Delta-hedge buying likely helped to fuel the stock market's expiration-week rally
"...the sentiment backdrop continues to be a supportive measure for equities after some participants were bracing for doom and gloom in December... This doom-and-gloom scenario is slowly being unwound, and indications are that much of this pessimism has further room to be unwound, which would allow stocks to continue to clear various technical hurdles overhead... We will see immediately if the early October and early December peaks carry into an early February top as the SPX battles yet another potential area of resistance just above the round 2,700 century mark."
-- Monday Morning Outlook, February 4, 2019
The S&P 500 Index (SPX - 2,775.60) experienced an expiration-week advance last week, and in doing so pushed above yet another layer of potential technical resistance levels. For example, after getting rejected at the popular 200-day moving average (situated at 2,744) in the first full week of trading in February, a second try last week to move above this trendline was successful, propelled by headlines related to positive progress on U.S.-China trade talks and an agreement to avert another government shutdown. This news follows the late-January decision by the Federal Open Market Committee (FOMC) to hold rates steady and an outlook that was perceived as dovish, which gave stocks another shot in the arm after languishing in the week leading up to the Fed meeting.
The SPX conquered a couple of other levels last week that are likely off the radar of many traders. For example, the index took out the round 2,750 half-century mark. I mention this because SPX 2,750 is equivalent to the SPDR S&P 500 ETF Trust (SPY- 277.37) 275 strike, where heavy call open interest resided in the February options series that just expired. Per the graph below, call open interest was heavy at the 276 strike, too. At both of these strikes, most of the open interest was generated via buy-to-open volume. Therefore, delta-hedge buying related to sellers of those calls being forced to buy a growing number of S&P futures to stay neutral likely gave added juice to the market's reaction to last week's positive headlines.
That said, total open interest at these call strikes pales in comparison to the 200,000-300,000 contracts in open interest that we have seen on various put strikes in the last few years. I point this out because any of the buying related to the call open interest last week was far below the selling that tends to occur when big put open interest strikes come into play when the market has headed south around standard expiration weeks.
Moreover, after an initial hesitation, the SPX pushed through the 2,758 level, which is 10% above its 2018 close. Perhaps the combination of a little bit of delta-hedge buying and momentum buying on the headlines offset a profit-taking mentality that benchmarks like the SPX are vulnerable to after they reach a round-number year-to-date percentage gain. Corrective moves, like we saw in the fourth quarter of last year, aren't typical once an index reaches a round-number year-to-date percentage gain like 10%, but such levels will often act like short-term speed bumps. That said, one should not be surprised to see a retreat below 2,758 in the absence of positive headlines this week, and in the absence of forced buying related to expiring call open interest.
From an options perspective, the outlook is mixed. On one hand, per the chart immediately below, the unwinding of a multi-year high in pessimism among equity option buyers that began in December continues, but the current equity-only put/call volume ratio is still above levels that have historically marked the kind of optimism among this group that leaves the market vulnerable to pullbacks.
That said, there is now evidence that influential hedged buyers are not accumulating stocks like they were in late December and January, as put buying on major exchange-traded funds (ETFs), such as the SPY, is slowing relative to call buying. When this ratio is heading higher as stocks advance, it is usually indicative that these market participants are in accumulation phase and using ETF puts to protect long positions.
In fact, oftentimes this ratio will peak well before the market tops. Therefore, this development becomes more of a concern if there is a technical breakdown, such as the SPX retreating below its 80-day moving average at 2,654, or a move below 2,640, its close ahead of the Jan. 30 FOMC decision to hold rates steady. The SPX enters the week roughly 4% above these levels and 5.5% below its all-time high.
The next obvious hurdle for the SPX is the round 2,800 area, which the index surrendered to briefly in March, June, October, and November 2018. For what it is worth, 2,820 is 20% above the December 2018 closing low and might be worth watching if the SPX manages to push above 2,800 in the weeks ahead.
Finally, the Commitments of Traders (CoT) report is s-l-o-w-l-y being updated, with Friday's published data current only through Jan. 22. If not for the government shutdown, the Friday data would be as of Feb. 12. This means we are still relying on data that is three weeks behind, which presents a risk for anyone relying on this data to assess risk and potential opportunity in the market.
That said, bulls should stay the course, as we aren't seeing an explosion in optimism as the SPX takes out multiple resistance levels in a short period.
That said, I have been very curious as to the positioning of large speculators on Cboe Volatility Index (VIX - 14.91) futures, who were again on the wrong side of a major move in volatility when they were in a rare net long stance ahead of this most recent VIX implosion. As of Jan. 22, this group was net short -- which they usually are, but the net short positioning was far from extremes like those of late 2017 and September 2018, before volatility exploded higher. It will not be until March 8 that this data is fully up to date.
Speaking of CoT data, I noticed that net longs on gold futures retreated, even as gold held steady in January. This could have bullish implications for gold, as it has not weakened amid a stronger dollar. Options on SPDR Gold Shares (GLD - 124.80) are very cheap, with implied volatility at a multi-year low, and one could use calls as a cheap way to play a continued rally in this asset. Or, if you think gold could pay a price and eventually crumble under dollar strength, buying a straddle may be a worthwhile strategy to simultaneously play the uptrend that has been in place since August and the risk of a retreat due to dollar strength.
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