“… I think if we are on the verge of an unwind of pessimism, immediate overhead technical resistance levels, such as 4,330, or the June and August lows (Friday’s intraday peak too), and 4,355, current site of the sharply declining 20-day moving average, can be taken out with ease, albeit there could be intraday or very short-term hesitations at these levels…”
–Monday Morning Outlook, October 9, 2023
Our latest sentiment data suggests that the pessimism build that we experienced has climaxed. The jury is out as to how long this “unwind” of negativity on stocks will last, but the longer the unwind occurs, the more robust the rally from the early October lows.
One piece of evidence suggesting negativity has climaxed, which is supportive of stocks as caution becomes more optimistic, is the rollover in the ten-day, buy (to open) put/call volume ratio on S&P 500 Index (SPX — 4,327.78) component stocks. The ratio peaked in late-September, just before the index began probing its early-October lows at the 4,225-level, or 10% above the 2022 close.
As you can see in the chart below, rollovers from extreme highs like we just experienced tend to precede sustainable rallies, which is a risk to bears at this juncture.
“I would view 4,455-4,465 range as a potentially more robust resistance point, which is the site of a trendline connecting lower highs from the late-July peak through last month. This trendline’s range will change and be at lower levels next week since it is sloping lower.”
–Monday Morning Outlook, October 9, 2023
As I suggested last week, if pessimism climaxed in the short term, the SPX could rally back above its June and August lows, plus its 20-day moving average, easily. This happened last week, with the cross above the SPX’s 20-day moving average occurring when it was in the vicinity of the SPX’s June and August lows.
However, sellers stepped in on Thursday and Friday, after the release of Consumer Price Index (CPI) data. The selling materialized roughly 60 points below a trendline connecting lower highs since the late-July peak that I theorized could be more robust resistance.
The 20-day moving average and June and August lows acted in concert to provide support at the end of the week and, as such, Monday’s trading will begin with the SPX sitting at this potential support level.
The short-term technical outlook is neutral, as potential resistance overhead and support below are almost equidistant. For example, and as seen in the chart below, the 200-day moving average and early-October lows are converging at 4,225, or about 95 points below Friday’s close. However, the trendline connecting lower highs since late-July comes into the week at 4,450 and ends the week at 4,438, or only about 110 points above Friday’s close.
If you include the sentiment backdrop in such a discussion, one should lean bullish amid this neutral short-term technical backdrop. But if the SPX moves back below the June lows, keep in mind that a retest of this month’s lows is likely, so be sure to account for this scenario in how you are positioned for the short term.
It is standard expiration week, so keep in mind that heavy put open interest strikes below the SPDR S&P 500 ETF Trust (SPY) Friday close of $431.50 could also be influential. If the SPY remains above all put-heavy strikes at 430 and below, a slight tailwind will emerge as we move closer to Friday expiration, as short positions related to the put open interest are slowly unwound.
But remember, those that sold the puts tend to hedge by shorting S&P futures, but the extent of their short position is based on the sensitivity of the put to increase in price as the SPY declines. Put strikes far below the current level of the SPY are less sensitive to SPY declines than puts in the immediate vicinity of the SPY.
As such, further out-of-the-money puts, or strikes below the SPY, are not hedged fully. But if the SPY approaches those strikes, those that sold the puts hedge by selling more and more S&P futures as the option’s sensitivity to SPY declines increases.
This process is referred to as “delta-hedge” selling, with delta a measure of the options sensitivity to price. Looking at the Friday, Oct. 20 SPY open interest configuration, the risk of delta-hedge selling begins if the SPY moves below the 425-strike, which is coincident with SPX 4,250. Such selling could intensify further if the SPY approaches the 420-strike, which is the site of the peak put open interest in the graph below.
Therefore, as we move through the course of the week and the start of earnings season, keep in mind the influence that options open interest could have on the market.
Todd Salamone is the Senior V.P. of Research at Schaeffer’s Investment Research.
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