My Stock Winners

The broad market put in solid performance last week, resuming its string of positive returns during options expiration after stumbling slightly into negative territory during January. The Standard & Poor’s Depositary Receipts (SPY: sentiment, chart, options) added 1.2 percent last week, while the Dow Jones Industrial Average (DJIA) jumped 1.5 percent to close at a fresh all-time high. In fact, 10 out of the past 14 expiration weeks saw the SPY finish with a positive gain.

While we’re on the topic of technicals, the S&P 100 Index (OEX) briefly conquered the 670 level to tag a high of 671.47 and even closed one trading day above the round-number mark before retreating once again. The index closed the week back below 670 level.

Elsewhere, the CBOE Market Volatility Index (VIX) for SPX options slipped below 10 on February 14 to tag a low of 9.70 before it quickly bounced back above the round-number level. During the rest of the week, the VIX managed to hold above the 10 level, but the relatively low VIX could entice a number of options players to snatch up put options when trading starts today in an effort to lock in some “cheap” protection. This would put downside pressure on the market.

As we have seen in the past, while expiration week tends to be strong for the market, the week following option expiration is often marred by a pullback in the major indices. Frequently, traders will jump back into put positions now that their previous positions have expired. This swelling in bearish bets is accompanied by hedging among the traders who take the other side of that trade and sell the puts, another factor that creates downside pressure.

Turning to a chart of the VIX, I found that over the past year, VIX peaks have been in the first half of the month, with the very notable exception of May 2006 and also November 2006 (July 2006 is on the bubble).

Another way of framing this could be that in the post-expiration period each month (always in the second half), market performance is “challenged” by the fact low VIX periods attract put buyers and stock sellers. A better explanation might be that the rise in the VIX from the second half of a typical month into a peak in the first half of the next month is the result of the accumulation of index puts in the new front month, with the VIX peaking (and selling pressure lifting) once all the put demand is satisfied.

Looking at the implied volatility readings for SPY out-of-the-money options, we continue to see the implieds for the exchange-traded fund’s (ETF) puts increasing at a faster rate than for its calls. Furthermore, the 10-day moving average of the ratio comparing put implieds against call implieds looks very much like the action coming out of July 2006 bottom and the beginning of the fourth quarter. In other words, periods preceding very bullish market action, thus suggesting that the market is in a favorable position from a risk-reward perspective looking out over the next several weeks, which means any downside we could see in the short-term is muted relative to the upside potential in the coming weeks. That would mean pullbacks should be viewed as buying opportunities.

On the other hand, the same ratio of put implied and calls implieds for the Nasdaq-100 Trust (QQQQ: sentiment, chart, options) options is on the decline, indicating that options speculators are exhibiting a growing preference for calls over puts. In the past when we saw this growing divergence between the SPY and QQQQ ratios, the tech-laden QQQQ showed weakness relative to the SPY during the following few weeks before a brief period of outperformance relative to the SPY.

While this week may be plagued with broad-market weakness as traders pile back into their protective puts, this swelling of bearish bets simply forms the building blocks for the wall of worry that the market continues to climb over the long term.