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Bulls: Be Patient Going Into Standard Expiration Week

Call traders will have to find another source of buying power

Senior Vice President of Research
Sep 16, 2024 at 9:15 AM
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Hedge Funds Add Bets on Yen Rally as Currency Rises 1% Again

            - Bloomberg, September 12, 2024

The other week, I wondered if there was risk of another carry trade unwind, in which hedge funds that borrow cheap Japanese yen to buy stocks are forced to unwind long positions in stocks to cover the strengthening yen. This happened in August, generating a delta-hedge selloff that marked a trough as the yen eventually weakened again.

The yen has gained strength since September, but stocks are not selling off like they did in July and August. It appears that hedge funds are now placing bets on a strengthening yen, which might explain why a 52-week low in the greenback/yen did not generate a selloff in stocks last week.

Perhaps hedge funds have gone elsewhere to borrow cheaply, or are making money on currency option bets to offset any forced selling? With traders braced for a stronger yen, it appears there is less carry trade risk like that of early August.

“Fast forward to the present and the closer the SPY is to the 540-strike, the more risk there is to bulls of another short-term, delta-hedge selloff… The risks to the bearish case include the dollar/yen holding the August low and the SPY holding above the 540 strike. In the latter case, any short positions related to put OI not far below the SPY will be covered as expiration approaches, lending support.”

            - Monday Morning Outlook, September 9, 2024

Last week’s commentary hinged on the importance of the SPDR S&P 500 ETF Trust (SPY -- 562.01) not straying too far below the 540 strike, which is equivalent to the S&P 500 Index's (SPX -- 5,626.02) 5,400-century mark.

In other words, a significant push below the SPX's 5,400 or SPY's $540 levels would increase the risk of delta-hedge selling like we saw in August. But at the same time, the index and exchange-traded fun (ETF) could hold above these levels as we move closer to standard September expiration. Another scenario was the unwinding of short positions related to out-of-the-money (OOM) put open interest (OI) at the SPY's 540 strike and below.

The initial reaction to last Wednesday’s inflation data tested the delta-hedge sell-off possibility, but both the SPX and SPY lows were at 5,407 and $539.96, respectively, before buyers came in. This level represented the prior week’s closing low and an area where buyers stepped in on July 25.

The end result when gauging the past two weeks' price action is a pattern in the SPX from the end of August through last Friday that looks very much like the “V-formation” that occurred from mid-July through the end of August. A possible explanation for the powerful advance off last Wednesday morning’s low is short-covering related to the massive put OI at the SPY's 540 strike and below, which was the other possibility I discussed in last week’s commentary.

SPX daily since March_09152024

The week ahead features the standard September expiration week, and the added bonus of the September Federal Open Market Committee (FOMC) meeting. Fed funds futures players are pricing in a 55% probability of a 25-basis point cut, and a 45% probability of a 50-basis point cut.

The biggest risk to bulls might be the Fed doing nothing again. Concerns have surfaced about the economy, and some officials indicated in recent weeks the time has come to cut rates..

With respect to the OI that is about to expire, the SPY is now near a call wall at the 570-strike, implying about 100 points upside to this level. Given that the 540 put strike delta is now extremely low, it would imply that any short covering related to put OI at the 540-strike and below is now over.

Through the lens of SPY September standard expiration OI impact, the short covering potential that existed last week at this time is not there. As such, bulls will have to find another source of buying power.

SPY September Open Interest Configuration_09152024

One potential source is from short-term traders, who are again at a pessimistic extreme, even with the SPX near an all-time high. Per the chart immediately below, the 10-day, buy-to-open put/call volume ratio on SPX components is at a level that has marked major buying opportunities in the recent past.

SPX Components 10-day BTO PC SPX_09152024

The obvious risk is on the chart, as sellers surfaced in mid-July when the SPX hit 5,667 and again in late August at 5,648. With Friday’s close at 5,626, the SPX is only about 20-40 points below these levels. One may conclude we are near the upper end of a volatile range between 5,400 and 5,650, so it is best to not get overly aggressive on the long side until a new high is taken out. 

In fact, a move to new highs means a move above the neckline of a bullish inverse head and shoulder pattern, with the head marking the early August low and shoulders being the short-term lows in late July and earlier this month. A breakout would signal a 500-point move above the July closing high in the coming months, or about 6,150- 6,200.

With short-term traders as pessimistic as they are now, a 500-point move higher is certainly possible in a short time frame if a breakout occurs. For now, however, be patient, as the potential bullish chart pattern has not yet fully materialized.

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

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