Options-related pessimism has unwound, which could result in short-term challenges
“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… 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…risk is mitigated at present by the high short position on SPX components…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.”
– Monday Morning Outlook, Nov. 4, 2024
Amid the presidential election and Federal Open Market Committee (FOMC) meeting “knowns and unknowns,” I presented both the risks and opportunities that traders and investors were greeted with, heading into last week’s trading.
Essentially, it came down to binary outcomes with respect to the market. Either a delta-hedge sell-off that could push equity benchmarks below support levels that it clung to ahead of both events (including its 50-day moving average), or a major short-covering rally off these support levels. Fortunately for bulls, it was the latter.
“…the SPX’s move above the July, August, and pre-FOMC rate-cut highs completes a bullish inverse ‘head and shoulder’ breakout….more evident on an hourly chart relative to a daily chart…suggests that we could be on the cusp of a near 10% rally in the coming months.”
– Monday Morning Outlook, Sept. 23, 2024
Last week’s sharp rally occurred in the context of not only positive seasonality, but the bullish “head & shoulder” breakout pattern from mid-September. This pattern was still “alive and in play” going into last week’s trading and has been mentioned multiple times before and after the breakout occurred.
The target for the S&P 500 Index (SPX – 5,995.54) based on the technical pattern, is roughly 550 points above the mid-September 5,665 neckline breakout level, or 6,215. With Friday’s close just below the round 6,000-millenium level, the index is only about 220 points (3.5%) below its (by end of year) target.
The 6,215 target is just that, with no details on the exact path it will take if the target is achieved, nor whether it undershoots or overshoots. With respect to the path toward 6,215 so far, the SPX rallied after a brief pause following the breakout. These bulls were tested lightly pre-election and FOMC, with an explosive move higher after these events finally unfolded.
With respect to potential support and resistance levels for the SPX, the first potential support level is last month’s high at 5,880. The second support level is nearly 100 points below at 5,782, or the close ahead of Wednesday’s gap higher on news that Donald Trump had won the presidential election and Republicans flipped the Senate. At 5,720 is the site of the 50-day moving average and the area of the pre-election lows, which coincide with the mark 20% above last year’s close. In other words, the bears have a lot of work to do with multiple support levels below.
That said, I find it interesting that the SPX high on Friday was 6,012 before closing south of 6,000. Similarly, the SPDR S&P 500 ETF Trust (SPY – 598.19), which is roughly 1/10 the SPX, found resistance just below the round $600 level.
The Friday SPY high was intriguing because in the five days before expiration of the weekly 11/8 SPY options, the 600 call was the strike with the biggest open interest (OI) additions, per the chart immediately below. In other words, the 600-strike became a call wall on Friday afternoon due to the pre- and post-election bets that unfolded during the week.
From a sentiment angle, there was a healthy mix of both put and call adds, implying exuberance in the options market was far from a level that you might infer, when looking at the price action last week. As such, from a contrarian view, this should have bullish implications since there is still evidence of naysayers among short-term traders.
The SPX 6,000 level may hinder short-term advances from a psychologically-important vantage point. For reference, the SPX chopped above and below 5,000 for two weeks in February 2024 before finally distancing itself from that millennium mark. A repeat of such action would be a challenge for those seeking direction in a short time frame.
But in looking ahead to standard expiration week, there is little in the way of a “call wall,” with only 20,000 outstanding call contracts at the 600-strike on the SPY (second graph below). Plus, the SPY is above the biggest call open interest strikes.
The downside to last week’s price action is that going into this week there is not really a short-covering tailwind associated with expiring put open interest, with the heaviest put OI strikes 7-8% out of the money, with only five days left until expiration. This might imply a pause is on deck since option-related short covering, which likely occurred last week, will not be a thing this week.
Todd Salamone is the V.P. of Research at Schaeffer’s Investment Research.
Continue Reading: