affiliates



Delta-Hedging Effect on the Stock Market



Stock Option Strategy – Did Delta-Hedging Contribute to the Latest Market Dive?

SPY Has Heavy Put Open Interest – A Further Contributor of Stock Selling Pressure?

Major Equity Indexes Have Violated Significant Support Levels!

Will the Bulls Prevail? -- The Technical Backdrop is Questionable at this Point!


by Ian Harvey

Share

delta-hedging

May 21, 2012

Introduction

“.....It has been a punishing last six weeks or so in the stock market – and markets continued to decline last week, erasing most of the gains achieved since the middle of January. For the first time since January 18, the S&P 500 traded below..... and early rally attempts fizzled quickly. It is important to note the deterioration in the technical picture since late March, when ....."The risk of a deeper correction remains high.....”
- The Week Ahead in the Stock Market, May 21, 2012

Now that the major equity indexes have violated significant support levels – as discussed in the excerpt above -- a warning is apparent that the technical forecast has grown cloudy.

Worries still remain over the embattled euro zone, but -- now that a potential options-related headwind is behind us it is important to concentrate on what will help secure further advancement for the investor.

One area that produced some sort of silver lining last week was the small 0.6% gain that Facebook (FB) eked out on its first day as a publicly traded company.

Before moving on to more potentially important matters, it is essential to understand the implications of last week’s fall, particularly looking at the effects that delta-hedging had on the market!

By highlighting the key chart levels to watch this week for the Russell 2000 Index (RUT), Standard & Poor's 500 Index (SPX), and PowerShares QQQ ETF (Nasdaq: QQQ) helps investors to realize the pitfalls and potential profits to be made and take action to implement appropriate strategies.

Caution of a Correction

“.....technical indications are being thrown around as corrective warnings - sell signals, yet with deeper research and practical understanding on these same indicators suggests a pause could be at hand, but not necessarily a correction. Sideways, choppy action within the current uptrend would not be a surprise, as the SPX battles the round-number 1,400 area concurrent with the S&P MidCap 400 Index (MID - 1,000.73) making its second run in as many years at the 1,000 millennium mark. Overall, this appears to be still a favorable environment for the bulls.”
- Sell Signals for the Stock Market, March 19, 2012

In March, caution was the “by-word” that the market could be in for a period of slowing momentum and choppiness, as major equity benchmarks simultaneously traded at key round-number resistance areas. After rejections at these levels -- and what appeared to be a mild pullback – the market began making bullish comments. The sentiment backdrop has been the kind that usually marks bottoms, major market indexes were trading around potential support levels, and there was evidence that big fund players were taking interest in stocks on the pullback.

Last Weeks Plunge

Last week, however, was a big disappointment from a technical perspective, as equities broke support and the market's benchmark volatility index advanced above resistance. For example:

1. The S&P 500 Index (SPX - 1,295.22) not only fell below potential support at the 1,340 level -- an area that acted as resistance on multiple occasions last year -- but it also fell below 1,333 (double the March 2009 low) and the round-number 1,300 area.

2. The Russell 2000 Index (RUT - 747.21) fell below the 780 area -- the site of its 80-week moving average, which has acted as support and resistance on multiple occasions going back to 2004.

3. The CBOE Market Volatility Index (VIX - 25.10) advanced above the 21 area, which is 50% above the March low and had capped VIX rallies in April and May. As previously mentioned a climb above 21 would put the bulls at risk for a move into the 27.50-28 region, which is double the March low.

The Reasons Behind the Decline in the Market

So what, exactly, created what has been described as "orderly selling" in the equities market last week?

1. Is it the negative headlines pouring out of Europe, with 16 Spanish banks downgraded by a major credit-ratings agency and political uncertainty still the flavor of the day? It is interesting to note that even as the Greece and Spanish markets finished higher on Friday (Greece to the tune of more than 3%), the U.S. market still managed to close lower, which is potentially indicative of domestic concerns.

2. Or is the current weakness due to the unwinding of a bullish position that JPMorgan Chase (JPM) took in the credit markets, which resulted in a huge trading loss for the company?

