Some market participants are pricing in tail risk again, and that could open the door to opportunities, depending on how things pan out.
That’s one message (among about a dozen others) from a Tuesday note by Nomura’s Charlie McElligott.
“As VVIX & Skew went ‘bid’ BIG TIME yday, this indicates that the market is now once again beginning to price-in ‘tail’ scenarios”, he wrote, just after 8 AM in New York.
“[That] offers attractive risk-reversal opportunities to play for an upside S&P breakout following a potential ‘hedge puke'”, he added, noting that in the event we do get confirmation from Trump that the December 15 tariff escalation is off the table or, even better, that some existing levies are set to be rolled back, “the market has [a lot of] protection which will get sold”.
I included that top chart to again emphasize that if you subscribe to the “countercyclical protectionism” theory whereby Trump is inclined to escalate (or, at the least, less inclined to deescalate) when US equities and the economy are doing well, the current situation doesn’t exactly scream “time for conciliation” – if anything, Trump might think he has carte blanche to stir the pot again.
In any event, McElligott goes on to say that downside protection in the S&P is “extremely rich, while upside sees little to no interest”. On Monday, for example, he notes “you could sell a 1m 4% OTM S&P Put to buy a 2% OTM Call costless”.
Of course, it makes some measure of sense that there’s demand for downside protection. As Charlie goes on to remind everyone, “equities positioning remains extremely LONG”. He cites, for example, a marked pivot in fund flows (one-week inflows to global equities funds in the 87th percentile), while asset manager positioning in S&P futures “remains a still-absurd 98th percentile since 2006 despite beginning to profit-take last week”.
And then there’s the systematic trend crowd. On Nomura’s model, they’re still deeply “in trend” (so to speak) with price signals at 100%, while gross exposure across global equities sits at a 22-month high. Oh, and macro funds’ beta to stocks is extreme, which to Charlie suggests they’ve effectively been stopped in.
Despite the extreme positioning, good news on the trade front could still produce another October-type rally as hedges are puked, especially in thin markets ahead of the holiday.
McElligott emphasizes as much. “In the base-case that we DO indeed get the tariff delay / rollback announcement sometime this week / weekend in conjunction with the market carrying so much ‘downside’ protection, it sets up a scenario where into next week’s terrible holiday illiquidity where we could very likely get an impulse ‘GAP HIGHER’ as said hedges are shed”, he writes.
Of course, Trump could change the game with one irritated tweet, and as we saw last week, a quick ~2% move to the downside is all it takes to strike (no options pun intended) one of the matches that can trigger a cascading systematic conflagration. Speaking of that, Charlie says the gamma flip level is now around 3,090, or 3,080 excluding this week’s options.