I Expect a Continued Trading Range Until Dec. Expiration

There are many ways that traders traditionally look at support and resistance in the markets. As I have mentioned in past posts, one of the main things I look at are gaps in the major index ETF's like SPY or QQQQ. As we stand today there are unfilled gap ups at 79.50, 88.00, and 89.50. These gaps I view as a support cushion below current prices. There are unfilled gap downs at 92.50 and 96.00 which are above current market prices and could be viewed as a short-term ceiling on a market advance. There is a large unfilled gap down at 110.00 from back in October in the midst of the dramatic waterfall decline in the first two weeks of that months. That gap did not get filled at all and should act as a longer term ceiling on prices should the market "breakout" of the current trading range.

Another concept that is more advanced in analyzing the market from both a technical and sentiment perspective is evaluating the open interest in option strikes in the index ETF's SPY and QQQQ. Options are typically used as hedging instruments and that will result in many puts held at strike prices below current market prices. Options can also be used for speculation in both directions. Call options above market prices can be a sign of speculation/expectation that prices will advance beyond those levels by expiration. Additionally there are complex option trading strategies that involve the purchase or sale of both put and call options simultaneously and may take advantage of range trading.

That is a very elementary view of options. The open interest is basically the amount of contracts held in that particular option. So how do you use this data? Looking at front month (current month) options can tell a lot, as that is where the heaviest open interest is.

Right now the peak call open interest for Dec 08 is at 90.00 on SPY. Peak put open interest is at 80.00 and a slightly lesser peak at 85.00. I would view these levels as market support for the rest of the month. It gets more interesting with the QQQQ options. Peak call open interest is at 35.00 in Dec 08. The amount of open interest here blows away the amount in any other strike price. Seeing as 35.00 is well above current prices, I view this level as a level of great speculation and anticipation for prices to move quickly higher in the next week and a half. History will tell us that usually these options will expire worthless. I would doubt that we make much progress to or beyond those levels by expiration.

Peak put open interest in Dec 08 QQQQ options is at 27.00, with heavy cumulative open interest from 27.00 to 29.00. According to the "maximum pain theory" areas of heavy open interest are often where the price will end up at expiration. This will make those options worth little or nothing typically and will inflict great pain on the holders.

Taking the front month data together, I believe it indicates a continued trading range until expiration. Also, I would place my bet on prices of SPY and QQQQ being near the current level or probably a bit lower at expiration. After expiration, when all those contracts are history, I think we will be likely (or more likely) to see a price breakout of the range.

One last interesting point comes up when looking at Jan 09 SPY open interest. There is huge call open interest at the 100.00 strike and is greater than corresponding put open interest by a 6 to 1 ratio. It seems that options players have an optimistic expectation for the beginning of the new year as SPY would have to rise well above 100 to really cash in on those options.

While I don't want to read too much into a single piece of data like that, I believe history would tell us to bet against points of optimistic or pessimistic extreme like that.

Pete