“…total short interest is rolling over from the highest levels in more than a year. But the rollover is small, implying short covering was minimal in the month of November. As such, short covering could very much be supportive of the market into year end, even as short-term option speculators bet against the upside action the past several weeks.”
- Monday Morning Outlook, December 18, 2023
The S&P 500 Index (SPX – 4,754.63) continued to climb last week, entering the last week of the year only 40 points below its January 2022 all-time closing high. Market participants will be focusing on this as a potential hesitation or pivot point, as those thinking “breakeven” relative to the peak nearly two years ago could be sellers.
Last week’s advance came on economic data suggesting the economy hasn’t cooled like originally feared, while inflation numbers continued to support the end of rate hikes and possibly rate cuts in 2024, as Federal Open Market Committee (FOMC) Chairman Jerome Powell suggested earlier this month in the perceived dovish pivot.
Moreover, stocks rallied despite continued cautionary comments from Wall Street strategists that began in late November. Last week, two brokerage houses continued this theme, cautioning market participants about “rally fatigue” and “risks of a pullback flashing red.” As I said a few weeks ago, the rally may persist longer than the strategists think, but they may eventually be right. As for now, I don’t see cause for concern unless the SPX breaks below its rising 20-day moving average that is currently at 4,640, or its July peak in the 4,600 area.
“…hefty volumes in put options that expire within 24 hours, known as 0DTE options, were sufficient to spark a pullback on the market, the sharpest in almost three months. Such trades would prompt market makers on the other side of the transactions to hedge their exposure, pushing the market lower, the argument goes…Wednesday’s total put volume on the S&P 500 was the third-highest of 2023.”
- Bloomberg, December 20, 2023
“Contrary to what some Wall Street analysts are saying, a surge in trading of zero-day to expiry options shouldn’t be blamed for Wednesday’s drop in the S&P 500 Index, according to Cboe Global Markets. For the S&P 500 4,765 put expiring Wednesday…buying exceeded selling by only about 1,000 contracts, the exchange’s data show.”
- Bloomberg, December 21, 2023
Per the excerpts above, a hot topic last week was Wednesday’s mysterious reversal from an intraday 52-week high to close more than 1% below the previous day’s close. The price action stirred debate between Wall Street option strategists and Cboe Global Markets (CBOE – 175.53), who lists what are known as 0DTE (zero days to expiration) options, as the root cause of the sell-off.
The CBOE pointed out that buying and selling of the heavily traded S&P 500 12/20 4,765-strike put was almost evenly balanced between sellers of the put and buyers of the put. This implied that option strategists’ claims of a delta-hedge selloff caused by the heavy 12/20 4,765 put volume was not possible, since market makers would not have been forced into such actions given the buy/sell balance.
My thought, after reading the CBOE’s counterargument, is that perhaps customers sold the 12/20 expiry SPX 4,765-strike puts to open the trade earlier in the day, betting the SPX would close above 4,765 at 4:00 p.m. EST. However, later in the day, these put sellers may have panicked and began closing positions as the SPX moved below 4,765, jeopardizing the profit potential of their morning put sell trade.
Such actions would create a near balance in buy and sell volume on this particular contract that the Cboe used as a counterargument. Moreover, if put sellers bought back the put to close their positions, market makers would sell S&P futures that were originally bought to hedge the trade opened that morning. In other words, it may have been the unwind of a big put sell trade that created Wednesday’s chaos, not a delta-hedge decline like option strategists explained. The only difference is in the unwind scenario, market makers took off hedges that spurred a decline, while in the delta-hedge scenario, they are putting on hedges that spark a decline.
As is the case with standard Friday expirations, when expiring open interest is big, huge moves can occur that are option-related but short lived. I suspect Wednesday’s move was option-related because after expiration of those 12/20 0DTE options, the SPX immediately recovered, just as it does when expiration-week sharp selloffs occur due to delta-hedge selling.
And amid the “drama” of the headlines, no damage was done. In fact, for those that use the Relative Strength Index (RSI) to assess whether an overbought or oversold condition is in play, the SPX remained “overbought,” but less overbought relative to its reading prior to Wednesday’s reversal day. With the SPX not selling off significantly from an extreme overbought condition, even after a seemingly bearish reversal, bears are likely discouraged.
Bulls, however, should keep their eyes on a few developments in our sentiment measures that could be cause for concern in the coming days or weeks. Yes, momentum favors the bulls and the short covering potential I discussed last week. But the short interest data is as of late November with data as of mid-December due this week.
But active investment managers, per the weekly National Association of Active Investment Managers (NAAIM) are nearly fully invested, suggesting they have helped push stocks higher in prior weeks. But this is an area of the market that may not be as supportive in the weeks ahead.
And equity option buyers are a lot more optimistic relative to weeks ago. The 10-day SPX component buy (to open) put/call volume ratio is at 0.49, down from 0.75 at it peak several weeks ago, and just above the 0.47 reading two weeks prior to the peak in July.
The direction of this ratio currently favors the bulls, but the level of this ratio is favoring the bears when anchoring to the mid-July low. I would not view this as a red flag at present since the technical backdrop still favors the bulls, and the direction of the ratio favors the bulls too.
It would take a technical breakdown in the SPX along the lines discussed earlier, with a turn higher in this ratio for a red flag to appear.
Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.
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