Earlier this week, we noted that the steep two-day slide in equities that unfolded on Tuesday and Wednesday (mirrored – and then some – across the pond) was likely exacerbated by systematic flows.
As Nomura’s Charlie McElligott wrote Wednesday, there was “a much deeper and more sizable Short $Gamma position for Dealers in both SPX and Nasdaq” this week. On top of that, spot SPX fell below deleveraging trigger levels on Nomura’s QIS CTA model, meaning some of the sell flow probably came from trend-following strats.
Here’s what Charlie wrote on Thursday morning, recapping Wednesday’s action, for instance:
US Equities were very much in the crosshairs of CTA deleveraging, with the ISM “macro catalyst” causing a fresh “growth scare” / “shock-down” impulse (later aided by the Bernie Sanders news and the heightened odds of a Liz Warren nomination—no comment), which then triggered mechanical “accelerant flows” that moved-us deeper into a more extreme dealer “Short Gamma” positioning that too was clustered with CTA deleveraging levels being broken to the downside (as the 3m window flipped outright “short” in a number of our models).
As a reminder, SocGen’s derivatives strategists wrote last month that most large daily moves in stocks (where “large” means magnitudes bigger than 1.5%) since May came “when the previous day’s aggregate gamma estimate was negative”. Wednesday’s action fit that description.
Fast forward to Friday and JPMorgan’s Marko Kolanovic is out with a new piece that takes a look at this week’s action in the context of the same systematic flows.
“In less than 48 hours, many major markets lost ~5% (nearly an average annual gain)”, Marko writes, before recapping the sequence of events that began with Tuesday’s ISM manufacturing miss.
“Later in the night, significant selling came in futures as the S&P 500 broke through 50- and 100-day moving average signals as well as 1- and 12- month price momentum”, he notes, adding that “a nearly identical sequence occurred with the Eurostoxx 50, which broke 1M, 3M, 6M price momentum signals as well as 50- and 100-day moving averages”.
That catalyzed what Kolanovic describes as “one of the largest CTA reversals (from long to short)”, which helped drive markets lower during the Tuesday-Wednesday rout.
Here’s an annotated visual which shows the 4.6% drop in S&P futures from the 2,994 highs made just prior to Tuesday’s ISM manufacturing release and the knee-jerk selloff on Thursday morning following the non-manufacturing miss:
More consequential than the CTA deleveraging was option hedging, something that comes up again and again.
“Even more importantly, due to the significant recent increase of put options outstanding, dealers were caught significantly short gamma in both indices”, Kolanovic goes on to say, adding that “this resulted in selling related to hedging index put options that is likely more important than the selling by CTAs”. Here’s a snapshot of where things stood on Thursday morning via Nomura’s McElligott:
So, just how much selling pressure did dealer hedging and CTA deleveraging exert this week? Well, quite a bit, in all likelihood.
“Technical flows likely drove more than ~$100bn of equities selling in a 48-hour period”, Marko goes on to say. “Going into this week, the setup for indices (CTA levels and option gamma) was vulnerable, and it didn’t take much fundamental selling to trigger much larger technical selling”.
This is reminiscent of a cascade effect that’s played out on a number of occasions over the past two or so years. Take the August 14 rout 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. At the time, 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.
As far as where things stand now, Marko on Friday writes that “dealers are still short gamma, and both the S&P 500 and Eurostoxx 50 are right below all of the key technical levels breached earlier this week”.
That, in turn, means that “if the market can move ~50bps higher during the day, it could spark a significant rally” driven by CTAs re-leveraging and “the same put options that helped push the market lower earlier in the week”.
Notably, McElligott made a similar point on Thursday, albeit with a number of caveats tied to his recent “binary”, “crash-down”/”crash-up” discussion. To wit, from Charlie:
If we do again “settle-down” with regards to the “macro shock” catalysts (e.g. Oct China / US meetings go well, or no further escalation in Trump impeachment noise), the daisy-chain of forced Dealer hedges they have had to take-on (due to the stuff they’re short to client in VIX OTM upside, or from other Dealers hedging the same flows) will then again likely need to be “puked” as they decay into expiration…
This would likely come in the form of any of the following—unwinding VIX upside hedges, unwinding S&P downside hedges or simply covering of “short Spooz,” and setting-up the potential for another “crash-UP” phase, similar to the +120 handle rally in S&P futures witnessed into- and after- the August expiries…”
FROM HERE, this is where SEASONALITY again matters, and makes the case for “HIGHER” market after making “local lows” in coming weeks—ESPECIALLY with these new “shorts” building, dealer “crash” building and again VERY “low nets” all as fodder for a move higher.
US stocks rose sharply on Friday, although the S&P still logged a third consecutive weekly loss as political and trade tensions conspired with evidence of a slowdown in the domestic economy to undermine sentiment.