How to Manage Market Risk After Friday’s Selloff

…if you are getting into the stocks, you might want to consider pulling back as there is still major potential resistance from 4,170 March closing low and 4,375 above. How the market behaves around these levels, if tested, can tell us more about whether it is a short-term rally in a bear market or a longer-term rally. For example, if the SPX fails to remove these two levels and then returns below its 24-month moving average, the odds increase that recent lows will be breached. But a break above these resistance levels would increase the chances that a longer-term rally is on the horizon..”

Monday Morning Outlook, May 29, 2022

While the longer-term charts look encouraging for the bulls, that’s far from a flashing “all clear” sign…A monthly candlestick chart of the SPX with its 24-month moving average is encouraging for bulls, as there is a lot of history on their side. But with the Fed rising in rates and an uncertain path as to how far it will go to fight inflation, the jury is out on whether several levels of resistance above will prove impenetrable. If you remain patient to commit more dollars and use the SPX price action to guide you, you will have little risk if any sellers emerge in those resistance areas I have pointed out to you.…”

Monday Morning Outlook, June 5, 2022

The observations and advice discussed in this weekly commentary served as helpful advice, based on the massive sell-off in stocks late last week. The S&P 500 Index (SPX – 3,900.86), after trading in a two-week range just below potential resistance at the June 2021 and March 2022 lows, made a decisive move below its fork hollow. If there is an upside, it is that Friday’s close at 3,900.86 was just above last month’s closing low at 3,900.79. However, the fact that the SPX closed at its lowest for the day on Friday implies that the sellers are still in control this week, at least until Monday morning.

Additionally, the SPX has moved back below its 24-month moving average at 4,071, implying that if you haven’t tiptoed back into the water yet, you should refrain from doing so at this stage.

If you tiptoed back into stocks, you were probably underweight, with little damage to your portfolio. While I’m sure there’s no need to tell you, I’ll just remind you that risk management is of the utmost importance in this environment, given the sketchy technical background.

You can manage risk by being underweight equities or by ensuring a hedge is in place using index options or exchange-traded funds.

That said, the bulls would clearly have preferred action like June 2019 or October 2020 – months in which the SPX pulled back and closed above its 24-month moving average. In these cases, the index rallied in the following months, without revisiting this long-term moving average. The current situation adds a layer of complexity in assessing risk as the SPX is moving back below the 24-month moving average after May’s monthly close above. A close below 3,850 would likely cause the SPX 36-month moving average to drop into the 3,700 range. This is a trendline that has marked several monthly closing lows in the past, with notable exceptions in June 2008 and March 2020. The monthly close below the trendline in March 2020 was followed by limited selling the following month, while June 2008 pointed to big trouble ahead for the next few months.

graphic mmo june 1 12

The SPX chart above clearly establishes resistance and support levels from various highs and lows or trendlines connecting lower highs.

Additionally, the week ahead brings the standard June expiry week and the added bonus of a Federal Open Market Committee (FOMC) meeting on Wednesday. Friday, according to CME’s FedWatch Tool Page, fed funds futures speculators are assigning a 76% chance of a 50 basis point hike and a 23% chance of a 75 basis point hike. On June 9, the day before Friday’s CPI reading, they assigned a 3.6% probability of a 75 basis point rise.

The below chart of the SPDR S&P 500 ETF Trust’s June open interest pattern (SPY – 389.80) can give us an idea of ​​what the expiry week might bring.

On the face of it, with the SPY entering the week well below the 400 heavy strike and trading just around the 390 heavy strike, plus heavy sell open interest stacked mostly in five-strike increments down to 330 – strike, it looks downright scary.

If the open interest on put options on each strike were made up of buy (to open) activity, there would be a serious risk of delta hedge selling throughout the week, as those selling the options shorts are forced to hedge by selling more and more S&P futures on additional SPY weakness. In other words, it would create a potential snowball effect, as selling leads to more selling as the expiry approaches and the next heavy hit appears.

However, after digging deeper into the makeup of the sell open interest on various strikes, I discovered that the 385 strike, and the heavy sell strikes below, are made up of a buy balance (to open) and sales (to open ) activity. As such, I don’t see the 385 strike and other heavy strikes below as having a destabilizing impact on the market like the 390 and 400 strikes, where most of the selling open interest was generated by buying (at the opening). Also, for what it’s worth, the 385 strike coincides with the 3,850 level of SPX, or the May intraday low.

As such, a further move below the SPY 390 strike could trigger more selling due to delta hedging activity, and that could happen as early as Monday morning. But other major open interest strikes below should not have such destabilizing consequences. Other factors outside the options market could inspire the emergence of additional sellers, such as a breakout of May’s intraday lows or the “known, unknown” regarding the Fed meeting.

graphic mmo june 2 12

Todd Salamone is senior vice president of research at Schaeffer’s

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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