Shorts coming out of hibernation remains a risk to stocks
After multiple equity benchmarks rallied above key round numbers that I pointed out about a month ago on Twitter, and the S&P 500 Index (SPX - 2,881.40) and Nasdaq Composite (IXIC - 7,916.94) ventured into new all-time high territory, the bullish action proved short-lived. In the blink of an eye, these indices sold off from the area of the 2018 all-time highs and, in the case of the Russell 2000 Index (RUT - 1,572.99), declined back below the round 1,600 century mark. The catalyst was President Donald Trump ratcheting up pressure on the Chinese by threatening and ultimately increasing tariffs on $200 billion worth of Chinese imports to 25%.
Trade headlines dictated the intraday action in equities, as comments by Treasury Secretary Steve Mnuchin that Friday morning's trade talks were constructive set the tone for a reversal off last week's lows.
Even though the SPX and IXIC pulled back significantly from all-time high territory last week, and the RUT experienced another failure at 1,600, these benchmarks did not retreat enough to break below key support. This is true whether looking at potential chart or option-related support.
"… another bullish factor for the IWM in the coming two weeks is the potential for short covering related to the big put open interest at the 157 strike and below. But short-term small-cap bulls should be ready to bail if the IWM falls below the 155 strike before May expiration, as delta-hedge selling could kick in as big put open interest strikes act like magnets -- in addition to technical selling from those who waited to buy the IWM until after the early April trendline breakout."
-- Monday Morning Outlook, May 6, 2019
The reversal pushed the iShares Russell 2000 ETF (IWM - 156.62) back above the 155 strike, which I discussed last week as an important level from an options-related perspective. The reversal occurred as the IWM was sitting on its 80-day moving average and just above the trendline connecting lower highs from August 2018 until the early April breakout.
I did not discuss the open interest configuration on the SPDR S&P 500 ETF Trust (SPY - 288.10) in last week’s commentary. Just ahead of Mnuchin's positive trade comments, I mentioned to a colleague that the SPY seemed to be stabilizing around the 283-strike area, which happened to be the last big put magnet before another big put open interest magnet at the 280 strike. The implication was that delta-hedge selling down to the 283 strike was in play, and that most of the heavy selling could be over. It wasn't long after that exchange with my colleague that Mnuchin's comments sparked a rally from the lows and the SPY rallied back above the put-heavy 285 strike -- a bullish development, as a retest of this strike mid-week failed.
"The short-covering that has taken place now becomes a risk factor for bulls, particularly on big-cap technology names. But there are additional sources of potential demand, such as sideline money viewing the breakout in the QQQ as permission to invest in these names. The price action supports taking long positions in these names, but with the short-covering dissipating, we strongly urge using call options to manage the risk. Or, if you are holding large-cap technology stocks, use put options to protect those positions."
-- Monday Morning Outlook, April 29, 2019
“… there has been a lot of short covering on SPX and Invesco QQQ Trust (QQQ - 191.11) components, and large speculators hold a record short position on VIX futures -- which I see as the biggest sentiment-based risk, as this group has been dead wrong on major volatility moves when they've been positioned at extremes.”
-- Monday Morning Outlook, May 6, 2019
Per the excerpts from previous commentaries posted above, sentiment-based indicators suggested heightened risk of a pullback and a surge in volatility. And a surge in volatility is exactly what we experienced, again catching large speculators off guard, who held record short positions on Cboe Volatility Index (VIX - 16.04) futures going into last week's trading.
The VIX exploded from the previous week's close of 12.87 to last week's intraday high of 23.38. However, Thursday's intraday high was just short of 24.02, which is double last month's 2019 closing low of 12.01. And, as I mentioned on Twitter, the high last week was just below big VIX call open interest that expires on May 22, in addition to the 2018 VIX close of 25.42.
The levels discussed above will be on our radar in the immediate days ahead if stocks experience another sell-off and short volatility futures positions continue to be unwound. If the VIX moves above such levels, risks grow of an extended decline in stocks as volatility surges. Note that through Wednesday of last week, roughly 30,000 of the 180,00 net short positions in VIX futures were covered. Given the action on Thursday and early Friday, I am suspecting the 30,000 number grew into the end of the week.
CoT large speculators on VIX Futures
A risk that we continue to see, particularly if there is a breakdown below support on equity benchmarks, is the shorts coming out of hibernation. Short interest on SPX components hit its lowest levels since early 2017, according to data updated by the exchanges through April 30. This does not necessarily mean that a top is in place, but it does mean that there is significantly less short-covering potential to contribute to a V-type rally. It will have to be sideline money that exited the market last year that comes into equities to drive a rally through previous highs. But as I said in a previous commentary, small-cap stocks still have huge short interest, and thus small-caps may outperform in the months ahead (see last chart in this commentary).
Support levels on major benchmarks did not break last week, and thus we continue to emphasize long positions, but using call options to manage the headline risks that have hit the market. Call options allow you to put less money at risk with the leverage they provide, giving you the potential for big profits. Moreover, to the degree that you view the premium paid as your total risk, you are less apt to get whipped out of trades as a constant stream of headlines hit the market, creating whipsaw action.
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