Hedgers Optimistic | IVolatility.com

Hedgers Optimistic

November 28, 2022

This week offers some additional evidence from the options market in support of the claim that the S&P 500 Index made a cyclical bottom on October 13 at 3491.58. Last week Treasury Bonds Higher Dollar Lower added bonds and the U.S. Dollar to the story following the prior week's first installment in CPI Short Covering.

The relationship to declining options implied volatility and advancing markets relies on the premise that motivated put buyers bid prices higher when implementing hedges for portfolio protection or shorting. Then when put buyers become put sellers anticipating the underlying will advance option implied volatility declines. In the short -term implied volatility changes might be temporary with or without significance. However, when it begins trending lower expect the underlying to begin trending higher.

Consider this chart showing the S&P 500 Index (SPX) 4026.12, blue line, the 30-day historical volatility, orange line and the 30-day implied volatility index, the green line.

Ivolatility spot price chart

Notice the implied volatility dropped below the historical volatility on October 25 and then continued lower ending Friday at an abnormally low of 18.48%.

The callout offers a clue. On October 25, the SPX closed above the minor downward sloping trendline (DSTL above) from the August 16, high that began at 4325.28 when it failed to continue above the 200-day Moving Average. Three days later, it closed above the 50-day Moving Average. Then after pulling back to retest the DSTL, it broke out to the upside after the November 10, CPI report. During all this confusion options implied volatility declined as shown by the green line.

As SPX approaches the long-term downward sloping trendline from the January 4 high at 4818.62 and the 200-day Moving Average it's like being pulled up by a magnet so implied volatility will likely increase as SPX tests formidable resistance. Then, will the wall crumble or remain impenetrable? Expect increased positioning on both sides and remember volatility regresses to the mean.

The next FOMC meeting on the calendar for December 13 & 14, followed by Chairman Powell's closely scrutinized commentary could be the decider. The markets expect the Fed will only increase the Funds rate by another 50 basis points, but with fiscal spending now likely contained, it seems the tough narrative could soften to a more wait and see approach presuming the rate of inflation continues to decline.

Summing Up

For equities, the picture brightened substantially following the October CPI report on November 10, as if the clouds opened and the sun came shinning through. In addition, the U.S. Dollar Index (DX) dropped and long dated bond prices increased. Further, options implied volatility already declining from October 25, made another leg lower.

As for rates, markets reflect the view they have likely peaked despite more Fed funds hikes ahead that will increase the odds of a recession next year as reflected by rising long bond prices from long- term investors seeking to lock in rates before they decline.

Unless derailed by the next CPI, employment report or some unforeseen macro event the S&P 500 Index will soon challenge resistance from the operative downward sloping trendline and the 200-day Moving Average as it attempts to close higher and turn the trend up.

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