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S&P 500 Index at Key Level

|Includes: DIA, IWM, QQQ, SPDR S&P 500 Trust ETF (SPY), SPY, VXX, VXZ
We've ended up yet again at the 105 level on the (NYSEARCA:SPY) S&P 500 Index etf, equivalent to 1,050 (SPX).  This is now the fourth time we've tested this level on the Daily chart -- see the first chart below.  Interesting that this was the exact bottom we reached on the "flash crash" day in early-May.  Also, take a look at the Fibonacci Retracement we've overlaid on this chart, which tracks the late-April high to the late-May lows.  Where did the upside rally fail?  Right around the 50% retracement (red horizontal line) of 113.25.  50% retracements of rallies, in addition to being a Fibonacci level, are also a common area of reversal that we've seen time and again in our years of chart analysis.  There is also a logical basis -- when a stock or index is in an underlying trend, a 50% retracement of that trend is a likely area for the bigger trend to re-emerge.

So now we've come down to test the bottom of this range yet again, where do we go from here?

SPY Daily Chart

Well, I've maintained for some time that we basically need to eventually test the round psychological SPX 1,000 (SPY 100) level on the downside, in order to give some finality to the downmove.  That is certainly a logical outcome to a breakdown below the current lows.  The 1,000 area is also important on the bigger picture weekly chart -- 1,014 SPX is an important Fibonacci area on the retracement of the longer-term downtrend in place since 2007.  I've mentioned previously that I anticipate a test of SPY 100 by the end of this calendar year.  Is it more imminent, going to occur in a week or a month?  That's not certain at this time.  We have seen in general more negativity rising and the drumbeat of bad economic and debt news from all over the world continues almost every day ... and don't forget the oil spill.  However, we haven't seen a clear VIX panic spike and/or Put/Call Ratio spike that would indicate a true panic bottom is here.

Also, 105 (and 100 to 110 as a range) is an important strike price in the SPY options, one that may actually draw us to this level and constrain us from big further downside until after July Expiration.  Take a look at the table below of SPY July option open interest.

SPY July Option Open Interest

What we see above is that there a massive amount of open interest has built up in the 110 to 100 July SPY Puts.  This is one of the reasons we have been drawn back down to this area.  And the 105 strike is the biggest of them all, with 368k Put open interest (and 50k Call).  This is why I mentioned to our Index Option Timer subscribers before this recent move lower that we are somewhat drawn to this strike.  The August open interest has not yet built up to levels anywhere approaching this, so when the July options expire on the 17th, it may free up the markets for a quick move down or up.

There are psychological, technical and market maker reasons why we move to and sometimes get stuck around a key strike price and technical level.  Big, round numbers (such as 105 SPY, 100 SPY, 10k DJIA, etc) are the ones that are most watched by traders, the media and the general investing public.  So they oftentimes become somewhat of a self-fulfilling prophecy -- if enough people are talking about a key level above or below the market, we become more and more likely to test that level eventually.

The market maker/open interest factor is not a pure "manipulation" as many think.  It's more due to actual financial numbers and hedging.  This large amount of 368k Put open interest at the July 105 strike is made up for the most part of Puts that were sold to the public by the option market makers.  Remember that the public is overwhelmingly option buyers, not sellers.  So the floor traders are "short" them -- and short the time premium they've sold at the 105 strike.  They do benefit from the SPY moving back to this level as time decay kicks in -- and notice how many times we've done so.  Market makers who have sold the Puts are likely also short the SPY against it -- and when we come down back into the 100/110 range of the large open interest they are looking to buy back the Puts they've sold in order to reduce risk exposure.  They also buy back the SPY underlying which does in effect provide some buying pressure on the market.  There also is the factor of delta hedging, gamma changes and standard deviation moves that can draw us around certain levels.  It's a bit complicated, but the net effect is that we are often drawn to large open interest strike prices.

Another quick note -- look at where the SPY July 105 Straddle is priced today with the SPY a bit under 105 -- it's basically right around $5 (28 implied volaltility).  So what range is this priced for the SPY July expiration?  100 and 110 are the downside and upside breakeven levels, anywhere in the middle is a loss ... if you think we can tank to 90 SPY or rally to 113.25 this may be a bit cheap.  But it shows the expectation of what the range will be.

Anyway, we've had multiple bearish signals over the past 2 months and had short-term Put recommendations from our systemized trading systems in Index Options Timer.  This move back down to the 105 area is not a surprise to me.  Now from here, if we do have a big panic selloff to SPX 1000, or even the 900 area (881.35 is a further big downside level on the weekly Fibonacci retracement), that should mark the bottom of the downside potential.

Disclosure: No positions.