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Stocks Are Levitating, But Nomura’s McElligott Says Backtest Shows Potential For Pullback Amid Options ‘Extremes’

The longer we linger 'up here'...

US equities have obviously powered to new highs on the back of delirious optimism around the “Phase One” trade deal.

“Delirious” because there is almost no chance that any of the structural issues at the heart of the dispute will be addressed in a meaningful way that leads to China actually implementing lasting changes vis-à-vis the myriad “thorny” issues behind America’s various and sundry gripes.

Then again, maybe it’s not “delirious”. After all, why should investors (let alone traders) really care about a resolution to those structural issues? Why not just hope to see the tariffs rolled back knowing that with the global central bank pivot now cemented, any rally sparked by tariff deescalation won’t have to contend with tighter monetary policy?

Read more: Tariff Rollbacks Imminent, China Says. Rejoice

Who knows what might have befallen markets in 2019 had central banks not been compelled by the trade tensions to cease and desist from normalizing policy. After all, that normalization push (spearheaded by the Fed) created an environment in 2018 where USD “cash” outperformed 90% of global assets. Fast forward 11 months and assets of all stripes have surged:

(Goldman)

That’s due almost entirely to the epochal dovish pivot from policymakers, which is itself largely a product of persistent trade tensions and the deleterious effect those tensions have had on the outlook for global growth and commerce.

(BofA)

Now, assuming it’s not too late to avert a global downturn (and that may not be a safe assumption), the market looks poised to get tariff relief on top of monetary policy easing.

One assumes that would be a powerfully bullish cocktail, and indeed it has been over the past month or so.

Amid the rampant bullishness that’s pushed S&P futures some 7.5% higher from the early October swoon, we’re seeing extremes in the options-implied length, Nomura’s Charlie McElligott writes on Thursday, reiterating a point from several recent missives.

He flags “monster $Delta in SPX/SPY consolidated and QQQ options”. That, he notes, makes sense given what we know about net exposure, which has been persistently low for quite a while, leaving folks (read: clients) to “grab upside through options”.

(Nomura)

The “problem” comes when market participants start to “believe” (so to speak) and begin to gingerly take up nets and add single-stock exposure. That, McElligott says, “makes it MORE likely that clients begin monetizing some of the options Delta/take profit in futures the longer we linger ‘up here'”.

That needn’t necessarily be bad, but backtesting shows the likelihood of a pullback is high given extremes in options-implied length.

“When $Gamma- (north of 95.5th %ile) and $Delta (north of 97.8th %ile) show at such extremes IN UNISON, we tend to see meaningful market pullback in forward returns [and] higher VIX”, Charlie writes.

Specifically, the near-term pullback in QQQ is nearly 3% over a 1-month window.

(Nomura)

For the S&P, it’s more of a medium-term story. The median pullback is -1.7% over six months.

Backtests show “meaningfully higher VIX across all forward tenors”, McElligott goes on to caution, flagging a peak +37% median return over the 3-month window.


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