"…if momentum continues, keep in mind that there is the 12/27 and the quarterly expiration of SPY options that expire this week and on the last trading day of the year… Without a catalyst, the SPY 323 strike could act as resistance and the longer the SPY is below these strikes, the more it can be seen as a headwind. However, if the year closes with a predominance of momentum players even without a catalyst in play, the SPY could easily test the 325 strike by year end, which is the site of the last heavy call strike that could act as a magnet if the SPY takes out the 323 strike."
-- Monday Morning Outlook, December 23, 2019
Stocks continued with their winning ways last week, as the S&P 500 Index (SPX - 3,240.02) made it five consecutive weeks of gains, amid low volume and an oversold condition during the holiday week. When volume is low, big open interest strikes on equities and exchange-traded funds (ETFs), such as the SPDR S&P 500 ETF Trust (SPY - 322.86) can become even more influential, as the number of shares represented by the contracts outstanding are a larger piece of the overall volume pie when trading activity related to the open interest occurs.
This may have been the case last week, as those short the calls and those who want to be neutral became forced buyers of more S&P futures, after a fair amount of call open interest at the SPY 322 and 323 strikes was overtaken. This sets up the potential for the SPY 325 strike, equivalent to SPX 3,250, to be tested by the year-end close this Tuesday, Dec. 31. The 325 strike is where nearly 100,000 call contracts reside expiring on Monday and Tuesday, which is a hefty amount amid low holiday-related volume.
That said, if the market cannot maintain December's momentum into the final two trading days of the year, the overhead call open interest will be a headwind as quarterly December 31 expiration approaches and the small number of long S&P futures positions already tied to these calls is unwound. This is called delta hedging, when the number of tied long positions grow as the underlying moves closer to and above the strike, because the option becomes more sensitive to the underlying's movement.
"[M]ost sentiment measures remain supportive of a breakout, which means the risk-reward favors the bulls. A post-FOMC breakout from the ascending triangle would likely trigger an 8-10% rally into the first quarter of 2020, akin to the short-covering rally that occurred in the second half of 2017."
-- Monday Morning Outlook, October 28, 2019
Regardless of how the year closes, bulls are in control and momentum is on their side, which sets up a potentially bullish environment for equities as we move into the first quarter of 2020. Since the breakout from an ascending triangle formation in late October, and on the heels of three rate cuts and perception of trade progress with China, Canada, and Mexico, the SPX has rallied about 6.5%, well on pace to for the 8%-10% rally that I was projecting into the first quarter.
However, one aspect of my projection has not yet played out. For example, I expected that on a net basis, short covering on SPX components would accompany a breakout. However, to my astonishment, after observing short interest data as of Dec.15 that was released to the public late last week, short interest rose once again from the prior report at the end of November. In fact, since the SPX broke out in late October, short interest on SPX components has risen 1% to the highest level since July 2018.
With the shorts continuing to bet against the rally, and the SPX and Nasdaq breaking into new all-time high territory, bulls should view this development favorably.
Not everyone is fading this rally, so there are risks from a sentiment perspective. The first is one that I highlighted last week, with the 10-day, all-equity, buy (to open) put/call volume ratio at a multi-year low. However, it is not yet turning higher. In most cases, a turn higher in this ratio from a low level precedes a notable pullback in equities. It would likely take a negative catalyst to reverse the current optimistic mindset of equity option buyers.
Another risk to bulls relates to a volatility pop concurrent with a drop in equity prices. Late last week, the Cboe Volatility Index (VIX - 13.43) again advanced from its 2019 floor at the 12 level as the SPY dropped back below the call-heavy 323 strike.
For the last two weeks, the VIX has found "support" at 12, but stocks have rallied even with this floor in place. While large speculators have covered some short positions in VIX futures, they are still at an extreme and thus vulnerable to a sharp spike in volatility futures that occurs with decline in stocks.
Bulls hope that if there is another VIX spike in the immediate horizon, the trendline marking lower highs since the August peak holds -- which is currently at 16.78, but declining daily.
If the SPX drops noticeably in the beginning of 2020, I look for the 3,150 area to be a first area of potential support, site of its 30-day moving average that caught the early December pullback and the November high.
Whether it was macro and monetary risks mentioned a few weeks ago, or sentiment risks in play at present, the index calls I recommended several weeks ago took advantage of cheap option premiums and prospects for a huge rally, following a technical breakout driven by short covering into the first quarter.
Looking ahead to 2020, one consensus theme that I have seen emerge during the past month is for European stocks to outperform their U.S. counterparts as the European economy bottoms out due to fiscal stimulus. If you are bullish on Europe, keep in mind that you are not alone, as risk grows when the crowd adopts a consensus belief.
I hope the holiday season has been a joy for you and your families. Thank you for reading Monday Morning Outlook in 2019. We certainly look forward to helping you navigate both the risks and the opportunities as they appear in the coming months, and wish you a safe and happy 2020.
Todd Salamone is Schaeffer's Senior V.P. of Research
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