A perfect volatility cocktail that could spark big stock trends could be brewing
With the July options expiring, we now have some of the tougher weeks for the market behind us. We have been hinting at a possible spike in volatility over the past few weeks, so I wanted to give our readers some data on that. Put simply, we see a seasonally spike in volatility after the standard expiry week in July, which usually results in temporary price declines.
“… As the Cboe volatility index (VIX – 15.62) goes into a new week and quarter at 15 – that was the value before the sharp sell-off of Covid-19 in early 2020 and a level from which it has been recovering in the last few months is – hedging long positions to protect against midsummer and / or late summer surprises may be appropriate. ”
– Monday morning outlook, June 28, 2021
The spot price of the Cboe Volatility Index (VIX – 18.45) traded below the historical average for most of the spring and summer months. In addition, the three- and six-month VIX futures contracts also trade at a discount to their long-term averages. Finally, to reiterate our last comments, the VIX seemed to have some support at the 15 level, which was the reading before the 2020 Covid-19 pandemic sell-off. With pent-up complacency finding support near significant levels, we may have brewed a perfect volatility cocktail that could cause major stock trends to decline further – or even potentially collapse.
Let’s take a look at a recent study we did. In the first chart, we compared the 10-year and 20-year seasonal patterns of the VIX. In the last 10 years, the VIX gained +12.72% from July 1st to the end of August and +9.59% over 20 years. After the expiry of the standard options in July, the 10-year average low is around -14.33%, while the 20-year average has only fallen by -4.32%. Our VIX low so far in July was -4.8%, which may put us right on track with the 20-year average. You will also notice in the next two charts that we have plotted the seasonality of the S&P 500 index (SPX – 4,327.16) alongside the VIX. As you can see, the stock market typically hits a low point towards the end of August, with a low being tied around August 25th on average.
The most reasonable explanation for this seasonal pattern is that trading volume and liquidity are lower as more market participants are on vacation. Psychologically, it could just be a self-fulfilling prophecy, as traders and investors expect, so they tend to avoid it by reducing the capital at risk and trading less until the end of August, when all routinely out of the summer vacation are back. Whatever the reason, the data doesn’t lie.
In addition, we have another volatility meter that waves a warning flag. The Cboe VIX Volatility Index (VVIX – 128.89) simply measures the volatility of the volatility index. It recently moved up ahead of the VIX, with a steeper climb since early July, while the VIX remained in a downtrend. This tells us that VIX premiums are valued higher by market makers, and this often happens when demand increases, when market participants expect volatility and want to take out insurance to hedge their portfolios. Two of the more recent examples where this type of move correctly predicted market volatility were February 2020 and January 2018. While this indicator in and of itself is not the most reliable signal that volatility is on the horizon, it combines this with a confluence of other volatilities – and sentiment indicators tend to make them more reliable.
“Similar to the breadth, sentiment values show us that market participants are too optimistic. NDX buy-to-open put / call volume hit a seven-year low last week at 0.354, the lowest since July 8, 2014. This tells us that we are in a higher risk environment as we are prone to pullback. What people often don’t understand when looking at put / call levels is that we usually want to see a confluence of changes before making bearish bets right away. Two things that we are looking for in particular are an upward rotation from an all-time low and a subsequent technical-level breakdown in broad indices. “
– Monday morning outlook, July 12, 2021
We mentioned last week that one of the things we look for when assessing sentiment is absolute lows. This week it seems that the purely optional put / call ratio is doing just that as it seeks to concrete a base at 0.353 last week and break the all-time lows from June. Additionally, SPX Components’ 10-day buy-to-open put / call volume ratio seems to be trying to get one with a close of 0.347 last week and the lowest value of the year despite not moving much Round bottom will occur on July 7th at 0.336.
Last week, the S&P 500 ETF Trust (SPY – 431.34) temporarily topped the + 100% mark for the first time since the pandemic lows. I couldn’t help but think how interesting it is that round numbers seem to work so well, something we’ve been preaching about for years. The SPY, which peaked at this + 100% level, coincided with the index, which was nearing the upper end of the price channel in 2021, and the highest call level at the 440 strike for the OPEX in July. As we explained last week, this could be an area of resistance.
– Matthew Timpane, CMT (@mtimpane) July 13, 2021
While we are now on the lookout for increased volatility, let’s take a look at potential pullback zones for the S&P 500. The first and most obvious area traders will be looking for an opportunity to buy the pullback at the 20-day moving average, now just 22 points away at 4,305 on the S&P. While the bulls will certainly struggle to hold the 20-day moving average, there are plenty of catalysts that are pushing the market further down. Another, slightly more obvious level is the 50-day moving average, but this area also brings with it a support zone between 4,232 and 4,252, where we are out of a two-month consolidation phase in June and right near the lower end of the price channel we are talking about have followed throughout 2021.
Finally, a less obvious but significant point would be the 80-day moving average, which is currently at 4,187. This would take us to the June low and the controversial area in May where we saw a gap on the downside. In addition, the 80-day period has marked many important lows over time, most recently the March 2021 lows, where we slumped back into the price channel.
It is almost as if the OPEX is ringing a volatility bell in July. It would therefore be advisable to wade carefully over the next few weeks as a precaution. Adding some speculative put positions or hedging are suitable measures to ward off possible short-term headwinds. However, one should also be prepared to reduce these positions in potential support areas and be prepared to go long again, as tactical action in the summer doldrums has proven to be a profitable buying opportunity.