3. Or was last week's price action driven in part by a delta-hedging decline related to the huge build-up of put open interest on major equity indexes and exchange-traded funds (ETFs)?

As popular put strikes were violated one after another during expiration week, sellers of the puts may have been forced to short futures to keep a neutral position, creating a steady but sure stream of selling. The heavy put open interest strikes essentially act like "magnets," as one strike after another is taken out. Delta-hedging risk certainly grows during expiration week if the market gets off to a weak start, as it did last Monday, and there is heavy put open interest just below current prices.

Check out the May put open interest (red) and call open interest (green) on the graph below heading into expiration Friday last week. If indeed the puts acted as magnets after the key 140 area was breached earlier in the week, it would explain the steady bleed down to the 130 strike.

Delta-hedging is an options strategy that aims to reduce (hedge) the risk associated with price movements in the underlying asset by offsetting long and short positions. For example, a long call position may be delta hedged by shorting the underlying stock.

This strategy, delta-hedging, is based on the change in premium (price of option) caused by a change in the price of the underlying security. The change in premium for each basis-point change in price of the underlying is the delta and the relationship between the two movements is the hedge ratio.

An example of Delta-Hedging -- the price of a call option with a hedge ratio of 40 will rise 40% (of the stock-price move) if the price of the underlying stock increases. Typically, options with high hedge ratios are usually more profitable to buy rather than write since the greater the percentage movement - relative to the underlying's price and the corresponding little time-value erosion - the greater the leverage. The opposite is true for options with a low hedge ratio.

Market Movement After Delta-Hedging

If last week's sell-off can be partly attributed to delta-hedging -- which is a high probability -- the market could right itself fairly quickly, as the short trades put on during expiration last week are covered, and mean reversion sets in after heavy selling in 11 of the past 13 days. But if this has everything to do with Europe and/or JPM, a negative tone could continue to beset the market for the next few months, in the absence of a positive catalyst.

051812-SPY open interest



30-Minute Intraday Chart of SPY
May 14-18, 2012

051812-SPY



The Sentiment Backdrop after Delta-Hedging

The sentiment backdrop continues to favor the bulls, but admittedly, the technical backdrop is questionable at this point. That said, the SPX comes into this week trading at yet another potential support level, as it sits on the late-October 2011 high, which coincides with a 38.2% Fibonacci retracement of the October low and April peak. If this level doesn't hold on Monday morning, look for a move down to the 1,257 area, which is both this year's and last year's breakeven point. In 2011, the SPX held its breakeven point at the March and June troughs. Maybe more delta-hedging will be put into place!

Daily Chart of SPX since April 2011

051812-SPX



Moreover, the RUT comes into the week trading 7 points above its year-to-date breakeven level at 740.92, which is potential support. But a move into the red could set up a retest of 700, which is double the March 2009 low, a 61.8% retracement of the October low and March high, and the site of the RUT's 80-month moving average.

Conclusion

Finally, note the closing level of the PowerShares QQQ ETF (Nasdaq: QQQ - 60.81). As you might remember, the QQQ struggled to overtake the 60 level throughout 2011, but finally moved above this level in the first month of 2012. The 60 level is the key, as it is half the all-time high in 2000. Bulls would like to see the QQQ remain above 60, but a move below this area would put the bears back in the driver's seat.

Share



”Success is simple. Do what's right, the right way, at the right time.”


Option Tip for your Success!
Options traders are not successful because they win.
Options traders win because they are successful.


membership





e-zine


FREE E-ZINE
SUCCESS WITH STOCK OPTIONS TRADING

Email

Name

Your e-mail address is secure and will never be shared.

GET FREE
SUBSCRIPTION NOW!




Back to Home Page

Back to Market News from Delta-Hedging







Search Stock Options
Made Easy





FREE E-ZINE
"SUCCESS WITH STOCK OPTIONS TRADING"

magazine cover for S.O.M.E.


Email

Name

Your e-mail address is secure and will never be shared.

GET FREE
SUBSCRIPTION NOW!






new

OPTION TRADES FOR $39.00/MONTH
Click here TO FIND OUT MORE INFORMATION




Follow S_O_M_E on Twitter