How important is dealer gamma positioning in driving short-term volatility and exacerbating price action in US equities?
Well, pretty important, as you’ve probably surmised over the past year during periods of acute market tumult. Indeed, this is a subject that, much like Frederick Douglass, “is being recognized more and more, I notice”.
Take the August 14 selloff for example. That day, the Dow plunged some 800 points on recession fears tied to the inversion of the 2s10s curve. The breakdown of equity flows suggested more than half of the selling was attributable to systematic flows, a large percentage of which came from hedging dynamics. JPMorgan’s Marko Kolanovic broke things down as follows:
~$75bn of programmatic selling, with ~50% of it coming from index option delta and gamma hedging, ~20% from trend-following strategies, ~15% from volatility targeting strategies and the remaining ~15% from other products (e.g. levered/inverse ETFs, etc.). While these outflows would have represented ~25% of futures daily volume, in an environment of low liquidity they can be a dominant driver of price action.
To give you another example, recall that on the evening of Sunday, May 5, Donald Trump broke the Buenos Aires trade truce with a tweet. Minutes later, Nomura’s Charlie McElligott sent out a client blast warning that depending on how things panned out, SPX/SPY consolidated gamma could flip negative beyond which dealer hedging could exacerbate moves or, as he put it, things “could get sloppy”. And indeed they did.
Well, in a new volatility outlook published Monday, SocGen takes a look back at this year’s action in the context of dealer gamma positioning. There are more than a few notable highlights.
“Price movements over this summer once again clearly emphasized the spot/gamma/realized vol dynamics”, the bank says, some 22 pages into a lengthy assessment of the prevailing volatility landscape. “All the big daily moves (magnitudes larger than 1.5%) occurred when the previous day’s aggregate gamma estimate was negative”, they continue.
(SocGen)
The bank gets pretty granular with their analysis, zooming in on specific dates. “While gamma was comfortably positive at $Bn 27 on 30 July, S&P500 lost 1.09% on the 31 July, bringing the aggregate gamma estimate down to $Bn -0.5”, they write, recounting the events around the July Fed meeting which, of course, was immediately followed by another Trump trade escalation.
“The following few days saw large fluctuations in spot (-2.98% on the 5 Aug, +1.88% on the 08 Aug; +1.48% on the 13 Aug again -2.93% on the 14 Aug)”, SocGen recalls, adding that “these moves were fundamentally driven by the ongoing trade war newsflow but in our view magnified by the negative gamma environment”.
(SocGen)
The bank goes on to note that while this impacts short-term volatility, it can have a lasting effect depending on the persistence of yield-enhancing flows in a world of persistently dovish forward guidance, suppressed rates and the proliferation of passive, systematic and algo investing/ trading.
“The level of annual yearly realized volatility since 2007 has been strongly correlated with the amount of time spent in negative aggregate gamma territory, SocGen observes, on the way to noting that “strong evidence of the increasing flow and impact of aggregate option gamma is provided by the fact that three out of the last four years — 2016, 2017 and 2019 (so far) — rank among the least volatile/most positive gamma years in the last decade”.
(SocGen)
In case it’s not clear enough, this is becoming more and more important as time goes on – or at least that’s the way it seems.
Over the last several days, for instance, Nomura’s McElligott has flagged the “unshackling” of US equities out of September Op-Ex. We’re no longer “pinned” in and around 3,000 on the S&P. “Directionally in US stocks and after Friday’s options expiration, we have now unshackled with ~ 34% of the overall $Gamma across all strikes coming-off, in particular with the enormous ‘Long $Gamma’ which was pinning-us ~3000 in SPX for the past few weeks”, Charlie wrote to start the week.
SocGen is careful to note that you shouldn’t necessarily get too comfortable when spot is resting on the “right” (i.e., positive) side of what McElligott labels the “flip” line in his popular daily gamma charts. “Despite the strong volatility dampening impact of a positive option gamma environment, the low volatility environment thus created is not inherently robust and stable”, the bank says.
Citing their own “speed index”, SocGen cautions that just “two moderately bearish sessions are enough to completely turn the aggregate gamma picture upside-down”.
