“… there is a chance that the VIX moves to the 24 area, which is double its 2020 closing low and another level from which a short-term pop could occur.”
- Monday Morning Outlook, May 26, 2020
“…during the past couple of weeks, short-term equity option buyers have grown more and more enthusiastic, which has resulted in a caution flag being waved during this period. But the current momentum off the trough is why I advised option strategies such as straddles, which give you both call and put exposure to play the momentum, while also hedging as short-term optimism enters the market.“
- Monday Morning Outlook, June 8, 2020
“…the SPX’s 2019 close hovers just overhead at 3,230.78, along with the round 3,200... this is the first time that the SPX’s 14-day Relative Strength Index (RSI) has moved into overbought territory since mid-January, which preceded only a minor short-term pullback.”
- Monday Morning Outlook, June 8, 2020
The above excerpts from previous Monday Morning Outlook reports along with various comments that I made on Twitter last week give you an excellent glimpse into what preceded and what transpired last week on Wall Street. In fact, I am not one
to post a lot on Twitter, but there was just too much in the way of developing situations.
For weeks I had been noting how short-term traders were approaching extremes in optimism, tagging the market as "vulnerable" even as it took out resistance level after resistance level. In fact, as I noted on Thursday morning, speculative
optimism among equity option buyers had reached levels that exceeded what was measured in March, ahead of a vicious decline.
It was a perfect storm, as the S&P 500 Index (SPX -- 3,041.31) was struggling to take out its 2019 close while coming into the week overbought for the first time since January. Sellers predominated around the SPX’s 2019 close as
market participants saw an opportunity to derisk after being presented a second chance to avoid losses this year amid lingering COVID-19 economic uncertainty, an event that was brewing but not yet seen as significant coming into 2020.
Around the same time that the SPX was flirting with its 2019 close, the CBOE Market Volatility Index (VIX -- 36.09) was trading in the 24 area -- double its 2020 low and site of its 200-day moving –- 24 being a level that I mentioned
at the end of May as a potential "target" before the next pop higher in volatility occurred.
And pop it did, admittedly more than I envisioned over such a short period. Of course, the volatility burst was accompanied by three consecutive days of selling in equities, highlighted by Thursday’s 5.9% decline in the SPX. This was
fueled by more warnings from the Fed on Wednesday, which suggested the economy may remain in the doldrums until 2022, as well as renewed worries about another wave of COVID-19. Given the sectors that got hit the hardest during the decline,
particularly on Thursday, it appears retail players that bid up sectors like airlines, hit the panic button.
As of now, the decline last week reminds me of the price action in mid-May, when the SPX pulled back 6% from intraday high to intraday low during a three-day period. The catalysts were Fed Chair Jerome Powell calling the outlook "highly uncertain,"
and notable hedge fund managers warning about a horrible risk-reward environment for equities.
The mid-May pullback began from a level that corresponded to a round -10% year-to-date (YTD) return and a 61.8% Fibonacci retracement of the 2020 closing high and closing low. The trough occurred at the SPX’s 30-day moving average, which
corresponded to a 50% Fibonacci retracement of the 2020 closing high and closing low.
Similarly, the Tuesday-Friday decline last week began at the level that corresponds to the SPX’s YTD breakeven this year on the heels of more Fed warnings. As of Friday, the SPX was trading at its 30-day moving average, situated just
below the 3,000 millennium mark, and in the general vicinity of the 61.8% Fibonacci retracement of the 2020 closing high and closing low.
In mid-May and last week, the VIX ventured near or into the 40 area and its rising 80-day moving average. This moving average marked the low in mid-February and the peak in mid-May.
Currently, the VIX’s 80-day moving average is situated just below 41.34, which is triple the 2019 close and 2020’s half closing high at 41.85. Given large speculators are not in an extreme short position and there were already
big inflows into leveraged volatility exchange-traded notes (ETN’s) since late May (see second chart below), I can make a case that the VIX is at or near its peak because fewer were caught off guard by last week’s volatility
event, relative to the one in February and March.
But all bets are off if the VIX moves through 46, which is 10% above the 41.85 half-high.
There are a few key differences from the mid-May pullback that present risks, beginning with a bearish island reversal on the SPX. This pattern began with the June 5 gap higher, followed by three days of sideways movement, including a doji
candlestick on June 9, and completed with a bearish gap on June 11.
Additionally, from a sentiment perspective, option buyers in mid-May were becoming more enthusiastic, but they were not at an extreme that warranted caution. Now, equity option buyer enthusiasm is at an extreme, which heightens risk of an
unwind of this enthusiasm that creates a giant headwind for equities.
If the SPX breaks its first line of support in the 2,985-3,000 zone on a closing basis, this might be enough to give short-term speculators the nerve to increase downside bets, creating a headwind for stocks in the process. If, however, last
week’s lows prove to be a short-term trough, I would expect a rally back to last week’s high in the 3,230 area, followed by a volatile summer trading range that washes out the optimism among short-term traders at present.
Finally, it is standard expiration week for June options. With last week’s selloff, I looked into the possibility of the selling becoming exacerbated by delta hedging. In other words, sellers of put options on index or exchange-traded
funds (ETFs), such as the SPDR S&P 500 ETF Trust (SPY -- 304.21), are sometimes forced to hedge their positions by shorting more and more SPX futures as the SPY declines toward a strike with heavy put open interest. They do this as
the put becomes more and more sensitive to changes in the declining SPY. This is particularly a risk during the days leading up to and during expiration week.
Per the SPY open interest configuration chart below, put open interest dwarfs call open interest at the 285 strike and under. So, as of now, delta-hedge selling risk is low. But, if the SPY trades below $290 before Friday expiration, delta-hedge
selling risk increases substantially, with puts stacked down to the 255 strike. If the SPY can hold above $285 to $290 (equivalent to SPX 2,850-2,900), there will be a slight tailwind from short S&P futures positions already tied to
those big put strikes.
Todd Salamone is Schaeffer's Senior V.P. of Research
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