Why Last Week's SPY Breakout is Suspect

"If the SPY moves above both the 247 and 248 strikes, not only is the chart resistance discussed above taken out, but the 250 strike becomes a potential magnet. In other words, a technical breakout on the SPY price chart during this expiration week would likely continue with a quick, sharp move to the $250 level, as both technical buyers step in and sellers of SPY 250-strike calls are forced to partake in the buying as a hedging strategy. Such a scenario would produce short-term call buying opportunities."
-- Monday Morning Outlook, Sept. 11, 2017

The SPDR S&P 500 ETF Trust (SPY - 249.19) entered last week below a "call wall" immediately overhead, in addition to chart resistance at $247.43, site of the July 26 close coinciding with the last Federal Open Market Committee (FOMC) meeting. If you are a new reader to this weekly market commentary, I had been discussing the importance of $247.43, as it has been the site of resistance since the late-July FOMC meeting.

While the odds were against an expiration week rally from purely a technical and options-related perspective, the SPY behaved exactly as I expected after the Monday morning gap above the 247 and 248 strikes. A quick, sharp rally ensued up to the $250 level, at which point the advance quickly ran out of steam.

As discussed last week and as displayed in the table immediately below, the SPY 250 call strike was home to monstrous call open interest. Therefore, after the move through the 247 and 248 call strikes, sellers of call options at the 250 strike were likely forced into buying more and more S&P futures to hedge their position, creating a massive tailwind for equities up to the $250 level. The larger the position that must be hedged, as indicated by the amount of open interest at that strike, the more S&P futures must be bought, and thus there's a greater impact on the immediate direction of the market.

I have previously mentioned that the kinds of technical breakdowns that occur around expiration week and are partly driven by "delta hedge" selling related to big put open interest strikes are suspect, especially during bull markets. In that respect, the breakout above chart resistance that pushed the SPY to $250 and the S&P 500 Index (SPX - 2,500.23) to 2,500 might be viewed as suspect, too, as options expiration week and the big call open interest at the SPY 250 strike may have helped induce more buying than usual. Therefore, it would not be surprising to see weakness early this week in the absence of a positive catalyst, as buying related to options expiration has subsided, and investors are now weighing important round numbers (including SPY $250 and SPX 2,500) -- not to mention another FOMC meeting in the middle of the week.

I have mentioned on several occasions that amid a constant stream of headlines related to North Korea, the Trump administration, debt ceilings, tax and healthcare reform, and terrorism, the most relevant headlines to investors are those related to the Fed. This is evident in how the SPY and SPX have behaved in the immediate days after FOMC meetings, as the closing prices around Fed meetings have proven to be resistance levels in the immediate aftermath of a rate hike, while breakouts have usually occurred when there is no interest rate action (with July 26 being the exception, although a very delayed breakout finally took place last week).

Traders of fed funds futures are assigning a near-zero probability to a Fed rate hike on Wednesday. However, the Fed will release its dot plot, or projections for the future, and this will receive a lot of attention -- especially as it relates to whether they see another rate hike by year end. As of Friday, fed funds futures were assigning about a 56% probability of a rate hike at the December meeting, up from 31% the previous week. I find it interesting that stocks rallied as the probability of another rate hike this year increased, perhaps as investors seek signs that growth and a little inflation will power earnings, even if the Fed does raise rates again in December.

Before the outcome of the Wednesday afternoon Fed meeting, options on September CBOE Volatility Index (VIX - 10.17) futures expire Wednesday morning. There are currently 10.4 million outstanding VIX calls, with 4.4 million in the expiring September series. There is considerable call open interest beginning at the 11 strike up through the 14 strike. If past is prologue, around 90% or more of these VIX call options will expire worthless. But beware that volatility could drift higher, as expiring September calls are replaced with October calls. Furthermore, the VIX comes into the week just above 10, and this level has acted as a floor, with a couple pops from this area occurring from Aug. 8-11, and a one-day pop that occurred on Sept. 5.

"... dare I say it, the 1,500 half-millennium area marked the beginning of the last two bear markets, which began in 2000 and 2007. The peaks in 2000 and 2007 took months to form, so as the SPX probes 2,500 we are not suggesting a bear market is necessarily imminent. But this is a risk to put on your radar as other technical and sentiment indicators are evaluated in the days and months ahead."
-- Monday Morning Outlook, July 31, 2017

With the SPX achieving an all-time high at 2,500 last week, it's worth revisiting the above excerpt about the potential importance of this half-century mark, based on the history of 1,500 marking the start of two bear markets. As I said back in July, tops usually take months to form, and what occurred at 1,500 may not necessarily occur at 2,500. For now, there is nothing actionable if you are a longer-term investor. We have yet to see significant technical deterioration in the market and, in fact, this still appears to be a market climbing a "wall of worry," and not yet feeding on rampant optimism.

Total $SPX component short interest (SI) +4% in latest report and near the pre-election Nov'16 level- SI +16% since 2/1 low, with $SPX +8.5% pic.twitter.com/kyHEdFsvX9

- Todd Salamone (@toddsalamone) September 13, 2017
Per an observation on Twitter I made last week, some evidence that we're climbing a wall of worry can be found by analyzing short interest trends on individual SPX component stocks with an SPX overlay. It is impressive that short interest is rising along with the SPX. This is evidence that the shorts are feeling some pain and are thus more apt to cover, particularly those who have been building positions since short interest hit its 2017 low point in early February.

After hearing a couple of fund managers on a financial TV program exclaim that they are surprised about how the market has behaved amid the negative headlines this year, I continue to strongly recommend call options to leverage stocks you favor in the weeks and months ahead. With options, you commit fewer dollars to the market relative to buying the equity, but you can still achieve profits as if you had bought a significant number of shares. In other words, if the trend is your friend, but the headlines scare you, call options should be considered so that you have less capital at risk.

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