Market Insider

Rally or not, market volatility looms

The Dow looks for a big 3 in a row
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The Dow looks for a big 3 in a row

Friday may not see another monster stock market rally, but the quarterly expiration of futures and options could surely bring more volatility.

Fueled by the Fed, short covering and year-end buying, stocks rallied hard for a second day Thursday. The Dow tacked on another 421 points, giving it a two-day gain of 4.2 percent, the biggest two-day rally since November 2011. The surged 2.4 percent to 2,061, its best day since January 2013. The S&P saw a 4.5 percent two-day gain, its best since November 2011.

"This looks like a short covering into-the-close routine," said Art Cashin, director of floor operations for UBS at the NYSE. "The Thursday before expirations have kind of a strange volatility."

He said the bias in the "quadruple witching" expiration, and an S&P index rebalance appears to be to the upside for Friday.

Traders work on the floor at the New York Stock Exchange, Dec. 18, 2014.
Seth Wenig | AP Photo

Stocks had been expected to move higher into the end of the year, but plummeting oil prices hijacked the stock market's late-year rally. But for the first time Thursday, there was a significant decoupling of crude and the S&P 500.

U.S. oil futures fell sharply, ending the day down 4 percent, an 8 percent decline from their morning high. Stocks shrugged off the drop in oil and moved even higher.

Read MoreOil plunges as market seeks bottom

West Texas Intermediate oil futures for January also expire Friday, and with the market in a bearish mode, that could put more downward pressure on prices. "We're in contango, and we have weak cash prices. The downward pressure as you get to expirations gets intense," said John Kilduff of Again Capital. "These are what bear markets look like. When you recall the bull markets of the past years, this is the same thing that happened on the upside."

Contango is when front-month futures contracts are priced lower than later months, and it is a bearish sign. "Tomorrow, we should see a significant downward push on the contract," he said.

The S&P energy sector led early morning gains, but turned negative when oil fell. However, it ended up a strong performer with a 2.1 percent gain.

"I didn't understand why falling oil is bad for the stock market so I think part of this is the reversal of that," said James Paulsen, chief investment strategist at Wells Capital Management. "I think most of it here is the Fed. Its real message was they are more confident than ever. The Fed pretty definitively said 'Don't worry about Russia. The U.S. economy will be able to handle it, and by the way it's strong enough for us to raise rates next year.'"

Read MoreBlackrock's Rosenberg: Stocks will beat bonds in 2015

Cashin said stocks could reconnect negatively with oil if WTI falls below its year low. WTI hit a low of $53.60 per barrel Tuesday.

Paulsen said while it seems lagging fund managers should be buying stocks, helping to drive the market higher into year-end, it's still unclear whether that will happen.

"We got more volatility going on. That's for sure. I don't know if we're going anywhere. We might just be doing it fast," he said. "Yesterday, as much as we were up, we were back up to where we were 24 hours earlier."

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Jon Najarian, CNBC contributor and OptionMONSTER.com co-founder, said clues to market thinking may be seen in the trade of one very large trader, who sold 90,000 January 20 calls in the VIX and bought 90,000 January 15 puts.

The trade is called a "risk reversal."

"It makes you synthetically short the VIX as you're obligated to deliver (sell) if it is over your $20 call strike and you are short at $15 or below," he wrote in a note. The VIX is the CBOE's volatility index. Often called the fear gauge, it reflects volatility conveyed by S&P stock index option prices.

"When a trader makes a 90,000 option bet, they are controlling 9,000,000 shares of VIX and thus, if VIX falls back into the previous range, those calls do decrease in value and the puts increase in value. The potential windfall could be multiples of $9M on up to $27M if VIX fell back to the $12 level where it was prior to this huge oil/Russia induced spike in volatility," noted Najarian, a CNBC contributor.

Najarian said the trader making this trade bet on lower volatility in the short term, which should result in higher S&P 500 returns.