A Tactical Warning For Bulls

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 |  Includes: SPY
by: Cam Hui, CFA

Well, that market reaction to the Spanish banking bailout was underwhelming! I wrote last week that seeing a market's reaction to an event can be an important clue to future direction, as it is an indication of investor expectations and what news is priced in.

We now know the path of least resistance for stocks is down. We got the first hint last week from the lukewarm market reaction to the ECB announcement and Draghi press conference; and later the reaction to the Bernanke testimony (see my comment Is the QE glass half full or empty?).

Now that the bias for equities is bearish, what's the short-term downside from here? Consider this note from Todd Salamone of Schaeffer's Research published on the weekend, which suggests that technical selling by option market makers could exacerbate the downturn as we draw closer to Friday's option expiry [emphasis added]:

The current open interest configuration on the SPDR S+P 500 ETF (SPY - 133.10) is very put-heavy, setting up the potential for short-covering related to the expiring put open interest at strikes immediately below the current SPY price. The odds are in the bulls' favor, absent a negative outcome with respect to Spain over the weekend. That said, a poor start to the week spurred by ongoing euro-zone concerns could create the kind of delta-hedge selling that occurred last expiration month, when put strikes acted as "magnets" once the ball got rolling to the downside.

Here is how he explained the mechanics of delta hedging as it related to the option market and market makers may have contributed to the market decline in May:

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.

Salamone postulated that the SPX could find some support at the 1,280 and 1,250 level:

It's usually the big put strikes that act like magnets, so 128 (which corresponds to SPX 1,280) would be a possible support area. There's a smaller-probability risk of a move down to 125 (or SPX 1,250), which is the next strike with significant put open interest. On the upside, a move into heavy call strikes at 134 and 135 would be a possibility in the event of a short-covering rally. These areas correspond to SPX 1,340 and 1,350, respectively, which we cited above as potential chart resistance.

Given Monday' market action, it is evident that the bears have the upper hand. Salamone's comments put some further context to the short-term downside that US equities face this week.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.