“…take advantage of cheaper index and equity benchmark exchange-traded fund (ETF) options and hedge your portfolio with puts. Or, given the heightened risk of a volatility pop, purchase calls on VIX futures options or another volatility benchmark.”
- Monday Morning Outlook, January 21, 2020
“While not all standard VIX expirations are followed by a big move higher in volatility… when VIX pops happen, it is usually soon following a big drop off in call open interest due to standard VIX expirations. April, July and November 2019 expirations are prime examples.”
- Monday Morning Outlook, January 27, 2020
During the last two weeks, I have discussed the heightened probability that we could be on the verge of a volatility pop of some magnitude. And last week, I mentioned how the risk to bullish equity market participants grew with the passing of the expiration of January standard expiration options. On the morning that last week’s commentary was posted, the Cboe Market Volatility Index (VIX - 18.84) gapped above key levels that I have identified recently. With Friday’s VIX high at 19.99, 56% above the January 21 close when I advised using volatility calls as a hedge, add the expiration of standard January 2020 VIX futures options to the list of volatility pops that occurred shortly after a standard expiration.
The cause of the pullback has been attributed to the outbreak of the coronavirus and its potential negative impact on world economic growth. Travel to and within China, the world’s second-largest economy, has come to a standstill. There were (and are) other uncertainties festering as well, such as the Senate hearings regarding President Donald Trump’s impeachment, Brexit becoming official, and the upcoming Iowa caucus that could be spurring election uncertainties.
Regardless as to “why” sellers emerged and volatility popped, we remain on alert for even higher volatility ahead. In fact, this was the implication in my Twitter post on Wednesday, in which I pointed out that following a VIX pullback from the Monday peak in the 18 area, the Wednesday lows held at the trendline marking lower highs since August and the 252-day (one year) moving average, both of which previously acted as “resistance” in December and the first half of January. My expectation from the VIX holding at previous resistance was that we were not out of the woods as far higher volatility ahead, which we saw briefly Thursday morning and more noticeably throughout Friday.
More volatility could be ahead, with the VIX closing the week (and the month) above the 18 area. I have mentioned the 18 point as an important one before, as it is half the December 2018 closing high and 50% above the general floor in the 12 area that has been in place since the second quarter of 2018. Early last week, the VIX found resistance in the area, as those looking to hedge equities likely disappeared, viewing hedging too expensive, and thus removed a coincidental headwind that occurs when hedging activities are rampant.
But with the VIX eventually moving and then closing above 18 on Friday, it could signal that more market participants are seeing more risks ahead in the short term. Additionally, the VIX moved above its year-over-year breakeven level, which acted as peaks in volatility early and late last year, but also hinted at more volatility ahead when moving into positive territory.
How high could volatility, as measured by the VIX, go? With the 18 level decisively taken out to the upside in the days ahead, do not be surprised to see it venture to at least the 24 area, double the 12 floor that has been in place for about two years.
In fact, the VIX technical pattern that stands out to me at present is similar to the early May through first half of July 2019 action – seen in the chart immediately below, in which a trendline connecting lower highs (similar to August-January) was taken out and retested before the VIX doubled in a matter of days. A repeat of this pattern in terms of the VIX doubling from the retest level of the August-January trendline would target a VIX move to the 30 area, or a round 150% above the floor at 12. If there is higher volatility ahead, bulls hope that the VIX peak is contained around 20.67, which is 50% above its December 2019 close.
Keep in mind that as I talk about the potential for more upside in volatility that my reasoning isn’t limited entirely to chart observations. The recent upside in the VIX comes as many were positioned for a downside move in volatility, as is evident by large speculators on VIX futures being near an extreme on short volatility futures trades. The unwinding of this trade has the potential to boost the VIX by triple-digit percentages that I referred to in the paragraph above.
“Yellow flags are waving for short-term bulls, as the SPX’s failure at 3,335 was followed by a close below the 3,300-century mark. Additionally, the RUT’s failure at 1,700 preceded a close below its year-to-date breakeven mark at 1,668.46. Finally, the Dow Jones Industrial Average’s (DJI - 28,989.73) failure at 29,000 is another factor that you can add to your list of indicators hinting at a pullback after an impressive run higher since October.”
- Monday Morning Outlook, January 27, 2020
After finding resistance at five times the 2009 low, a level I cautioned Twitter followers about on January 24, bulls should be further concerned with the S&P 500 Index’s (SPX - 3,225.52) break below its 30-day moving average, which acted as support during the early December decline. Additionally, a trendline that connects the early October and early December lows was broken in Friday’s trading, after acting as support when the SPX gapped lower last Monday. Finally, the SPX closed the week and the month below its December 2019 close at 3,230, putting the bears in control as far as 2020 is concerned. Admittedly, the damage is not widespread, but bulls should be prepared for more pain.
The 100-point-plus SPX pullback since late January and breakdown below multiple short-term support levels is occurring within the context of our 10-day, equity-only, buy (to open) put/call volume ratio advancing from multi-year lows. Equity option buyers, previously at an optimistic extreme as the SPX peaked at resistance in the 3,335 zone, are becoming less enthusiastic, as they purchase less equity calls relative to equity puts compared to the previous days.
The unwind of the multi-year extreme in optimism is in its early stages. Therefore, the risk to bulls is that, to the extent that a sentiment transition like this among equity option buyers is representative of other market participants, the unwind of enthusiasm could further pressure the market in the days and weeks ahead.
Put open interest is building on the SPDR S&P 500 ETF Trust (SPY - 321.73), and I will be monitoring which strikes are seeing the bulk of the activity in the days ahead, as they could become important if equities continue to sell-off and February expiration approaches.
Meanwhile, if a VIX in the 24-30 range is in the cards, what would this mean for the SPX? Per the chart below, a trendline connecting higher highs since early 2018 sits at 3,100 when fast forwarding to February standard expiration. And if a pullback to the 200-day moving average is on the horizon, which has acted as support on five pullbacks since early 2018, the 3,000-millennium mark would be a target, which is 10% below the recent high. As for overhead resistance on rallies, the SPX’s 3,295 level is one to focus on, which is the close that preceded last week’s Monday gap lower.
Todd Salamone is Schaeffer's Senior V.P. of Research
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