Nomura’s McElligott: This Is ‘The Next Battle In Equities’

There’s a new battle in equities after Monday’s dramatic selloff on Wall Street.

As documented here prior to the cash open, US stocks were effectively “unshackled” coming into the new week, as the gamma grip came off post-Op-Ex.

Monday was, as Nomura’s Charlie McElligott puts it on Tuesday, “all about ‘freedom to move‘ in the absence of the recently extreme dealer long gamma insulation flows”.

Of course, “freedom to move” manifested itself in a wholly pernicious way for equity longs on Monday, but you might have expected as much. After all, the COVID-19 headlines over the weekend had a “28 Days Later” feel to them and, colloquially speaking, US stocks were a screeching tea kettle.

“The persistent weight of gamma positioning while in positive territory keeps [the market] pinned, just as a heavy object warps spacetime”, SocGen wrote last month. That dynamic helps to explain both the persistence of stability over long periods and the sudden downdrafts when dealer gamma positioning flips, ushering in a selling-begets-selling environment that can push spot through key levels associated with CTA trend deleveraging and other systematic selling.

There are a couple of key points to note on Tuesday.

First, the vol.-targeting crowd has seemingly already begun to deleverage in “lagged” fashion, as realized vols were pulled higher by coronavirus worries and Bernie Sanders’s ascent in the polls. McElligott on Tuesday reminds you that Nomura’s estimated allocation rank for target vol. exposure to US stocks was in the 95th %ile (going back to 2010) a month ago. Fast forward to Tuesday, and it’s come all the way down to the 24th %ile, when you include Monday in the sample.

McElligott also notes that CTAs were deleveraging “almost everything global equities” on Monday, with selling in European and Asian stocks.

This is where things get interesting.

Despite the possibility of further mechanical deleveraging from price insensitive, systematic strats and funds, Charlie flags “a potentially very significant and stabilizing ‘BUY flow’ which could be unleashed via the options market”.

He notes that dealers are now squarely in the short gamma zone, which contributed to Monday’s decline as they were forced to sell into the selling. But, McElligott then points to a “wall of puts”, which, if monetized, could change the dynamics.

“As these ‘short puts’ turn to ‘long puts’ for Dealers as they’re monetized by clients – particularly in weeklies which have to be traded very dynamically per the IV – Dealers will then need to ‘buy’ the market to get right”, he points out.

(Nomura)

That buying of futures as downside protection is monetized by clients would then serve as a stabilizing flow for the market.

So, that’s the “battle”, if one can call it that.

And speaking of battles, McElligott reminds you that when it comes to the Democratic primaries and markets, “Bernie Sanders matters”.

The market-implied moves for Super Tuesday show “event risk disproportionately explode higher” both for SPX (the most liquid expression of US “growth risk”) and, more specifically, for healthcare.