Will We Get a VIX Spike With This Week's Rate Hike?

"If fed funds futures traders are correct, and if past is prologue, bulls should welcome the FOMC standing pat this week... [there's] a propensity for stocks to rally in the short term following FOMC decisions to hold rates steady, with a bias toward broad-market weakness in the immediate days and weeks following a rate hike."
-- Monday Morning Outlook, October 30, 2017

"For now, the short-term playbook reads as follows for those using volatility to time stocks: 'Buy equities if VIX rallies into its 2017 breakeven zone at 14.07 and retreats back below this level; be cautious on closes above 11.25 or 14.07, and be on guard for a volatility pop/stock drop when the VIX reaches a sub-10 reading and crosses back above 10.00.'"
-- Monday Morning Outlook, December 4, 2017

Last week, I presented a short-term playbook for buying and selling equities based on the CBOE Volatility Index (VIX - 9.58) behavior over the past few months. Now, ahead of a mid-week Federal Open Market Committee (FOMC) meeting, I revisit a playbook many of you have seen before -- the S&P 500 Index's (SPX - 2,651.50) behavior in the weeks following a meeting in which the Fed raises rates versus those where it holds rates steady.

The SPX behavior I have observed relates only to the current tightening cycle, which began in December 2015. Simply put, in the four times that the Fed has raised rates -- even if expected to do so -- the next month has been challenging for stock market buyers. On the other hand, after the 12 instances where the Fed held rates steady, it has been a rather lucrative time for stock buyers in the following month.

Additionally, throughout the current tightening cycle, the levels marking the SPX close on the day prior to and on the day of Fed meetings have been important to key on, from a technical perspective, in terms of gauging potential short-term resistance or support in the days after the meeting.

Per the tables and the SPX chart below, if the Fed indeed raises rates, both the expected return and the probability of the market moving higher over the following one-month period declines relative to the expectations if the Fed were to surprise market participants by holding rates steady.

And market participants do expect the Fed to raise rates for the third consecutive December. According to the CME Group FedWatch Tool, in the hours following Friday's November employment data, fed funds futures speculators were placing a 90% probability on a rate hike of 25 basis points. Whether or not these speculators prove correct again, time will tell. Note that the Fed delivered on the "hold steady" expectations at the last meeting on Nov. 1, and the SPX subsequently rallied 2.4% in the month following the decision.

As we move into Fed week, coincidentally, it is also expiration week for standard equity and index options. I find it interesting that with expectations of a Fed rate hike on Wednesday, the SPX comes into the week around the 2,650 level. You have heard me say on multiple occasions that half-century marks on the SPX have proven to be pivotal in terms of support/resistance, and have acted as short-term to longer-term hesitation areas during the SPX's advance over the years.

After first touching 2,550 in early October, the SPX was still flirting with this area on pullbacks during an upward-bias grind through mid-November. In the second half of November, the SPX finally left 2,550 in the dust. The action in recent days around SPX 2,650 is somewhat reminiscent of the action around 2,550.

SPX 2,650 is equivalent to the 265 strike on the SPDR S&P 500 ETF Trust (SPY - 265.51), which is the site of peak call open interest in the immediate vicinity of last week's SPY close. Our data from the major options exchanges suggest that most of the overhead call open interest, including that at the SPY 265 strike, was sell-to-open activity. This implies that these heavy open interest strikes will act like lids when approached, as those who took the other side of the trade and bought the calls will short a growing number of S&P futures to stay neutral. However, if those who sold the calls to open decide to close their positions, it would unleash short-covering in S&P futures.

For now, consider the SPY 265 and 266 strikes as potential resistance levels in the short term, which is equivalent to SPX 2,650-2,660.

With a Fed rate hike looming, the SPX situated around a half-century mark, and SPY facing heavy call open interest overhead, the VIX enters the week below 10.00. Therefore, short-term traders should be on guard for a VIX move back above 10.00, as these "9-handle" closes have been a precursor for VIX pops in recent months. In fact, in late November, the VIX surged above 14.00 just days after retreating below 10.00, with tech stocks taking the brunt of the punishment.

"...the IXIC low point on Friday was at 6,737 -- nearly 2% below Thursday's close... The Friday low was just above its 40-day moving average, too, in a pattern that looks very similar to the late-September and late-October lows... If past is prologue, a rotation back into the tech group is due -- but all bets are off on a close below the channel line and moving average shown on the chart."
-- Monday Morning Outlook, December 4, 2017

The "rotation out of tech" was a storyline throughout most of last week. However, as it was being discussed, it was a rotation back into tech, with the Nasdaq Composite (IXIC - 6,840.08) continuing the pattern like that of September and October, in which the 40-day moving average and a trendline connecting higher lows came into play as support around 6,735. Now, the challenge is for the IXIC to overcome a channel line drawn through most of the highs since June, which is currently situated just below 6,900, and represented Friday's high.

As tax reform, Brexit progress, and a deal to extend government funding through Dec. 22 were the positive forces last week -- and will likely remain in the headlines in the days to come -- be on guard for the market to stall or pull back into the rest of the year if the Fed raises rates on Wednesday, even though such a hike is widely expected.

But the trend is with the bulls, so continue using call options, or stock-replacement option strategies, to play your short-term bullish ideas. The leverage allows you to profit handsomely with fewer dollars to manage the Fed risk in the days and weeks ahead. Sprinkle some bearish plays into the mix, via put options -- preferably short-term weekly options that expire before the end of the year, in anticipation of the fact that when the Fed does raise rates, the market is vulnerable to underperformance relative to when the Fed holds rates steady.

Continue reading:Indicator of the Week: This VIX Signal Has Happened Just One Other TimeThe Week Ahead: Economic Schedule Centers Around Fed Meeting, Quadruple Witching Friday

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