"…with investors raising cash and hedging stock portfolios at an increasing pace, and the headwind we have observed is quite clear... But, so far, the market has not experienced a significant amount of technical damage… The implications of the hedging activity could create a big directional move in the coming weeks, as the descending triangle pattern is resolved…
"With the SPY just above the put-heavy 280 strike, and huge open interest stacked all the way down to the 245 strike -- equivalent to 2,450 on the SPX -- a break of the SPY 280 strike, or SPX 2,800, could set in motion a steady move lower, as these big put strikes tend to act as magnets, especially in instances closer to standard expiration... Even though much of this put build-up could be ‘China-related,' it could be any number of catalysts that sets the ball in motion for this to occur between now and June expiration."
-- Monday Morning Outlook, May 28, 2019
In last week's commentary, I explained that increased hedging activity related to growing concerns about the impact of deteriorating trade talks with China could set the stage for a big move in the coming weeks. The reasoning was that hedging activity, specifically put buying on SPDR S&P 500 ETF (SPY - 275.27) options, set up a situation in which huge SPY put open interest had built up at strikes down to the $245 level on the SPY, which equates to about $2,450 on the S&P 500 Index (SPX - 2,752.06).
During periods of market weakness, heavy put open interest strikes below the market sometimes act as magnets, as those that sold the puts are not entirely hedged via shorting S&P futures, but shorting of S&P futures increases as these put strikes come into view and the put options become increasingly sensitive to downward moves in the market.
I suggested that some of the put open interest build could be protection trades to guard against an increasingly negative tone in China-U.S. trade relations. But I also mentioned that even though China-U.S. trade talks were front and center on the minds of investors guarding against a market decline, it could be any catalyst that puts into motion the possibility of a correction that pushes the broad SPX to the 2,450 level by June expiration.
A combination of continuing negative headlines on China-U.S. trade, an inversion in the 3-month/10-year Treasury yield curve, and a surprise catalyst -- President Donald Trump threatening tariffs on Mexico in retaliation for allowing illegal immigrants to move through Mexico and into the United States -- combined to push the SPY below the put-heavy 280 strike, and keep it submerged below this level as we head into June and closer to June expiration.
The action last week contributed to a weakening technical backdrop, as the SPX broke below support at 2,800, and failed on a Thursday morning retest of this level. Moreover, the SPX broke below the Wednesday lows on Friday, following the headlines related to President Trump threatening tariffs on Mexico as punishment for not controlling its border.
The headlines and market action last week set the stage for a possibility that I previously mentioned: big put open interest strikes on the SPY acting as magnets following a technical breakdown below SPY $280, or 2,800 on the SPX.
In a worst-case scenario, a move down to the SPY 245 strike, or SPX 2,450, remains a possibility into June expiration, as the SPY 245 strike is the last of several heavy put open interest strikes below the market. In fact, per the second chart below, the put open interest that is stacked below the SPY's current level reminds me of the December 2018 open interest configuration, when puts were stacked below the SPY after the break of the 270 strike.
The possibility of a sharp sell-off in the coming weeks becomes more of a reality if those that sold puts to portfolio insurance buyers are forced to short S&P futures to hedge -- a process called "delta hedging." The further the SPY is above these put strikes, the less sensitive these put options are to SPY movements, therefore less of a need for put sellers to hedge. However, as the SPY moves closer to these strikes, these options become more and more sensitive, and thus shorting activity increases.
A move below the 270 and 275 strikes would further increase the possibility of a sharp sell-off by June expiration. With that said, the bulls can hold their breath for now, as the SPY 275 strike held in last week's pullback, which is equivalent to the 2,750 half-century mark on the SPX.
The SPX 2,750 area is just below the unpopular -- but sometimes significant -- 320-day moving average, which acted as support in March. Coincidentally, the SPX 2,757 level is a round 10% above the 2018 close, and potentially supportive.
With uncertainties growing around trade and fueling questions about future economic growth, and with the 3-month/10-year Treasury yield inverting for the second time since March, anticipated volatility in the market is increasing, as measured by the Cboe Volatility Index (VIX - 18.71). The VIX moved above half the December 2018 closing high of 18.03 on Friday, which increases the risk of this volatility index spiking higher in the immediate days ahead.
With an increasing risk of the current pullback extending into June expiration, traders should have exposure to puts to either hedge long positions or for speculative purposes. This does not mean to ignore the long side via call trades, as a surprise positive headline on trade could halt the market's current slide, and short positions related to the put open interest on the SPY would be unwound, helping support the market.
Nonetheless, options continue to be an outstanding way to navigate the uncertainty and various risks in the market, as they allow you to limit your risk to the premium paid. And the leverage options provide you still allows for excellent profit potential.
And the move above 18.03 occurred as some large speculators on VIX futures -- as measured by the Commitments of Traders (CoT) report -- moved back into the short volatility trade, after major covering activity a few weeks ago. While they are not as short volatility as they were going into May, the net short position is still pretty large, leaving significant potential for unwinding. As long-time readers know, large speculators have historically been wrongly positioned around major moves in volatility, implying that another risk to stock market bulls is a volatility spike accompanied by a market pullback.
Todd Salamone is Schaeffer's Senior V.P. of Research.
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