Delta-hedge selling is a risk this February expiration week
“During the course of the SPX’s January rally, each week’s theme has been one major resistance area taken out, and another in immediate view… After reaching an overbought condition for the first time since August going into Friday’s trading, according to its 14-day Relative Strength Index (RSI), the SPX declined from the 4,150-4,160 area, which was not a huge surprise. For example, 4,150 represents a 50% retracement of its all-time record high in January 2022 and the October 2022 low.”
-Monday Morning Outlook, February 6, 2023
The first full week of trading in February was a contrast to what we had become used to in January, when the S&P 500 Index (SPX--4,090.46) rallied each week above the next level of resistance. Last week was different, as the resistance level that came into play on Friday, Feb. 3 continued to act as resistance last week.
Specifically, the SPX area that is a round 10% above its late-December closing low and a 50% retracement of the January 2022 all-time high and October 2022 low in the 4,150-4,160 range continued to act as resistance. This area, by the way, also marked a major short-term peak in June 2022. After various Fed officials indicated the inflation fight is not over throughout the week, the SPX closed lower, due to a combination of technical and monetary factors.
A quantified way to look at how comments from various Fed officials impacted rate expectations is utilizing data provided by CMEGroup.com. Fed funds futures traders increased the probability of two more rate hikes after the June meeting from 14% on Feb. 3 (after the release of January payrolls data) to 37% as of this past Friday.
The bad news is that stocks traded lower last week. But the good news is that investors are now factoring in higher rates in the immediate future and there was not any technical damage in the midst of last week’s pullback. By factoring in higher odds of higher rates by the June FOMC meeting, this could help alleviate the size of any negative surprise when economic data is released this week, particularly the January consumer price index (CPI) data slated for Tuesday morning.
Piggy-backing on the good news being that there was no technical damage that occurred last week, the SPX remains above the popular 20-day moving average, which marked a low after three days of selling in mid-January. Moreover, the index found support Friday around the 4,075 level, its close ahead of the last rate hike and, coincidentally, its early-December closing high that preceded a 7% decline into the end of December.
More importantly, the index comes into the week well above the 3,970 level, site of last month’s breakout above a trendline connecting all major highs since the January 2022 all-time closing high. A break below this level, in my opinion, would tilt the technical backdrop back in favor of the bears, as breaks back below trendline breakout levels since January 2022 have been major red flags for investors.
Therefore, the SPX 3,970 level is one to closely monitor if stocks sell off during a February expiration week that is accompanied by a plethora of key economic reports. I already mentioned January CPI data set to be released Tuesday morning, which could be the most important data point for investors in the week ahead. This will be followed by January retail sales and industrial production data Wednesday morning, plus the producer price index (PPI) number and housing starts on Thursday. The extension of the major trendline that connected all major highs until last month’s breakout will be sitting at 3,900 area at the end of this week and would represent the next level of support if 3,970 is breached.
If buyers surface this week, potential resistance remains at the 4,150-4,160 zone, per the earlier observation. Above that level is 4,225, which coincides with a round 10% above the 2022 close and therefore a potential hesitation or pivot point.
Per the SPDR S&P 500 (SPY--408.04) open interest configuration graph for February 17 standard option expiration, delta-hedge selling risk becomes a real threat to bulls if the 395 strike is broken, which is the equivalent of 3,950 on the SPX (which is just below the important 3,970 level that I discussed). The 395 strike is the first below the current SPY level where there is significant put open interest and where put open interest significantly outweighs call open interest. Big put open interest below that strike could act as magnets if the 395 strike is broken.
An additional risk that I see for bulls in the upcoming week is with respect to recent Cboe Market Volatility Index (VIX--20.53) action. Per the chart below, the VIX advanced above a trendline connecting lower highs since the December peak. This could be hinting at a couple of things: 1) a correction on the horizon and/or 2) the path for bulls will not be as smooth in February as we saw in January. This is in context of VIX futures option buyers purchasing calls relative to puts at a rate of five to one. Historically, these option buyers have been smart money, but since November, their call buying bias has not played out correctly.
The horizontal line in the graph below is the VIX’s 2022 close. Note that it marked the mid-January high and this past Friday’s high. As such, I think risks to the bull case increase if the VIX gets significantly above its 2022 close at 21.67.
Finally, options on VIX futures expire Wednesday morning. A VIX futures settlement price on Wednesday morning between the 21 and 22 strikes would maximize the profit of sellers of call and put options on VIX futures, as this is the point where the largest number of calls and puts would expire worthless.
Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.
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