The broad market resumed its rally last week, with the S&P 500 Index (SPX) not only closing with a gain of nearly one percent from the previous Friday’s finish, but the index notched a new six-year high in the process. A mid-week pullback and some concerns surrounding the release of November’s nonfarm payrolls caused the CBOE Market Volatility Index (VIX) to pop briefly higher, but the index continues to be capped by its 80-week moving average. Since mid-August, the VIX has locked in only one weekly close above this intermediate-term trendline.
Looking ahead, we find ourselves facing the final option expiration week of 2006 and this could be a good week for the Street. We have found that the SPX tends to rally during expiration week. If fact, during the past 11 months, the Standard & Poor’s Depositary Receipts (SPY: sentiment, chart, options) have suffered a weekly loss during the week of expiration only three times and the average return during this time period is a gain of 0.64 percent.
Jan.: -2.1 percent
Feb.: +1.7 percent
March: +1.6 percent
April: +1.9 percent
May: -1.7 percent
June: -0.5 percent
July: +0.3 percent
Aug.: +2.9 percent
Sep.: +1.3 percent
Oct.: +0.1 percent
Nov.: +1.5 percent
I think one potential reason for the upside bias in expiration weeks is the unwinding of heavy out-of-the-money puts that accelerates during that week. As these out-of-the-money puts are bought back to capture what little time value is left, those who took the other half of the trade and sold the puts are able to buy back the SPY shares they sold as a hedge against the short put position. This unwinding action in turn helps to add buying pressure to the SPY during this week.
As we head into this final week of trading for December options, the SPY has a solid accumulation of puts at the 135-139 strikes, totaling nearly 225,000 contracts.
Of course, the S&P 100 Index (OEX) isn’t without its own supply of puts, which could be unwound this week. The December 630 -650 puts have a total of more than 56,000 contracts in place at the moment.
Shifting to a more technical perspective, we enter this week with the SPX facing the 1,400 level as support versus its prior role as resistance. Furthermore, since the market put in a bottom during July, all corrections so far have occurred in non-expiration weeks.
Changing gears to check in on small caps, we find that the Russell 2000 Index (RUT) is back to leading the market on a year-to-date basis (though by a smaller margin that we saw earlier in the year). The index is currently up more than 17 percent since the start of 2006, compared to the SPX’s return of nearly 10 percent and the Dow Jones Industrial Average’s (DJIA) gain of almost 15 percent. The RUT is currently struggling to overcome round-number resistance at the 800 level. Last week, the index was soundly rejected by this level on more than one occasion.
The one wild card that investors have to keep an eye on this week is the Fed. The Federal Open Market Committee is set to meet on Tuesday and will release its comments on the economy (along with its decision on any change in the interest rate) at 2:15 p.m. Eastern time. Economists are currently expecting the Fed to keep rates unchanged at 5.25 percent. Comments from Bernanke will be closely watched for any indication as to which way the Fed is leaning. A recent weak manufacturing report paired with a strong-than-expected employment report have left many traders scratching their heads.
