Where Sellers May Emerge to Reduce Equity Risk

“…the Friday low was at its 100-day moving average, which could set up a bounce this week if market participants take their cue from the April low, when the SPX trough was just above this upward-sloping moving average. In fact, Friday’s close was just above another moving average that we typically follow, the 80-day moving average, sitting at 5,334. One risk to a bounce materializing quickly is that the SPX’s 14-day Relative Strength Index (RSI) is around 40, not quite the oversold reading around 30, which it reached at the October 2023 and April 2024 troughs.”

          - Monday Morning Outlook, August 5, 2024 

In reviewing the S&P 500 Index (SPX – 5,344.16) price action last week, the risk of the index not yet reaching an oversold condition based on its 14-day Relative Strength Index (RSI) reading, was worth noting for anyone betting on a bounce materializing quickly.

As such, it was not until after the Monday morning gap below the SPX’s 80-day and 100-day moving averages that the index finally hitting an oversold RSI reading when it reached 30, on par with the levels that occurred at troughs in October 2023 and April 2024.

From the Monday intraday low -- just 19 points above the 5,100 level that is 10% below the mid-July closing high -- the SPX rallied into Friday afternoon. However, the 80-day moving average capped the Friday high, but the index closed the week with two consecutive daily closes above its 100-day moving average.

A bounce materialized quicky, but not before additional damage was experienced after Monday’s 3% decline that had some begging for an emergency Fed rate cut. Thursday’s better-than-expected jobless claims number, along with a host of strong earnings, and guidance reactions from a few tech companies and drugmaker Eli Lilly (LLY – 891.68), helped ease the growth worries.

We enter standard August expiration week with a mixed technical picture, as the index is sitting between its 80-day and 100-day moving averages.

Additionally, while the SPX recovered from its Monday low and traded back above the 5,235, area which marked resistance in the March-April period and support in late May, the Friday high was at the previous week’s close. This mark at 5,346 preceded the 3.6% Monday morning gap lower. As such, this is where sellers could emerge, as investors and traders jolted by last Monday’s gap opening may view a move back to 5,346 as a welcome “second chance” to reduce equity risk.

To sum up the week, the SPX traveled 556 points when combining downside and upside movement but had almost no directional movement relative to the previous week’s close.

Something that caught my eye with respect to the Aug. 5 gap lower is how delta-hedge selling may may have played out in the pre-market last Monday.

With the SPX poised to gap lower that morning, sellers of the SPDR S&P 500 ETF Trust's (SPY -- 532.99) 525- through 530-strike puts (equivalent to SPX 5,225-5,300), may have sold S&P futures, as it was apparent those strikes were going to be in-the-money at the open.

When it was apparent the 520-strike was coming into view as pre-market open selling was occurring, selling may have picked up significantly, as the SPY 520 put was (and still is) home to more than 100,000 contracts – more than double the open interest (OI) of the 525 through 530 strikes. Those that short the 520 puts were at risk of huge losses given the size of the open interest and thus may have stepped up their selling of S&P futures to hedge against more losses, which is known as delta-hedge selling.

The next big put magnets were at the SPY 510 and 515 strikes, and of interest is that the SPY low was just above the 510 strike. This implies the severity of the SPX’s gap lower has delta-hedge selling footprints, especially in light of the immediacy of the V-rally that quickly followed when the delta-hedge selling was over.

As such, last week’s price action and volatility spike may have been driven more by options market mechanics, with various macro headlines related to employment data fanning moves in both directions.

The potential for the options mechanics of last week impacting stock prices this week are still in play, especially with key inflation data due out Tuesday and Wednesday pre-market. Even further, this will be followed by retail sales data on Thursday morning before the market open.

A short-term risk to bulls is that if this data disappoints, like the July employment number, a gap to and below the big put strikes mentioned above could fan another round of delta-hedge selling and spike in volatility, as measured by the Cboe Volatility Index (VIX -- 20.37), which shot up to 65 last week for a short period. This is a level not seen since early 2020, when panic set in due to the country being shut down from Covid-19.

As a side note, whereas in early 2020 the SPX crashed far below its 200-day moving average, the VIX high last week was concurrent with the SPX trading 100 points above this long-term moving average. In other words, it was a panic VIX reading -- even though it was pre-mature to panic from a longer-term technical perspective.

Todd Salamone is the V.P. of Research at Schaeffer's Investment Research.

 Continue Reading:

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