Today’s market action, despite a modest spike in Eminis after the big retail sales miss and the even more unexpected jump in yields despite the latest confirmation the US economy is slowing down rapidly, generally makes sense at least in the context of the absolutely bizarre market action in recent weeks: Chinese Equities are struggling to digest the ugly weekend data misses coupled with the latest now-daily crackdown and warning from SEC head Gensler, while in the US, stocks are drifting on fresh lockdown fears (after New Zealand locked down its entire economy after 1 (ONE) case of covid) and fears the best is far behind us in an economy where retail sales have missed for the past three months while the Citi Global Economic Surprise Index is lunging back towards “zero” after 14 consecutive months of “upside surprises” from the economic recovery.
But – as Nomura’s Charlie McElligott writes in his morning note, – “how about yesterday’s S&P 44-handle rip off the lows?! “
Rehashing what we wrote last June in our primer on gamma and option-driven equity flows, where we quoted Goldman who said that “Gamma has the potential to be one of the most important non-fundamental flows in equity markets (particularly when “short gamma” causes volatility to accelerate)“, McElligott writes that in standard “tail wags the dog” fashion, “two monster options-derived / vol-sensitive flows simply overwhelmed all macroeconomic- and geopolitical- narratives on the day” and continues:
Options Dealers are choking on prolific long ATM Gamma into Op-Ex (SPX and SPY consolidated $Gamma at $39.3B, 94%ile), which simply means that selloffs would be bot and ripped back – crushing the daily distribution of outcomes into a narrow band for effectively an entire month now and smashing realized volatility.
This goes part-and-parcel with enormous Vol Control universe buying as we told you expect Thursday, adding prolific amounts exposure off the back of the absolute collapse in trailing realized volatility; as of this morning, we see SPX 5d rVol = 0.9 (which was last seen in Sep and Oct of 2017), while 1m rVol printed 8.3 / 3.5%ile rank…and 3m realized registered 9.2 vols, a stunning 0.4%ile
While we have discussed the nuances of gamma’s impact on markets, most recently yesterday when we addressed the possibility of a VIX acceleration, we give the podium to the Nomura cross-asset strategist who unpacks the equities options positioning component of the power move higher off the nervous morning lows made yesterday, “especially as hedger sensitivities are inherently growing into tomorrow’s VIXpiration and Friday’s Op-Ex which should act as the peak of this week’s melt-up.” Here is his explanation:
Currently, markets are absolutely stuck and pinning btwn the large ATM $Gamma strikes ($5.5B at 4450 and $5.7B at 4475, with $12.3B acting as potential gravity for a move up to 4500, which is now the largest strike by a factor of 2x), as Dealer Gamma profile vs spot location means pure insulation / mean-reversion hedging flows
As our analysis projects as of this morning, we expect a lumpy / outsized ~36% of SPX / SPY consolidated options Gamma to drop after Friday’s monthly expiry, with $Delta of course growing into expiration and in nosebleed territory at $407.8B (95%ile)—meaning this could act as an enormous unwind flow on a pullback when / if those hedging buffers are reduced in that magnitude, allowing the market to “move” thereafter as volatility could then again expand.
QQQ (Nasdaq) options positioning is even more extreme, with 99%ile $Gamma and 94%-ile $Delta, with an eye-watering 53% of that $Gamma rolling-off Friday…just a massive potential “un-pinning” thereafter, but “stuck” for now
But with the “Gamma Hammer” spraying the Street with LOADS of $Gamma twice a day and ~ 3 times a week (via their “strangle selling”) — while overwriters too pile-on in standard index and single-name option selling programs — the inability for the market to move more than 20 to 50bps a day is totally unsurprising, while being simultaneously excruciating for anybody bleeding Theta
Gamma aside, there is also the Vol Control component (forced buying or selling around given vol lookback levels) of yesterday’s rally, which occurred on account of trailing realized volatility windows making new lows in large part thanks to this aforementioned “peak long Gamma” placing the market in a chokehold, which in-turn mechanically elicits what has been extremely “outlier” exposure adding in recent days / weeks / months, and has now taken the overall dollar allocation to Equities in Nomura’s Vol Control model to 87%ile over the past 10 years relative.
Here are the staggering forced buying numbers per Charlie: 1d Vol Control exposure change = +$35.6B, 99.5%ile; 2d change = +$46.1B, 99.3%; 1w change = +$49.7B, 98.2%ile; 2w change = +$ 60.8B, 97.1%ile; 3m change = +$107.1B, 91.4%ile; 6m change = +$118.5B, 91.9%ile
And there you have it: according to McElligott, the recent action has been “just massive “buy” flows into that itsy-bitsy pullback Monday morning and taking-us right back in the peak “long gamma = rVol pinning” strikezone, feeding our anticipated “melt-up into Op-Ex” call.” But, as he further adds, “outside of this decimated index-level realized volatility in isolation, many volatility metrics continue screaming YIKES!, which is why we have continued to see super “nervy” jumps in VIX space on utterly negligible moves lower in spot index in recent months.”
