Election Hedging Indicators

With the U.S. election fast approaching, it should be interesting to explore how the markets are positioned going into November 3. However, earnings reporting for many of the widely followed growth stocks are also on the calendar this week, and don't forget Covid-19 and the stalled fiscal support negotiations. This week's Market Review includes several new insightful indicators that should be useful.

S&P 500 Index (SPX) 3465.39 lost 18.42 points or -.53%, mostly occurring last Monday when it dropped 56.89 points as it headed for the 50-day Moving Average. Then Thursday it successfully tested the average again and turned higher on Friday. Considering all the uncertainty, support at the 50-Day Moving Average, now 3407.86, seems remarkable.

Invesco QQQ Trust (QQQ),284.74, called "the decider," slipped 3.77 points or -1.31% last week and like the SPX tested and held support at the 50-day Moving Average, now  280.71. Several attempts to rotate away from the growth stock favorites resulted in "the decider" underperforming the SPX last week. However, it could be temporary since several favorites report earnings this week and the pullback may just be the way the game is played before reporting so they can advance again when they announce better than expected results.

CBOE Volatility Index® (VIX) 27.55 added .14 points or +.51% last week. Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, gained .27 points or +1.13%, ending at 24.14

For now, it looks like more up and down as implied volatility appears to have arrived in the low 20's most likely due to increased uncertainty caused by Covid-19 and the upcoming election compared to pre-Covid-19 March when it declined into the mid-teens. The IVXM and SPX charts follow.

Next by comparing the implied volatility of options expiring in 30-days to those expiring in 9-days, may help focus on the level of hedging activity using SPX options. This chart shows the differences as a spread for the year.

The spread between the 30-day options and the 9-day options averaged 1.97 from April 9, when it turned positive again after the March market decline, to September 30 (the green line above). For the last three weeks, it averaged 4.74. Since the 30-day options remain elevated it seems to suggest a collective desire by hedgers for downside protection beyond November 3, thereby confirming the delayed results assertion.

Looking at put/call ratios may also help. Of the six ratio categories and the total put volume reported by the Cboe, the Equity Only Put/Call ratio sends the clearest signals at important turning points.

With an average of .60 since January 2019, on Friday it closed at .49, up from the August 28 contrarian sell signal low of .41. Until it crosses back above .60, it seems reasonable to assume the believers outnumber the doubters.  

Now for a look at VIX futures and options on VIX futures. 

VIX Futures Premium

This next chart shows as our calculation of Larry McMillan’s day-weighted average between the first and second-month futures contracts as of last Friday.  

With 17 trading days until November expiration, the day-weighted premium between November and December allocated 85% to November and 15% to December for a premium of 4.42%, with the volume-weighted version at 4.23%.

The elevated VIX reflects hedging activity with SPX and SPY options so the spread narrows unless the futures also advance. This chart courtesy of vixcentral.com shows the VIX futures term structure and the relationship between the 9-day Day short- term options at 24.29 and the traditional 30-day options at 27.55.

The term structure reflects a willingness to pay more for November and December futures although they have the greatest loss of time premium and are in a constant state of rotation from the closest future to the next. While this downward-sloping term structure appears abnormal, for VIX futures there is no normal term structure.

For a short-term look at VIX futures activity ahead of the election, the chart shows both declining volume and open interest.

So far, no sign of a rush to hedge market risk with VIX futures.

Going one step further, how about options on VIX futures? Few would be willing to sell futures contracts on the VIX unless the risk could be hedged. This chart shows the weekly average open interest of options on VIX futures used for hedging futures risk.

Friday's tally at 6.9 million contracts, up from 4.6 million on September 25, but still near the bottom of the range since mid-2016.                  

The relationship of the futures curve to the VIX, as measured by the premium, usually makes a good real-time sentiment indicator based upon actual commitments of large Asset Managers and Leveraged Funds. Currently, evidence of additional hedging before the election with VIX futures appears negligible. However, the somewhat elevated VIX suggests more hedging with options on the SPX and SPY. 

For daily updates, follow our end-of-day volume weighted premium version located about halfway down the home page in the Options Data Analysis section on our website.

Strategy

One widely followed market pundit claims as long as the SPX remains constructive,  and above the 50-day Moving Average would qualify, the equity markets defined by SPX and QQQ will continue working their way higher unless upset by some unexpected news other than the election. Therefore, expect SPX to advance back up and retest the September 2 high at 3588.11 and then,

1. Attempt to form a double top or
2. Exceed the previous high, and start forming a potential H&S Top pattern or
3. Resume the long-term uptrend. 

At the previous high begin considering hedging long stock, ETFs, and index
positions.

More important earnings reports this week so check out our Volatility Kings™ list in Digest Issue 41 "Volatility Kings Third Quarter 2020" for volatility trading ideas

Summary

While attempting to isolate revealing indicators around the election date, other concerns such as earnings reporting by several big-cap growth favorites, new reported Covid-19 cases, and the fiscal support negotiations complicate matters. While the VIX remains slightly elevated the VIX futures term structure and options on VIX futures suggests no increase in hedging activity.