Posted by Pete Stolcers on January 24
In my morning comments I referenced the Coronavirus as a potential problem.
Many of you are asking yourself if this market decline is for real and you are wondering if we might see a bounce into the close. Here are some reasons that I don’t think the market will bounce today.
Are stock valuations so compelling that Asset Managers don’t feel like they will have another chance to buy stocks? No. At a forward P/E of 18, stocks are at the upper end of the valuation range. Earnings season has barely started and the results have been good, but they will have to be exceptional for the market to move higher.
Is the Coronavirus really that dangerous? We don’t know for sure. What I do know is that there won’t be a cure for it this weekend. I also feel that we won’t have news that it is contained this weekend. It is likely to spread, but we don’t know to what extent. We also don’t know how dramatic the impact will be on the Chinese New Year. This is the biggest holiday of the year and it will definitely have an economic impact. 40 million Chinese citizens have travel restrictions. On the bearish side, we could learn that the virus is spreading quickly and that it has surfaced in other countries. That would certainly spark more selling.
Were Asset Managers prepared for this type of event? No. Option implied volatilities as measured by VIX are at historic lows. Much of the uncertainty has recently been resolved (USMCA, Phase 1 Trade Deal and Brexit) and Asset Managers don’t have any put protection. If they had been buying puts at this level the VIX would not be making historic lows. Today Asset Managers will be buying puts and that will put downward pressure on the market. Asset Managers can also short S&P 500 futures as a hedge and that will also put downward pressure on the index.
Is shorting the VIX and over-crowded trade? Yes. Traders have been selling option premium like mad and low interest rates have reduced market volatility. They are going to scramble to buy VIX futures and they are about to get squeezed.
Is there a lot of bullish speculation currently? Absolutely. Bullish sentiment has been off the charts and they will get shaken out during this wave of selling. We might even see some margin calls and that will fuel the decline.
Will investors start to sell? After a 30% market rally in 2019, many investors will be eager to take profits on the first market pullback. We are not likely to see selling until next week.
With the degree of selling that we’ve seen so far today Asset Managers will pull bids and wait for lower prices. They will also buy protection in the form of SPY puts more they will short the S&P 500 futures. Bullish speculators will be forced to exit and we could see some panic selling. They will try to hit bids that quickly vaporize. Institutional cell programs are likely to kick in and I expect the market to close on its low.
Option implied volatility will definitely spike today and that will benefit put buyers.
Hang on to your puts and take some profits near the close. I plan to hang on to some puts over the weekend as well.
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