Even with standard September options now expired, delta-hedge selling remains a risk
“…we are in one of the end-of-quarter months with standard expiration less than 10 trading days when the bell rings Tuesday morning. As such, in such situations, you can sometimes throw your chart work out the window, as delta-hedge selling knows no chart boundaries...You should be on high alert for the potential of a severe, sharp decline these next two weeks as long as the SPY remains below the 400-strike. This is especially if it dips below the 390-strike between now and Sept.16 expiration”
- Monday Morning Outlook, Sept. 6, 2022
“…the SPX is not out of the woods… there are catalysts this week that could produce volatility in either direction, implying the SPY 400 strike is still very much in play. First and foremost is inflation data due out Tuesday (Consumer Price Index numbers for August) and Wednesday (Producer Price Index for August)… the SPY 400 strike represents the first potential magnet if a decline, sparked perhaps by various economic data releases…Continue to be in tune with where the SPY is in relation to key put strikes as we move through the rest of this month”
- Monday Morning Outlook, Sept. 12. 2022
Going into standard September expiration last week, the bulls were encouraged by a three-day, 4% rally in the S&P 500 Index (SPX -- 3,873.33). Specifically, a rally from the “make-or-break” 3,900 level to above the 4,000-millennium mark.
The technical backdrop improved a bit on the first trading day of the week, after the SPX closed above a trendline connecting lower highs since mid-August. However, as I cautioned last week, Tuesday’s August Consumer Price Index (CPI) data debuted, which tends to be a potentially market-moving event that could be magnified during expiration week. As I also explained in prior weeks, a report that was not welcomed by investors could easily send stocks lower and such action could be exacerbated by the huge put open interest at on SPDR S&P 500 ETF Trust (SPY -- 385.56) and SPX index options.
Last week’s major takeaway was that the SPX was not out of the woods, with catalysts on the horizon that could push it down to and below 4,000. In turn, this gives the potential to spark “delta-hedge” selling -- a process in which big put open interest strikes below the market act as magnets. This happens because sellers of those puts are forced to sell a continuous amount of S&P futures to remain fully hedged. Then, as the put strikes are approached and ultimately breached, the sold puts become more and more sensitive to the SPX’s or SPY’s downside action. Sparked by the CPI number, the action last week smelled very much of delta-hedge selling.
Risk of this delta-hedge selling process increases when an exchange-traded fund or index is trading just above a series of heavy put open interest strikes in the days preceding expiration. This was the case for both the SPY and SPX during the past two weeks. There is a known calendar event (in this case inflation data) of unexpected news that scares investors, as well. A prime example last week was when FedEx (FDX), General Electric (GE) and Huntsman (HUN) lowered guidance after the close Thursday.
Even with standard September options now expired, delta-hedge selling remains a risk. With September being the end of the quarter and the Federal Open Market Committee (FOMC) scheduled to meet this Tuesday and Wednesday, put open interest on SPY daily, weekly, and quarterly expiration options cannot be ignored. There appears to be a significant amount of hedging and/or speculation to guard against or profit from an unwelcome FOMC outcome and/or any other negative news into quarter-end.
This is evident in the still huge put open interest for options expiring through quarter end, per the second graph below, which can be viewed as potential magnets to the downside. In other words, despite the decline last week, there may be more to come with big put open interest for expiring options. The FOMC meeting this Wednesday will likely be the event that generate more volatility in the coming days. Be prepared for either an unwinding of short positions associated with the put open interest if the FOMC outcome is well received, or action on the scale of last week if the FOMC outcome disappoints market participants. The enormous put open interest can exaggerate both upside and downside moves.
Based on the below graph, SPY downside to the 330-strike, which is equivalent to SPX 3,300, by month’s end, while improbable, is still a higher probability than normal. This is because exactly like last week, the SPY is trading barely above big put open interest strikes below the market – the 330-strike being the last major put open interest strike - on options set to expire within 10 trading days amid a major catalyst between now and month end (FOMC).
When option-related buying or selling occurs around expiration weeks, technical analysis sometimes goes out the window for a short period. That said, the SPX did pullback to and rally from potential support levels we have discussed in the past. For example, SPX 3,581 is the SPX’s close when U.S. President Joe Biden took office. Just below that is 3,837, a level that corresponds with 20% below the SPX’s all-time closing high. And below that is 3,812, or a round 20% below the SPX’s 2021 close. The former two were tested intraday on Friday, but thankfully for bulls, closed above both. On the upside, potential resistance is at 3,900 and 4,000 as we move toward month and quarter end.
Todd Salamone is a Senior V.P. of Research at Schaeffer's Investment Research
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