The market has bent pre-election, but remains above multiple support levels
“If a deeper selloff is in the cards, the 5,725 level is another level of support, where sideways movement occurred in September. This came as buyers were somewhat hesitant to accumulate stocks, as the SPX was 20% above last year’s close. The final short-term support level is 5,665, site of the July high and neckline of the inverse “head and shoulder” breakout in mid-September that targets 6,200 by year end. A break below this level would likely mean all bets off on 6,200 being achieved by year’s end…Momentum has slowed and short-term option buyers are reacting to this loss, which could feed coincidental headwinds as put buying, relative to call buying on individual equities, picks up. But the recent short-covering action that was evident in October’s first half could put a floor on individual stocks if it continues.”
– Monday Morning Outlook, October 28, 2024
In last week’s commentary, I discussed the loss of momentum with respect to the S&P 500 Index (SPX – 5,728.80), as we approach uncertainty related to Election Day on Tuesday, as well as the Federal Open Market Committee (FOMC) meeting on Wednesday.
Specifically, I pointed out the resistance that had been making its mark since mid-October in the 5,860 area, as equity put buyers on SPX components were increasing activity relative to call buyers, creating a coincidental headwind. The sideways movement finally met its resolution on Thursday, when the SPX gapped lower following several disappointing earnings reactions, most notably tech heavyweights Microsoft (MSFT) and Meta Platforms (META).
Per the graph below, the loss of momentum and eventual pullback began in mid-October, beginning with a near bearish “outside day,” a single-day candle in which bulls control early action, but the bears control the late-day action and the close. Such candles have occurred ahead of multiple short-term declines of varying degrees this year.
The Thursday and Friday lows and weekend close were in the vicinity of the 5,725 level, which is 20% above last year’s close and a level that marked the beginning of a brief congestion phase in late September and early October.
The market has bent pre-election, but going into this week and the FOMC meeting, it remains above the lower boundaries of multiple support levels I mentioned last week. The support boundaries include that 5,725 level and the summer highs in the 5,650-5,666 area, which define the neckline of the bullish “head and shoulder” breakout that occurred on Sept. 19, one day after a mi-September rate cut (another of which is expected this Wednesday).
The middle of this week could see a lot of intraday volatility, so traders should emphasize the closes and exercise patience as the market reacts to headlines.
If the SPX closes the week above its July high, the bulls remain in control and I would anticipate that volatility expectations, as measured by the CBOE Market Volatility Index (VIX – 21.88), will recede. A move below this support level might suggest more uncertainty ahead and a VIX that remains high relative to historical volatility.
It’s worth taking a look at Senior Quantitative Analyst Rocky White’s commentary on the historical implications of an inflated VIX relative to SPX historical volatility, along with past occurrences of a high VIX in election years since 2000.
The short-term risk for bulls is the direction of the SPX component, buy-to-open put/call volume ratio, which continues to work its way higher from an extreme low (as illustrated in the chart below).
This risk is mitigated at present by the high short position on SPX components, but this short position becomes less relevant if the index or many of its components break below support levels in the coming days, as it becomes less urgent for shorts to cover if support levels are not holding.
Finally, with Friday marking the first day of November, standard November expiration is less than two weeks away. This implies that delta and gamma risk increase, implying option open interest could exaggerate moves if the SPX or SPDR S&P 500 ETF Trust (SPY – 571.04) begin approaching heavy open interest strikes. And this tends to occur with the help of a catalyst. With the election outcome and FOMC meeting imminent, these are the type of catalysts that could trigger exaggerated market moves.
An immediate concern is that, with large open interest strikes on the SPY being put heavy only at strikes immediately below the SPY Friday close of 571.04, delta-hedge selling risk is extremely high. The bigger the put open interest at any one strike, the bigger that this strike is a potential magnet.
This is because sellers of the puts must short an increasing number of SPX futures to remain neutral if the SPY declines toward heavy put open interest strikes. This last occurred in early August. The upside is that if the SPX remains above these put strikes and volatility expectations decrease, there could be short covering related to some of these heavy put open interest strikes that are just below the SPY’s current level.
Todd Salamone is the V.P. of Research at Schaeffer’s Investment Research.
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