One such metric is the Skew which we have discussed frequently in the past touching on the various drivers of all the demand for skew…not just longer-date “crash” downside hedges, but really about a mismatch on tenor and general Vol supply-and-demand. Here is an updated SKEW list from McElligott:
- Huge notional Equities books to hedge with markets at all-time highs, rallying in violent and uncomfortable fashion (SPX closing yday +100.2% off the 3/23/20 COVID19 pandemic low)
- Fed “taper tantrum” concerns, as emergency liquidity accommodation is set to be unwound, as the recovery continues to power-on
- Inflation regime change risk impact of “bonds as your hedge” correlation, in-turn driving new user demand for Equities Vol as a hedge
- But most critically, this is simply about complete and utter imbalance in the enormous demand for term-volatility, versus little-to-no supply of volatility that is not short-dated and/or at-the-money without daisy-chaining into more pricing extremes, which is largely a function of Dealer regulatory risk management implications (too many VaR events in recent history, which require desks to try and stay “crash positive” in stress slides)…and why, according to Nomura, “all these vol metrics are so out-of-wack!”
Said another way, Dealers can’t be short skew / crash / tails / gamma without causing knock-on into even more extreme vol metrics as they need to hedge themselves likely via liquidity from other risk-constrained Dealers and a downsized market-maker liquidity profile. Meanwhile, vol metrics remain super-tense, tightly-wound and pricing “crash,” juxtaposed to realized vol grinding ever-lower—which simply means one side will have to converge to the other in likely precipitous fashion as this “trues-up” eventually – translating either into an epic risk meltup or… meltdown.
- SPX 1m iVol / rVol 91.5%ile, 3m iVol / rVol 93.5%ile
- QQQ 1m iVol / rVol 96.4%ile, 3m iVol / rVol 99.4%ile
- SPX 1m Skew 97.8%ile
- QQQ 1m Skew 94.0%ile
- SPX 1m downside Put Skew 99.0%ile
- QQQ 1m downside Put Skew 95.7%ile
- VIX 2w Call Skew 99%ile, 2m 100%ile, 3m 100%ile, 6m 100%ile
- SPX 3m / 1m Term Structure 97.6%ile
- QQQ 3m / 1m Term Structure 97.0%ile
- VVIX / VIX ratio +2SD (1Y relative)
This is where it gets even more complicated, because with realized volatility this low on absolute levels, and with systematic exposures this high (the CTA Trend model also sitting at 86%ile gross exposure over the past 10Y), this is how a seemingly “small” move in market could feed into a larger move in Vol which could see a totally outsized “CRASH” selloff occur thereafter—particularly in the case of the Op-Ex cycle “turn” timing, as we earlier stated a significant amount of “Gamma unclench” this expiration.
As such, this extended loading of systematic exposure on the realized vol compression is most likely the single largest “risk” in this market, because whatever the “spark” that lights the flame of movement, there is simply an enormous amount of mechanical derisking to occur, especially if we were to push “spot” down to a point where options Dealers are then piling-onto de-grossing flows via their “short Gamma” accelerant flows, i.e., selling leading to much more selling. Indeed, as shown in the SPX options charts, “Gamma vs spot” would flip below 4306 this week / 4301 ex this expiration, with peak “short Gamma” around 4180.
So as McElligott summarizes, the post Op-Ex cycle turn “is the window where any semblance of pullback would then need to align with these big “delta one” type flows being hyper-susceptible to a de-grossing event, all thanks to this extended positioning against extraordinarily low realized volatility—low probability it can all occur, but definitely the way a -1.5% move could turn into a -3% or -5% too.”
- A market super-long $Delta as potential flow “out”–check
- Prolific systematic “vol sensitive” fund exposure as potential flow “out”—check
- Relaxation of the current “long Gamma” market insulation which chokes-out movement—seemingly in position to occur after Friday morning’s expiration (See below strikes for SPX options gamma dropoff, particularly ATM kind)
One final point for those wondering how bad the ensuing deleveraging could be, the Nomura quant writes that with all this “outlier long” systematic exposure vs “historically low” realized vol, here are his forward $ estimates of exposure reduction supply which could hypothetically occur on even just a smallish “down day” (-1.5% to -2.0%), Friday through next week in the Vol Control model.