Equity option buyers could be potentially supportive
–Monday Morning Outlook, December 9, 2024
Buyers went on strike last week, with the S&P 500 Index (SPX-6,051.09) pulling back less than a percentage point. As of Friday’s close, the index was sitting in the vicinity of the first level of support in the 6,050 area.
We enter this week’s trading 175 points below the 6,215 yearend target that is just two weeks away. Even if buyers go on strike again this week, the next level of support isn’t far below in the round-number 6,000 region, which is site of the mid-November high before a short-term pullback. Additionally, the SPX’s ascending 20-day moving average, which caught the mid-November low, is currently just above the 6,000 level.
The focus in the coming week will be Wednesday’s monetary decision by the Federal Open Market Committee (FOMC). Fed funds futures traders, per data from CME Group, are placing a 97% probability of a 25-basis point cut. The odds of a rate cut moved up 11 percentage points from the prior week, after traders processed reports on inflation and jobless claims.
The first rate cut in September was a catalyst for a breakout above resistance that asserted itself during the dog days of summer. Additionally, buyers emerged after both the elections and a second rate cut by the FOMC early last month. Bulls will be looking for the Fed to sprinkle some holiday cheer that sparks a rally in the final weeks of the year.
Who could support a rally? One group that is currently supportive is equity option buyers, who are buying puts (bets on lower prices) at the lowest rate in years relative to calls (upside bets). But they are doing this in the context of all-time highs and if they have solid reason to continue emphasizing calls, this will be supportive. But beware, their level of enthusiasm for upside in equities presents a risk too, as this group is usually most enthusiastic at tops and least enthusiastic at bottoms. But if such call buying relative to put buying continues amid broad market strength, it will remain a coincidental tailwind.
A constant theme in this newsletter in 2024 has been short sellers being an eventual and potential source of buying power via short covering. But to my amazement, after the bi-weekly release of short interest data by the exchanges last week using data as of Dec. 1, the shorts have only been a headwind, implying the rally this year could be stronger.
In other words, short interest on SPX component stocks has now increased 15% this year and is now at the highest level since October 2019. At some point, bulls might be treated to a short-covering rally that lasts for months.
Finally, whereas the technical backdrop is bullish amid a mixed sentiment backdrop, one group of option buyers that I am monitoring closely is option buyers on CBOE Market Volatility Index (VIX-13.81) futures. Note in the graph below that the decline in the VIX to near its 2024 lows has attracted call buyers anticipating or hedging against higher volatility and lower stock prices.
Heavy call buying relative to put buying on VIX futures has tended to foreshadow higher volatility as you can see in the chart below. In fact, the ratio of call buying to put buying on VIX futures options is approaching the levels of July when stocks were about to embark on their July-August swoon.
This, in addition to the extremely low equity buy (to open) put/call ratio on SPX component stocks, is something to recognize as risks that take on more meaning if there is a broad market technical breakdown.
But it might be worthwhile to hedge long positions so you aren’t caught suddenly off guard. That is, if these risks are indeed foreshadowing weakness like that of July-August in the weeks ahead.
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