I spent a good portion of Wednesday pounding the proverbial table on the necessity of viewing things through a VaR lens at a time when daily swings are being exaggerated materially by a volatility-flows-liquidity feedback loop which, if there were any justice in the world (and/or if everyday people were actually inquisitive), should be familiar to every market participant on the planet.
The “problem” (if that’s the right word) is that most fundamental/discretionary investors aren’t willing to view the world through that lens, let alone admit to being caught up in (or at least subject to) the dynamic.
A gym interlude
There’s a little community gym here in the neighborhood. I’m told it’s funded by my board fees, but I have my suspicions given the equipment’s persistent state of disrepair.
Although it’s rare that anyone else uses it (most residents on the island I call home are octogenarians+), on Wednesday, I had company.
Unfortunately, the TV in the gym doesn’t have Bloomberg Television, so for one, painful hour each day, I subject myself to CNBC.
Yesterday, the network put up a graphic showing how large the swings were (in Dow points, of course) for Monday, Tuesday and Wednesday. The man in the gym with me sighed and shook his head in apparent disbelief.
Not that I would have expected them to, but the anchors offered no color whatsoever on the extent to which those type of swings are not something that is explainable without reference to systematic flows, hedging dynamics and the interplay with volatility. It’s important to note that the same can be said of prolonged periods of seemingly inexplicable calm. For example, the ~70-some-odd-day stretch from October to January without a 1% move coincided with the market’s longest stretch of persistently positive gamma on listed options since the third quarter of 2018 (on SocGen’s estimates).
I didn’t bother to engage the gentlemen at the gym with the specifics. I’ve alienated my neighbors enough without subjecting them to a gym rant about gamma hedging. But the fact is, assuming he’s invested (and everyone on this island is), his portfolio is being whipsawed by these dynamics.
Dry tinder, meet lit match
On Thursday, in a note called “We Are All Momentum Traders In A VaR World”, Nomura’s Charlie McElligott drives this point home better than I can.
“Equities Investors right now are suffering under the two-way slingshot of vol dealer hedging flows”, Charlie writes, noting that on the bank’s latest SPX/SPY consolidated options-implied gamma analysis, dealer positioning dynamics “remain deeply in negative gamma territory, and will stay that way as long as spot remains below the ~3225-3250 area in S&P futures”.
McElligott continues: “As such, every directional move sees exacerbation [and] momentum overshoots”.
I mentioned this repeatedly on Wednesday, because, frankly, it’s frustrating to see it and know that the vast majority of the investing public has no conception whatsoever of what, exactly, they’re watching on the screen. Here’s what I told my buddy Kevin Muir (of Macro Tourist fame) on Wednesday night:
I mean technically, there are humans involved, but you know what I mean. CNBC was acting today like the last three days were all just down to discretionary investors who are apparently about to jump off a bridge one minute and then furiously bidding up the entire market by 2% the next.
Of course, having run an equities derivatives desk, Kevin doesn’t need me to tell him that, but my general lack of a social group and self-imposed isolation means that he (and a handful of other folks) are in the unfortunate position of having to listen to me rant.
They say no man is an island, but I do live on one.
The whole damn thing
In his Thursday note, Charlie goes back over how this manifests in markets.
“Say, in the case today, dealers get ‘longer’ the lower stocks travel and thus hedge by selling Delta in hole OR, in the case of yesterday’s relief trade, dealers get ‘shorter’ the higher stocks go and thus hedge by buying Delta at the highs”, he writes.
To recap, the reason we’re in this position (i.e., to answer the “How did we get here?” question), is because coming out of expiry, the gamma “pin” lost quite a bit of its influence. Recall the following chart from February 24:
That left stocks “unshackled” – free to move, as it were.
And boy, oh boy have they moved.
