My Comments: As I write this Tuesday morning, early trading suggests what happened last Thursday and Friday is continuing. I have no idea where today will end or whether we’re looking at a dramatic fall. I wouldn’t be surprised if it continues this week and next. All I can say is good luck and don’t hold your breath.

by Mott Capital Management \ 3 SEP 20 \ https://tinyurl.com/y4f2nb8h

Stocks have risen unchallenged in recent months, and now volatility levels are starting to increase. But there’s something more profound taking place, as we have been tracking many of the different warning signs the market has been sending over the last few weeks. However, now we could be at the start of the massive unwind of what has helped to fuel this equity market rally. It may be too soon to know the potential impact that lies ahead, but it’s something essential to monitor continually.

Vol On The Rise

The VIX and VXN indexes have been steadily rising the last several trading sessions, suggesting that implied volatility has been slowing rising beneath the surface. As those volatility levels rise, the pricing for options increases, making it more expensive to purchase puts and calls. But more importantly, it speaks to what could be a self-fulfilling prophecy that has been behind what seems to be a never-ending rally.

The VIX has quietly been ticking higher in recent days to around 28, from 22 on Aug. 25. The rising levels in the VIX come despite the S&P 500 increasing by nearly 6%. It’s not the inverse relationship we have grown to understand over the years.

Since Aug. 21, we have seen the implied volatility levels for the S&P 500 move from roughly 16.5% to around 24% on Sept. 3. It’s another way to illustrate the rising volatility levels seen in the VIX.

Trading Activity Surges

One reason why implied volatility levels have been rising before today’s sell-off is because of the massive amounts of options trading that has been taking place, especially call buying. The chart below shows the explosion in the level of daily trading activity since the March lows, specifically the call activity.

This can be further demonstrated by the sharp decline in the put to call ratio that has taken place across the entire equity market. The Put to Call ratio has fallen to its lowest level since October 2015 to less than 0.4.

This call activity picked up around Aug. 20, the same time we started to see an increase in implied volatility levels and the run-up in the S&P 500 and the Nasdaq 100. The reason why implied volatility levels have been rising is that market makers take on the risk from investors and traders who are buying the calls, meaning the market maker is the one selling the calls to the investor. For the market maker to properly hedge their book, they then need to go out and buy the underlying stock, ETF, or index.

It creates a vicious feedback loop without getting too complex. The higher the stock or index goes, the more of the stock or index the market maker needs to buy of that stock or index to remain hedged. That, in turn, brings in more call buying and speculators, which results in the market maker selling more calls, and having to buy more of the stock or index to hedge.

To take on this never-ending potential risk, the market maker begins to raise the pricing to buy a call or put. It pushes the implied volatility levels higher, and this why the VIX index has been rising steadily the past few days. In essence, it creates similar characteristics of a short squeeze.

This activity is particularly noticeable in a stock like Tesla (TSLA), which has seen massive amounts of options trading in recent weeks and an enormous increase in its implied volatility.

The same thing has happened in Apple (NASDAQ:AAPL) as well and across any number of prominent technology names.

But more importantly, is that Apple, Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Alphabet (NASDAQ:GOOG) (GOOGL) account for 22.4% of the S&P 500 ETF (SPY), while the technology sector as a whole account for 33.2%.

Meanwhile, in the Nasdaq 100 ETF (QQQ), the same five stocks account for almost 47% of the index. Add in Tesla and Nvidia (NVDA), and it jumps to nearly 52% of the entire ETF, and as a result, the Nasdaq 100 index is controlled by just seven stocks.

Because these few big stocks all represent such a significant portion of the overall market, market makers can also use the S&P 500 Futures and Nasdaq 100 futures for hedging purposes, thus putting a bid in the entire market.

The Unwind?

The bad news is that if this trade is starting to unwind, then it’s possible the selling can continue for some time, mainly as the value of the calls fall or investors sell their calls. It would mean that the same market makers taking the market higher now need to start selling their hedged positions, basically selling the stocks, ETFs, and indexes they may own. In essence, they have become over hedged and are now pushing prices lower.

Technical Trend

There’s a critical technical piece to the equation, which is more worrisome. The S&P 500 touched and tested a crucial level of support, an uptrend that started on April 3. The critical level of support at the moment comes around 3,450. If that level of support should fail, then the index could have a long way to fall. The first significant level of support comes at approximately 3,225, just 6.5% lower. But more problematic would be a drop to about 2,860, a decline of around 18%. That’s where the next significant level of support for the market would be, with a gap that’s waiting to be filled from May 18.

The index hit extremely overbought levels, with the RSI hitting a level of nearly 83. The last time the index hit a level that high was in January 2018 when it climbed to around 87, it led a peak to trough decline of about 12%.

Risks

Of course, these are merely the risks and help to explain why we have seen such crazy trading in recent days and weeks. If the S&P 500 can hold that April uptrend and continue to push higher, it may only happen once some of the excesses are taken out of the market. The dip buyer has helped to take these markets to levels that, in April, seemed unimaginable.

Regardless, the market doesn’t go up in a straight line, and at some point, something will give.