The question on traders minds as we look forward to the last 2 months of the year is whether we get a year-end Santa Claus rally to cap off a back and forth 2014. Considering that the S&P 500 index has finished the year in the red only once in the past 11 years, the historic odds certainly favor the bulls.
With that in mind, I was intrigued to see that positioning has moved significantly in the options market in the past few weeks. After the selloff from the mid-September high to the mid-October low, options traders have rapidly changed their positioning in the major macro ETFs.
As we saw in the past month, SPY and VIX options are the preferred macro instruments for portfolio managers looking for protection or leverage against their overall portfolio. SPY put and VIX call volumes hit multi-year highs last week as protection buyers and sellers became especially active on the big moves.
VIX call open interest actually hit a 1 year low this week after October VIX options expired on Wednesday morning:
VIX call option interest always falls after an expiration since the numerous upside call positions usually bought for protection expire worthless. However, the fall to a new 1 year low is notable, possibly signaling that traders see less need for protection. I checked for the possibility of a seasonality impact looking at history, but October has no special significance based on how VIX options open interest has moved.
At the same time that VIX call option open interest fell to a 1 year low, SPY call option open interest has risen to a 10 month high:
In this case, historically we have generally seen more call option interest later in the year than earlier in the year, so there is a possible seasonal impact here as well. However, the magnitude of the call option open interest suggests that options traders have become more willing to embrace the idea of a rally compared to earlier this year.
There are still two main macro catalysts for the U.S. market over the next month. The FOMC meeting next week became much more important after St. Louis Fed President James Bullard suggested last week the possibility of maintaining a small amount of QE given the recent fall in inflation expectations. The Federal Reserve has already indicated its intention to remove the final $15 billion of bond buying at its October meeting. Maintaining even a nominal $5 billion bond buying at next week’s meeting would certainly change interest rate and monetary policy expectations for all financial markets.
The second major catalyst is the U.S. congressional and gubernatorial elections. GS Research summed up the situation for financial market participants in a post 2 weeks ago:
At the start of this year, we characterized the political outlook for the coming year as “less risk, less action.” If the consensus among election forecasters is correct and Republicans win the Senate majority, we would expect this to lead to a bit more action on a few smaller items with a possibility of action on a few larger ones. However, we would also expect more uncertainty from fiscal deadlines like the debt limit as markets adjust to a new regime.
Polls continue to show a slight edge to Republicans winning the majority, though it remains quite close. Whatever the outcome, the expected impact on markets is not anticipated to be large, with the FOMC’s meeting next week the more important catalyst in our view.
Against that backdrop, and given the market’s V bottom last week, the options market positioning suggests that traders have placed the odds on the all-clear signal for the balance of 2014. We are more skeptical and our current positioning generally reflects that. Regardless, I view the next 2 weeks as critical for the general market climate for the balance of 2014.