An Options Pullback Play On The SPY

Includes: DIA, QQQ, SPY
by: Andrew Sachais

Technical and Fundamental data suggests a SPY pullback over the following month. Beginning with the chart below, technical levels suggest a downward pullback just under 130.

This is near a level where two trend lines converge, as well as a Fibonacci retracement level. The market internals, as seen in the small cap vs. large cap in the Russell indexes below, show that small caps have exuded weakness as of late. This is bearish and may be a driving factor towards a pullback of a 1 month or so duration.

Below is a custom oscillator of the percentage of S&P 500 companies above their respective 50 day moving averages. This oscillator is correlated to market turns and could provide further evidence of a 1 month pullback. Currently the oscillator is at peak levels (90) and shows a slight divergence with equity markets.

The last technical factor in this argument is the VIX (Volatility Index). Below is a chart showing the VIX and its retreat into calmer grounds.This follows the extreme volatility of last summer and the latter half of the year. However, what looks to be emerging is a reversal on the charts of both equity and volatility, as is to be expected. With confirmation of a VIX run up, equity short for the duration of at least a pullback can be expected.

Fundamentally, the markets are at risk of commodities inflation, European contagion and potentially weaker economic data. This all converges on the idea of sentiment and its influence on market behavior. The run up of equities thus far has seen a decoupling of SPX and euro, then a subsequent return to positive correlation as the Greece problem has magnified. Commodities on their own pose a threat to the consumer and businesses alike. This too would invoke aversion in society that is bearish. Weaker economic data is not expected, but the volatility of the indicators provides a broad range of possibilities.

The play on all of this data is a bearish options move buying volatility. A simple vertical put spread will provide exposure to our price range, with a limited downside to a failed projection of the outlook. A 2 to 1 payoff is possible if the price moves accordingly. Buy the 133 May Put and Sell the 130 May Put in order to again gain exposure to this point of view.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.