Is the Chop Really Over?

After over two months of rangebound choppy action we finally made all time highs on Friday. Those that have fought the recent rally can list a plethora or reasons why the recent high is bearish; however, let there be no mistake that closing at highs is bullish as it has been in every other instance since the bull market has begun. Being bullish though doesn’t necessarily equate to higher prices next week as a consolidation period is often followed by new highs. Keeping it simple though the path of least resistance is higher and for the time being any pull-backs will probably be limited and bought back up.

Bigger Picture:

Since the corrections of 2013 and 2014 no longer serve as prototypes for our most recent pull-back, I took a look at the two similar periods of choppy corrections in 2011 and 2012 (albeit both larger corrections than the most recent). Both would suggest that there is more upside to come from the recent choppy action; however that the upside would be followed by a sizable pull-back of half or more of the original correction size leading to a higher low. I realize this is a very small sample and in no way predictive of what is to come, but just taking a look at those two scenarios has opened my eyes to scenarios that I personally may not have considered (especially after adapting to the V-shape recoveries of 2013 and 2014).

The charts below illustrates both the corrections as well as the breakout area that I have marked with a black line. In 2011 (total correction of 20%), when SPY finally broke out of its up/down choppy range (roughly a 15% range) note it was not making a new high as it is now, but was just breaking a period of resistance that lasted a few months. It went about 5% higher in less then two weeks, but then gave back 10% over the next month to make a higher low. In 2012 (total correction of 10.5%), SPY did breakout to make a new high after months of choppy action; however, then spent a couple weeks consolidating before resuming higher. Furthermore, after a couple months of rangebound action about 5% above the breakout, it too gave back about 10%  to make a higher low.

2011Screen Shot 2015-02-14 at 7.11.14 PM

2012Screen Shot 2015-02-14 at 7.13.20 PM

The current correction was close to 5% if using 208.97 as the high and 7% if using the single print at 212.97 made on December 18th of last year. Given those two examples as possible scenario’s then a 2011 type of sharp break higher over the next two week should heed caution to a decent size pull-back shortly after. On the other hand, a 2012 type consolidation period that could include a slight gain yet still remain in a tight range for a couple of weeks would likely lead to a further gain of roughly 5% (which also corresponds to a similar pattern we saw after making new highs in 2013 and 2014). However, if following the 2012 scenario then after reaching new highs we would see another couple months of similar up down action that resolved itself markedly lower than the breakout zone and yet still as a higher low from the current pull-back. This scenario seems the most plausible based on how 2015 has already shaped itself to be.

2015Screen Shot 2015-02-14 at 7.15.43 PM

Very rough prototype of what a 2012 type correction would look like: Screen Shot 2015-02-15 at 5.41.42 PM

Next Week:

As mentioned, the path of resistance is higher and whether using 2011/12/13 or 2014 as a prototype, all scenarios would suggest range bound to higher next week. Below I have outlined the SPY open interest in two separate graphs with comments about how you can view them taking into consideration the technical picture as well.

spyThe first, displayed above (with a less expanded range) shows that if we happen to drift back down below the breakout zone of 208/209 then there is room all the way to 206 before it catches support from the outstanding open puts. Note that support aligns with the technical support that acted as resistance in December 2014 as well as a couple of times during the month of January (see blue arrows on the chart below).Screen Shot 2015-02-15 at 5.52.04 PM

If we instead drift higher, then the first area of resistance based solely on the outstanding calls would be at 210 and 212. Although there is no technical resistance at all time highs, there is also perhaps psychological resistance and or “overbought resistance.” Having said that, the 210 and 212 calls aren’t substantial and if SPY moves over 212, delta hedging by market makers (see here for better understanding of that) could push it higher.

This brings me to the second graph which shows how skewed the open interest actually is due to the roughly 450,000 open 215 calls. If SPY gets over 212 and the market is showing incredible strength then it has room to 214/215, which could potentially serve as a magnet. That scenario would possibly be setting the market up for a 2011 type move, which equates to roughly 5% higher over a 2 week period that ultimately takes back the entire move plus some over a month period.SPY.A

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