The stock market tried to get off to a good start this year. With seasonally positive factors now expired, the S&P 500 Index finds itself mired in a trading range once again.
Bulls and bears are awaiting a breakout from 3760 to 3870 points in the index
Overhead, there is still heavy resistance in the 3900-3940 area, with the major downtrend line of the bear market above that (it was last tested at 4100, in early December). Below the current levels, there should be minor support at 3700 and then better support at 3500 (the 2022 lows).
Overall, SPX remains bearish in that it is in a downtrend.
The ”modified Bollinger Bands” continue to contract as realized volatility diminishes (due to the recent trading range). There is no McMillan Volatility Band (MVB) buy or sell signal in place at this time. The next one will set up when SPX moves outside of the extreme bands in either direction.
The seasonally positive Santa Claus Rally period has come to an end, with the close of trading on Wednesday. The seven-day period showed a slight gain by the SPX — from 3822.39 to 3852.97. That’s a little less than the average 1.1% gain of such a rally. If it had been a negative move, that would have been a sell signal for stocks.
Equity-only put-call ratios continue to rise. There is an interesting “side story” to this, and it is discussed in the Market Insight section below. For now, though, all one needs to understand is that these ratios will remain on sell signals until they roll over and begin to decline. The heights of these put-call ratios at the current time do indicate an oversold condition, but that alone is far from a buy signal.
Market breadth has begun to improve this week, and both breadth oscillators are now on buy signals. However, since this indicator is subject to whipsaws, we would prefer to see a validating move by SPX before acting on this new signal.
Meanwhile, new 52-week highs on the NYSE have still not been able to climb above 100, so the “new highs vs. new lows” indicator remains bearish as it has since April.
VIX continues to be the area of our most bullish stock market indicators. First, the “spike peak” buy signal on the VIX chart remains intact. That buy signal was generated on December 13th and lasts for 22 trading days unless stopped out. In addition, the intermediate-term trend of VIX buy signal that emanated in the green circle on the accompanying VIX chart is still in effect as well. VIX would have to rise above its declining 200-day moving average (currently at about 25.50) to stop out that buy signal.
The construct of volatility derivatives remains essentially bullish for stocks as well. That’s because the term structures of the VIX futures and most of the CBOE Volatility Indices continue to slope upwards. Moreover, the VIX futures are all trading at healthy premiums to VIX. The one potential warning sign here is that the nine-day Volatility Index (VIX9D) has jumped above VIX because of the pending unemployment report Friday and the CPI announcement next week. Those events will likely cause market volatility, which the VIX9D is reflecting.
In summary, we continue to maintain a “core” bearish position because of the downtrend on the SPX chart and because of the December breakdown below 3900. We will, however, trade other confirmed signals around that “core” position.
Market Insight: ‘Put’ volume surge in stock options
There have been several days in the last two months (the phenomenon began on November 2nd) on which put volume in certain stocks has surged. These surges have occurred for the most part on Wednesdays. This was particularly noticeable on the CBOE, which publishes its equity-only put-call ratio daily, and that data is tracked by many analysts.
That surge seemed odd and out of character with the history of CBOE put-call ratio readings. The surge in put volume has continued since then, mostly on Wednesdays, but occasionally on other days as well. Some of that was, of course, related to the bearish market itself, but the data was odd enough that many were questioning the CBOE’s data accuracy.
It turns out that the CBOE data is accurate, but that there is a “new” form of arbitrage taking place in equity (stock) put options with large open interest. This arbitrage was spurred by the rise in interest rates. I’m not sure why it took until November 2nd for these arbs to begin this strategy, but it did.
Briefly, the arb works similar to dividend capture arbitrage, which involves call options, and has been going on for decades. In this new put arbitrage, this is what happens:
- Two arbs trade a five-point deeply in-the-money put spread for five points. So there is no apparent edge to the trade itself.
- Both arbs exercise their long puts, making themselves short stock and short the other deeply in-the-money put from the original spread trade. That is essentially a riskless position, as long as the stock remains below the strike, which is far above current stock price levels.
- Both arbs then hope to not get assigned on their deep in-the-money short put. That is where the “large” open interest comes into play. They are figuring that other (non-arb) traders who are short these ITM puts will not cover them.
