Late last week, in the course of detailing both the mechanics behind the Tuesday-Wednesday rout in US/European equities and the case for the bounce which played out to fairly dramatic effect on Friday, we went back over the familiar dynamics which often contribute to exaggerated price action.
The emphasis was on option hedging dynamics and CTA flows. Earlier in the week, Nomura’s Charlie McElligott cautioned that “US Equities were very much in the crosshairs of CTA deleveraging… which then triggered mechanical ‘accelerant flows’ that moved us deeper into a more extreme dealer ‘Short Gamma’ positioning”.
On Friday, JPMorgan’s Marko Kolanovic wrote that in addition to “large CTA reversals from long to short… the significant recent increase of put options outstanding caught dealers significantly short gamma”. Between CTA deleveraging and option hedging flows, Marko estimated systematic, technical selling at more than ~$100bn in a 48-hour period. He also predicted that those flows would reverse on Friday to spark a rally, which they did.
In that linked post, we cited a SocGen volatility outlook piece from last month in which the bank noted 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”. Here’s the chart they used.
Last week’s selloff fits that description.
Well, on Tuesday, Nomura’s McElligott is out underscoring the point in a brief note touching on the evolving trade dispute which is the very definition of “fluid” right now.
“The ‘partial’ trade deal story was floated into the ether last week, and only generated a ‘meh’ market response, because most realize that there is no substance if a deal doesn’t address ‘the seven deadly sins'”, he writes, in a characteristically colorful passage. Here are those “7 deadly sins”:
- IP theft,
- forced tech transfer,
- subsidies for SOEs,
- fentanyl and,
- currency manipulation
“Nonetheless and DANGEROUSLY, I would say that investors CONTINUE to expect a DELAY to the new tranche of US tariffs in order to keep discussions at least partially ‘thawed'”, Charlie continues. That, he says, “means there remains significant downside risk still from here if we do NOT see the expected delay come to pass”.
After delivering some additional macro color, Charlie updates the daisy-chained, “knock-on” “crash” hedges story. “[The] US equities market is massively under-pricing ‘upside’ breakout potential, as ‘growth scare’, trade skepticism [and] US election risk skews investor flows and the ensuing dealer ‘crash’ hedge knock-on massively towards downside protection”, he writes, on the way to noting that the market is “shifting implied SPX outcomes the ‘wrong way'”:
Finally, he delivers the following visual, which is an even more poignant illustration of the extent to which “this stuff matters” so to speak, when it comes to all of the dynamics mentioned here at the outset and documented here exhaustively last week (and every other week when the price action is some semblance of dramatic):
US equities careened lower in morning trading Tuesday amid a series of negative trade headlines, lackluster economic data and more political drama from D.C. to London to Ankara.