McElligott gets more granular. “The term structure and the distribution of the $notional size of the Greeks remains bastardized by the high-profile monster macro hedges in the S&P Put Wing and the VIX Call Wing on top of other client book hedges that dealers, by and large, are short”, he notes, before making the following absolutely crucial series of points:
This all stands in stark contrast from where we were two weeks ago, where a 90th+ %ile long $Gamma in SPX options kept markets so extraordinarily placid and in relatively tight intraday ranges, as dealer hedging flows would generically buy dips and sell rips and thus helped to insulate the market into a ‘Minsky-trap’.” However and as we noted at the time over the past month, Dealers also were very-much “short the wings” in Equities Index / ETF options—so as those dual “left tail” macro shock-down catalysts hit and gapped spot from aforementioned comfortable “long gamma” levels into “short gamma” levels…and in conjunction with the then mechanical deleveraging flows from the systematic “risk control / vol target” universe….the entire Equities trading dynamic has been flipped on its head from just 11 days ago, where incredibly, we made all-time highs in S&P just before the February expiry (and on the exact day of VIX futures expiry YET AGAIN, fwiw)
That’s it, right there, folks. That’s the whole damn thing, in a nutshell.
That’s what you’ve seen over the last two weeks. These are the dynamics that allowed the COVID-19 scare to precipitate a true “shock-down” avalanche in equities. It’s true that the threat of the global economy effectively shutting down is cause for extreme consternation and, perhaps even a larger selloff than the one we’ve seen. But the rapidity and manic character of the price action is, to a greater or lesser degree depending on the day, attributable to everything outlined here.
The doom loop, briefly revisited
In an environment where every directional move is exacerbated and momentum always overshoots, the attendant volatility saps liquidity – and in exponential fashion.
“Given that an increase in volatility often results in systematic selling, this relationship is the key to understand market fragility and tail events”, Marko Kolanovic wrote, in early 2019.
In the right pane above, you can see the negative relationship between volatility and market depth (i.e., liquidity) has become more pronounced (i.e., gotten “worse”) over the past decade.
When volatility spikes, the VIX becomes the only thing that matters for liquidity. The following chart shows the % of liquidity variation that can be explained with the VIX over time (rolling R-squared). As Kolanovic noted last year, “the higher the VIX, the more liquidity is driven by the VIX, and recently up to ~80% of liquidity variations were explained by the VIX”.
It all falls neatly into place from there. “An increase in volatility typically leads to an increase in systematic selling, which happens in an environment of reduced liquidity, and hence can produce outsized market impact”, Kolanovic went on to say.
That becomes self-referential. Volatility spikes lead to less liquidity and also to systematic de-leveraging, which means selling into a falling and illiquid market, which in turn drives volatility higher, and around and around.
Once trailing realized starts to move higher in a sustainable fashion, target-vol. deleveraging starts and executes “passively” in the market over the ensuing days until there’s nothing left to purge. That is precisely what you see in this visual:
We are all momentum traders in a VaR world
On Thursday, McElligott brings this all together when it comes to how if affects “regular” market participants who are blissfully unaware of the extent to which they too, are caught up in it all.
“These CTA Trend short-term/tactical reversals seem to impact the market so much not just because of the AUM and leverage deployed in these strategies, but in a more qualitative ‘top down’ sense, because we are all subject to the same risk-management parameters”, he writes.
Why is that? How is it that we are “all” subject to the same dynamics?
Well, it’s actually pretty damn simple: Because at a very basic, conceptual level, everyone’s calculus (even if it’s not actually enshrined in any computerized trading model) permits more leverage into positive momentum and dictates reducing exposure when the “instability” part of the all-too-familiar “stability breeds instability” dynamic comes calling.
I’ll leave you with one last quote from Charlie:
With CTA flows in conjunction with other systematic vol-control funds (which use realized volatility as the toggle to manage positions / exposure / leverage), even traders who view themselves as “fundamental” or discretionary are in the same boat as “momentum” / “negative convexity” players—as we ALL operate under frameworks which allow for greater leverage deployment into trending markets, and conversely, dictate de-grossings into “VaR-events”