- As long as these arbs are short stock and short that deep ITM put, they earn interest on the trade. In particular, if they do the spread on a Wednesday, and exercise that day, the stock doesn’t settle until Friday. If the person who was suddenly assigned on a short put is forced to buy stock, he probably won’t unwind his side of the position until Monday, and thus these arbs can earn the interest on their “short stock, short ITM put” position over the weekend.
Seems like a lot of work for a small payoff, but it is apparently working well enough that has continued to disrupt CBOE (and other) equity-only put-call ratios since then. Recently, where there have been holidays resulting in three-day weekends, this activity is occurring on both Wednesdays and Thursdays.
What affect does this have on the validity of using equity-only put-call ratios as predictors of the broad stock market? Essentially none, as long as one uses local maxima and minima on the put-call ratio chart to identify buy and sell signals, as we do. What is affected is the absolute level of the put-call ratios (they are moving higher with this extra put volume), so comparing today’s levels to past levels –– say, those of March 2020, for example — is probably no longer valid. But we do not use the put-call ratios in that manner anyway, so I don’t view this arbitrage as damaging to our signals.
It is amazing what people have been attempting to attribute the recent surge in put volume to, but what I have shown you here is the actual reason. It has nothing to do with daily option expirations, with T-bill auctions, or any of the other superfluous reasons that people have been spouting in the last couple of months.
New recommendation: Moderna
The weighted put-call ratio in Moderna
has given a sell signal. If that is confirmed by a price breakdown, we want to own puts:
IF MRNA closes below 174,
THEN Buy 1 MRNA Feb (17th) 170 put
In line with the market.
MRNA: 172.17 Feb (17th) put: offered at 12.60
We will remain in this trade as long as the weighted put-call ratio is rising (i.e., is still on a sell signal).
All stops are mental closing stops unless otherwise noted.
We are using a “standard” rolling procedure for our SPY spreads: in any vertical bull or bear spread, if the underlying hits the short strike, then roll the entire spread. That would be roll up in the case of a call bull spread, or roll down in the case of a bear put spread. Stay in the same expiration, and keep the distance between the strikes the same unless otherwise instructed.
Long 2 SPY Jan (20th) 375 puts and Short 2 Jan (20th) 355 puts: this is our “core” bearish position. |As long as SPX remains in a downtrend, we want to maintain a position here.
Long 0 IWM Jan (20th) 185 at-the-money calls and Short 0 IWM Jan (20th) 205 calls: this was our position based on the bullish seasonality between Thanksgiving and the second trading day of the new year. We exited this position at the close of trading on Wednesday, January 4th, the second trading day of the new year.
Long 1 SPY Jan (20th) 402 call and Short 1 SPY Jan (20th) 417 calls: this spread was bought at the close on December 13th, when the latest VIX “spike peak” buy signal was generated. Stop yourself out if VIX subsequently closes above 25.84. Otherwise, we will hold for 22 trading days.
Long 1 SPY Jan (20th) 389 put and Short 1 SPY Jan (20th) 364 put: this was an addition to our “core” bearish position, established when SPX closed below 3900 on December 15th. Stop yourself out of this spread if SPX closes above 3940.
Long 2 PCAR Feb (17th) 97.20 puts: these puts were bought on December 20th, when they finally traded at our buy limit. We will continue to hold these puts as long as the weighted put-call ratio is on a sell signal.
Long 0 SPY Jan (13th) 386 calls and Short 0 SPY Jan (13th) 391 calls: this was the trade based on the seasonally positive “Santa Claus rally” time period. This spread was exited at the close of trading on Wednesday, January 4th (the second trading day of the new year).
Long 1 CVX Feb (17th) 180 call: we will hold this position as long as the put-call ratio of CVX remains on a buy signal.
Send questions to: email@example.com.
Lawrence G. McMillan is president of McMillan Analysis, a registered investment and commodity trading advisor. McMillan may hold positions in securities recommended in this report, both personally and in client accounts. He is an experienced trader and money manager and is the author of the best-selling book, Options as a Strategic Investment. www.optionstrategist.com
Disclaimer: ©McMillan Analysis Corporation is registered with the SEC as an investment advisor and with the CFTC as a commodity trading advisor. The information in this newsletter has been carefully compiled from sources believed to be reliable, but accuracy and completeness are not guaranteed. The officers or directors of McMillan Analysis Corporation, or accounts managed by such persons may have positions in the securities recommended in the advisory.
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