Why Buyers Should Use Risk Management Options This Week

Last week there were more bears than bulls for the first time since late April

“…TThe November 15th candle that triggered the bearish “island reversal” marked the low as support from the October high at 5,880 partnered with the SPX’s upward-sloping 20-day moving average before the gap to the downside from the 15th last week . closed in November, suggesting the bulls remain in control…There is still a lot of work to be done to drive the recovery through near-term support. The mid-November closing and intraday high near 6,000-6,008 is above us.”

– Monday Morning Outlook, November 25, 2024

Looking back over the holiday-shortened Thanksgiving week, nothing has changed as the Bulls remain in control. After the S&P 500 Index (SPX – 6,032.38) failed to break resistance in the 6,000-6,008 range from Monday to Wednesday, options bulls exerted their power in a shortened session on Friday, moving above 6,000 to 6,008 . Keep in mind that during half-day sessions like Friday, the volume is low.

Last week’s breakout will be more convincing going forward if the daily lows are above the previous highs from early last week. As we approach December, the SPX is well on its way to my year-end target of 6,200 to 6,215 resulting from an inverse “head and shoulders” breakout in mid-September.

“…Many US stock benchmarks are struggling with potential resistance to round numbers. Additionally, Bitcoin (BTC) and the CBOE Market Volatility Index (VIX – 15.24) are trading near round numbers, with 15 considered round number support for the latter.”

– Monday Morning Outlook, November 25, 2024

The stock market options bulls also exerted control from the perspective of round resistance levels. The Dow Jones Industrial Average (DJI – 44,910.65) had more room for the next big run than other indexes, but a rally last week dropped it just below the 45,000 mark. But the SPX, the Nasdaq Composite (IXIC – 19,218.17) and the Russell 2000 Index (RUT – 2,434.73) overcame round numbers that were either above or just below in play at the start of last week’s trading.

Additionally, the Cboe Market Volatility Index (VIX – 13.51) fell below 15.00 to its November low. But Bitcoin (BTC – 97,064.43) failed to rise above the psychologically important 100,000 level despite “risk-on” trading being evident in the stock market.

“…These are risks to keep an eye on in the coming days. If the SPX fails to fall below a support area, the risks are less significant, but that could change quickly.”

– Monday Morning Outlook, November 25, 2024

The above exceptions relate to sentiment-based risks related to a possible bounce in the VIX from the 15 level and sentiment among equity option buyers on SPX and Nasdaq 100 components (NDX – 20,930.37). The current level of optimism, as measured by the buy-to-open put/call volume data, shows an optimism that has caused problems for these benchmarks in the past.

The current optimism among equity option buyers remains a risk, but in the context of price action, the risk will be downgraded unless and until equity benchmarks give option buyers a reason to become more pessimistic. With new all-time highs set on Friday, buyers are feeling no pressure to abandon current optimism.

The same applies to active investment managers who are almost fully invested and near levels where short-term peaks have been reached. But like stock option buyers, they don’t feel the need to exit long positions yet.

With the VIX now below 15.00, there is scope for a decline to the 12.30 level where it bottomed in May and June. But during that time, the VIX barely moved while the SPX rose. Both bulls and bears should keep this in mind going forward.

After all, not all segments of the market are enthusiastic, especially given the SPX’s new all-time high on Friday. The American Association of Individual Investors (AAII) survey last week found that 37% said they were bullish and 39% said they were bearish. It’s the first time since late April that there have been more bears than bulls, which preceded a huge rally in stocks through mid-July.

Consider the chart below, which measures how short-term options players are using the SPDR S&P 500 ETF Trust (SPY – 602.55). Note that there were liquidations at this strike in the days leading up to the breakout above 600. There is a slight bias in trading out-of-the-money puts versus out-of-the-money calls, suggesting that a fair number of index and ETF option buyers are betting on a near-term decline.

My advice would be to stick with momentum and use options to manage sentiment-based risks. With earnings season mostly behind us, premiums are low, so leverage is great and you can bet on momentum names with fewer dollars at risk by using options instead of the underlying stocks.

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