As of this writing, former Vice President Joe Biden is the president-elect of the United States of America. Meanwhile, the jury is still out on whether or not the Senate will continue to hold the Republican majority, as races in Georgia head toward a January runoff. However, the House majority has been called to remain Democratic. In terms of market expectation, ahead of the race, a theoretical "blue wave" was expected, given a surge in mail-in voting mid-pandemic were expected to lean democratic, as President Donald Trump previously encouraged his voters to cast ballots in person. While the "blue wave" was less prevalent than anticipated, mail-in votes did end up leaning in Biden's favor in Pennsylvania, Georgia, Nevada, and Arizona, with the race finally called on Saturday morning, five days after election day.
In addition to the presidential election, the Federal Reserve recently reiterated its perception of the risks the COVID-19 pandemic presents to the economy, and maintained its pledge to keep interest rates low.
“…put buying on VIX futures options has historically tended to precede a bullish equity environment and lower volatility. There is still a chance that these buyers will be proven correct on the direction of volatility, but they may have been premature or too aggressive in their bets, and many may risk losing their entire investments -- even if they are correct about a post-election volatility contraction.”
- Monday Morning Outlook, Nov. 2, 2020
As I have been discussing recently, put buyers on CBOE Market Volatility Index (VIX – 24.86) futures options were making historic bets on declining volatility in the coming weeks. Such bets established a multi-year high relative to bets on higher volatility, which was evident prior to the pre-election volatility spike, and continued as volatility spiked prior to the election (pictured in the chart below). VIX futures options buyers are typically correct about the direction of volatility, although this does not mean they “cash in” on such bets.
For what it’s worth, the VIX futures options put buying began to really ramp up in early October, with the VIX trading in the 28-30 area, and the continuous front-month VIX futures contract (/VXc1 – 25.35) trading between the 30-32 levels. As I mentioned last week, it was possible that these put buyers would be correct about the direction of post-election volatility, but they may have been too early in their bets to profit from these puts, given that a huge majority of the November futures put open interest is situated at the 20-26 strikes.
Just as VIX call buyers typically see their option purchases expire worthless -- even when they were correct about the direction of volatility -- the same could be true for put buyers with November VIX expiration on the morning of Nov. 18. This is something that we will monitor closely in the days ahead, with the November futures contract trading just above a mountain of potential put open interest support.
Note that the contracts’ recent closing-high on Oct. 28 of 36.00 was around strikes in which call open interest levels exceeded put open interest levels. This could create a situation in which buyers of volatility – whether their bets are on upside or downside volatility -- lose most or all of their investment on Nov. 18.
Adding to the discussion above, I find it interesting that large speculators, who are typically wrong on volatility direction at extremes, covered roughly 20% of their short bets in the week that volatility measures peaked in late October/early November. Ahead of the election, their net short position on VIX futures was the smallest in four months.
“If you are looking for more clues regarding the direction of the next big volatility move, you can key to the levels I identified on the VIX graph above. In other words, I could see the June high in the 41.85-42.70 area as a potential volatility peak, since these levels represent one-half the March closing high, and double the August closing low, respectively. And if the VIX moves back below 36.30, or three times the January closing low, this could be indicative of volatility heading lower.”
- Monday Morning Outlook, Nov. 2, 2020
The VIX peaked just short of the key levels discussed last week, and I did not mention 41.34, which is three times or 200% above its 2019 close. The VIX closed below 36.30 on Election Day, which is three times its January closing low. This was a level I told readers to look for as a potential indication of lower volatility, an observation that was proven invaluable as volatility was crushed throughout the rest of the week. In fact, the VIX went on to fall below two key trendlines I have been following -- the 30-day and 252-day moving averages – which had been connecting lower highs in September/October and higher lows since early August.
So, now what? According to most measures, the VIX action looks bearish for volatility, and bullish for equities. And if those that took the other side of the massive put buying on the November VIX futures contract are forced to hedge their position to remain neutral, we could easily see the VIX and November VIX futures contract drop to the 20-21 area. If the VIX pops back above 27.56, which is double its 2019 close and back above key trendlines connecting lower highs and higher lows, watch out for a move back to its October closing high.
Turning to levels on key benchmarks, bulls should be aware that we are near levels that have been sold in 2020. For example, after the S&P 500 Index (SPX – 3,509.44) found support on Oct. 30 at the 3,230 area (the site of its 2019 close), it closed sandwiched between the round 3,500 area and below 3,553, which is 10% above its 2019 close. As you can see in the chart below, buyers have emerged at the SPX’s year-to-date breakeven level, but sellers have generally emerged at the level that is 10% above the SPX’s 2019 close. With the elections coming to an end, will this pattern finally break in favor of bulls? Or will the lawsuits and recounts be enough for the pattern to continue?
Additionally, the Nasdaq Composite (IXIC – 11,895.23) closed just 115 points shy of the key 12,000 millennium mark. Since first touching this level on Sept. 2, this marks the only time this benchmark closed above 12,000.
On the sentiment front, I think there is enough sideline money to push stocks higher. Per my comments on Twitter, equity option buyers were at their most pessimistic since late-May prior to the election. While this pessimism was not anywhere near historical, the fact they were accumulating puts at a higher rate than calls compared to the past few weeks lays the foundation for a short-term rally. Moreover, the weekly National Association of Active Investment Manager (NAAIM) indicated a reading of 69 last week, down from a 104 reading in mid-October (100 represents fully invested).
Finally, a reversal or even slowing of the massive outflows from domestic equity funds could be enough to reduce the resistance at levels that we have seen sellers emerge in recent months. For instance, when observing the combination of domestic traditional equity mutual fund and exchange-traded fund flows, the months of July, August, and October represented the three biggest outflows since at least December 2017.
Todd Salamone is Schaeffer's Senior V.P. of Research
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