“It’s happening again”, Nomura’s Charlie McElligott warned on Wednesday morning, picking up where he left off in a short client blast sent out Tuesday afternoon.
What is “it”? Well, “it” is another buyside hedging program which Charlie notes is “effectively ‘maxing-out’ Dealer risk-capacity”. He likens this to the setup in late July/early August in terms of the potential for second order effects to manifest themselves directionally in equities.
“Mimicking the experience of late-July into August, we are once-again witnessing extreme VVIX- and (downside) Skew- levels which are representative of the knock-on impacts from Dealers being forced to hedge options they are short in the VIX Oct. Call Wing”, he writes.
The “problem” (if that’s how you want to couch it) is that in the event any of the myriad macro catalysts currently in play were to “realize” (so to speak) in the market, pushing stocks markedly lower and driving vol. higher, the dreaded short gamma feedback loop would exacerbate the situation.
“Dealers short VIX Gamma to not just this trade, but to other Dealers as well, so they [would] then have to buy more VIX upside to stay hedged at worse levels and with worse liquidity”, McElligott cautions. They could also pile into more equities downside hedges “or simply ‘short more Spooz’ to feed-into a “‘crash-DOWN’ as these trades are daisy-chained and attempted to be digested by the Street”, Charlie adds.
If that sounds familiar, that’s because we outlined the same dynamics early last month, both in terms of a “crash-down” and, later, a “crash-up” (see here, for example). McElligott says the current situation “rhymes” with the setup going into the S&P’s -200 handle selloff from July 26 to August 5. You can refer to the following simple annotated visual if you need a reminder of what macro catalysts contributed to that slide.
But, in the event the macro catalysts don’t take a turn for the worse in October, the potentially pernicious dynamics outlined above also work in “reverse”, if you will.
That is, in the event next month’s principal-level trade talks in Washington go well and things don’t deteriorate any further on the impeachment front, “the daisy chain of forced Dealer hedges they have had to take on will then again likely need to be ‘puked’ as they decay into expiration”, Charlie goes on to say. “Puked” there just means upside VIX hedges and/or downside hedges in equities would be unwound and shorts would get covered.
This is all just another manifestation of market feedback loops interacting with an absurdly fraught geopolitical backdrop.
Those feedback loops can create a “dry kindling” type of environment, and Trump’s various trials and tribulations can, at times, be the struck match.