a trading rally is an increasing likelihood. Sure, the put magnets we discussed last week are still in play, especially if another negative news event hits the market.
Beware that short-term market sentiment is
suggesting an extreme in fear that has marked bottoms in the past, leaving bears vulnerable to sharp, short-covering rallies. For example, the 10-day, all-equity, buy-to-open put/call volume ratio reached a multi-year high late last week, nearing the levels that marked the bottom of the bear market during the financial crisis and surpassing the level reached last fall.
Equity Option Buyers -- Is the multi-year extreme in negativity a contrarian buy signal?
If the catalysts late last week are enough to generate a turn in sentiment, there is much fear to be unwound in the days ahead -- setting up the potential for a multi-week rally like we saw in September through early November last year. Moreover, absent a negative headline that reverses the late-week action last week, short covering related to expiring put open interest on index and equity ETFs could be an additional upside driver in the week ahead. Such a possibility exists as long as the SPY remains above put-heavy strikes, such as the 185 strike we discussed last week. For your reference, the SPY's February open interest configuration is displayed below.
SPY February Open Interest Configuration
Continue Reading: Indicator of the Week: When to Buy Stocks During Presidents Day Week The Week Ahead: Energy and Gold Earnings, Fed Highlight Short Week