Nomura’s McElligott On ‘Classic Short Gamma’ And $62 Billion In Potential Vol. Target Fund De-Risking

If you were looking to explain the price action into the close on Monday, look no further than dealer hedging.

“In the final ~30 minutes of the US Cash Equities session yesterday [it] was textbook Dealer Gamma-hedging”, Nomura’s Charlie McElligott wrote Tuesday morning.

Early Monday, Charlie noted that the risk-off swoon in equities from a weekend’s worth of virus headlines had likely flipped dealers’ gamma profile, putting markets at risk of entering the dreaded selling-begets-selling zone.

Read more: ‘Violent’ Virus Contagion Flips Dealer Gamma Profile, Prompts ‘Massive Stop-Outs’ In Treasury Shorts

Describing Monday’s close, Charlie writes that “after trading down from the ‘Gamma Neutral’ level we highlighted around 3263, futures quickly were hammered from 3252 all the way down to 3237 at 4:04pm”.

That, McElligott writes, is “classic ‘Short Gamma'”.

He then breaks things down in the simplest possible terms.

The new “flip” line is 3270, “or 3258 ex the 1/31/20 expiry (ref 3255 last in futures)”, Charlie says. The straightforward implications are… well, they’re straightforward.

A move below that line means “Dealers are getting ‘short-er Gamma’, particularly into the US Cash close” which would entail “more Dealer SELLING the lower we go”.

On the other hand, a move back above that line means “Dealers flows should actually help insulate the market as they are ‘long Gamma’ and thus will buy weakness / sell into strength”, Charlie writes, clearly intent on spelling this out in layman’s terms, perhaps in recognition of how important/prominent this discussion has become, especially at times like these.

(Nomura)

Regular readers will note that, on Monday, we mentioned vol.-targeting exposure again, as a polite way of suggesting that if volatility remains elevated, you could get some de-risking from that crowd too.

Although slower-moving, exposure recently touched some of the highest levels since January 2018, stoking fears that a negative catalyst could lead to “elevator down”, so to speak.

Read more: ‘Extreme’ Positioning From CTAs, Vol.-Targeters Raises Virus Contagion Risk

On Tuesday, McElligott takes a stab at estimating the likely rebalancing from vol.-targeters using what he calls “an overly simplistic model” (it looks like SPRP10T, for reference).

This is a “generic” estimate, he emphasizes, but since September of last year, the implied growth in notional exposure is more than $250 billion and “would have recently touched upwards of ~$360 billion as of last week per the low vol. Equities rally”, he writes.

Now, coming off a two-day rout which included Monday’s first 1%+ S&P down session since October, McElligott estimates that a ’10’ target vol. would “imply ~$62 billion of selling in [the] coming days from this recent high point / large accumulation”.

(Nomura)

As was the case in, for example, October of 2018, you have to consider that in conjunction with possible offsetting flows – that is, that de-risking doesn’t come in a vacuum. And yet, do note that the buyback “plunge protection” is presumably constrained during earnings season.

Ultimately, the above is another reminder of just how much these purportedly “esoteric” things matter. Hopefully, folks are beginning to realize that “esoteric” is a misnomer. Indeed, it is crucial to avail oneself of any and all opportunities to glean a better understanding of the dynamics driving the price action, and these are the dynamics.

Oh, and one more thing. Charlie’s “1m Price Reversal” factor expression trade recommended last month has now performed so well in January that it’s almost comical. After Monday, it was up 11% since five days prior to the turn.