Take Advantage of the Sharp Volatility Pullback

Now is a good time to hedge stock positions after volatility decreased sharply

"More volatility could be ahead, with the VIX closing the week (and the month) above the 18 area .... VIX technical pattern that stands out to me at present is similar to the early May through first half of July 2019 action - seen in the chart immediately below, in which a trendline connecting lower highs (similar to August-January) was taken out and retested before the VIX doubled in a matter of days. A repeat of this pattern in terms of the VIX doubling from the retest level of the August-January trendline would target a VIX move to the 30 area, or a round 150% above the floor at 12. If there is higher volatility ahead, bulls hope that the VIX peak is contained around 20.67, which is 50% above its December 2019 close."

- Monday Morning Outlook, February 3, 2020

After warning of potentially more volatility to come in last week's commentary, the CBOE Market Volatility Index (VIX - 15.47) did an about face, reversing sharply lower as buyers came surging back into equities. The VIX's Jan. 31 peak was at 19.99, just below the 20.67 level that is 50% above the 2019 close.

The equity rally was as equally impressive as the plunge in volatility. The S&P 500 Index (SPX - 3,327.71) climbed back to the 3,335 area in only a week's time. It was a "V-type" rally that began around its year-to-date breakeven mark and the popular 50-day moving average.

While the technical and sentiment backdrop is looking better than one week ago, volatility indicators suggest that risks to higher volatility and lower stock prices in the short-term have yet to disappear.

For example, ahead of a small volatility pop on Friday morning, Thursday's VIX low occurred at the trendline connecting lower highs since August, as well as its 252-day moving average. The VIX would have to be below 14.18 by this week's end to give me confidence that January 31 was indeed a peak in volatility expectations. In other words, the VIX's behavior in recent weeks is similar to its April-July 2019 action, displayed in the chart immediately below.

$SPY - huge put adds after yesterday's action. In fact, 18 of the top 20 open interest changes favored the put side, with only two of those put strikes seeing net liquidations...500j+ put additions vs 104k call adds

I mentioned above that one thing that has improved relative to a week ago is the sentiment backdrop. The coronavirus and fears on how this could impact the economy, and perhaps uncertainty related to how Trump's impeachment would play out in the Senate, caused a continued surge in put buying on SPDR S&P 500 ETF Trust (SPY - 332.20) options -- even as early as last week as stocks rallied.

The put buying was evident not only in the lopsided open interest changes that favored puts, but in the buy (to open) put/call volume ratio on SPY options. Ahead of the sell-off, there was little put buying relative to call buying, as option buyers were not anticipating trouble ahead. In fact, just two weeks ahead of the sell-off, the SPY's 10-day buy (to open) put/call volume ratio was around a multi-month low. The increase in SPY put buyers relative to call buyers that picked up steam as stocks fell and continued into last week, seemed to be a reaction to the sell-off that pushed the ratio of put buying to call buying to near a multi-month high.

With the SPX closing at an all-time high on Thursday, put buyers emerged. This is certainly a plus for bulls, as it suggests the market is more prepared than two weeks ago to handle negative news.

However, the SPX is clearly having trouble clearing the level that corresponds to five times its 2009 low, so bulls should be cautious about going "all-in" at this particular juncture, as some may view the rally back as a "second-chance" opportunity to de-risk. On the flip side, the pullback in volatility may invite more hedging activity that could coincidentally pressure stocks. That is, if buyers disappear with the SPX back at a level that marked the beginning of a sell-off only two weeks ago.

Returning the discussion back to the SPY put buying during the past two weeks, the below graph gives you an idea of where they were adding most of the puts that expire on standard February expiration. The tall red bars represent the biggest increases in open interest, which are at the 315, 317, 320, 323 and 324 strikes.

As the market rallied further above these strikes, incremental buying could have emerged as short positions associated with the recently added puts were covered as they are further above the strikes when initially bought, which means they became less sensitive to changes in the SPY. However, such incremental buying has likely dried up, which is another reason why it could be a challenge for the market to surge above its January highs.

The other implication, now that we are two weeks away from standard February expiration and on the heels of a big build in put open interest in recent days, is that risk of a delta-hedge sell-off grows if the biggest put strikes come into play in the coming days. In other words, the first big put magnet occurs at the 325 strike, which is only 2.5% below Friday's close. If a break below $325 occurs, there is risk that other big put open interest strikes act as magnets. Additionally, note the big call open interest sitting at the 332 strike. A move below this strike as we get closer to expiration could mean an unwind of long positions associated with the purchase of these calls. If you are a bull, you don't want to see a move below $332, or the SPX to 3,320, as selling related to options open interest could emerge.

If you haven't yet hedged and stuck with your long positions, now is a good time to do so by taking advantage of the sharp volatility pullback, as measured by the VIX last week. Additionally, if you're looking to play it safe in terms of an entry point, be patient and wait for the VIX to move back below the trendline that has marked lower highs since August. If the VIX is above both its 252-day moving average and the this trendline, continue to be vigilant as prospects for higher volatility and lower stock prices remain higher than normal.

Todd Salamone is Schaeffer's Senior V.P. of Research

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