Unshackled!

If you’ve been flabbergasted by the daily gyrations in US equities, you’re hardly alone among market participants. But, as patiently explained in these pages nearly every, single day, these yo-yo swings (as it were) are not wholly inexplicable.

Nobody questions that the coronavirus scare is the proximate cause of the market’s consternation, but the stage was set for the kind of wild price action we’re currently witnessing once we lost the vaunted “gamma pin” after expiry last month. It was at that point that stocks were “unshackled”.

Indeed, it was on February 24 when I penned the following headline: “Gamma Collapse Opens Door For COVID-19 To ‘Shock-Down’ Stocks“. Here you go:

“This needs to be considered against a post-Op-Ex reality that finds the ‘gamma pin’ (colloquially: the force that’s kept spot ‘sticky’ and acted to damp volatility) losing a good bit of its influence”, I wrote, on the way to citing Nomura’s Charlie McElligott who reminded folks that until then, “dealers have ‘generically’ had to buy weakness/sell strength to remain hedged [and] thus provided us a natural counter-flow ‘buffer’ to large market shocks in any direction”.

Of course, once that benign dynamic “flips” (i.e., once dealer hedging begins to exacerbate directional moves instead of dampening them) it sets the stage for the kind of wild price action that drives up volatility, which in turn depletes market depth in a pernicious feedback loop.

As spot careens through key levels for CTA trend and momentum strats, they deleverage into a falling market. That “abrupt unwind propagates their own negative momentum“, to quote JPMorgan’s Nikolaos Panigirtzoglou.

Read more: We’re All Momentum Traders Now

Well, in a Wednesday note, SocGen’s Jitesh Kumar and Vincent Cassot underscore the point – and then some.

“The sharp drop in equity prices on 24 February sent the dealer positions deep into negative gamma territory, leading to daily amplitudes not seen since 2011”, they wrote, before essentially saying that the “doom loop” was activated. To wit:

After that, all the other drivers went into play and enhanced the vol pick-up: deleveraging from passive funds (risk parity and vol target), short covering in the VIX market and forced selling in various assets to meet mark-to-market constraints among others. The plunge in the oil price came as the final blow.

Yes, indeed it did. Over the weekend, I excerpted a chart from Cassot which showed, in scatterplot form, the relationship between negative dealer gamma and subsequent S&P absolute returns.

On Wednesday, he updated the visual to include Monday’s historic plunge on Wall Street. Feast your eyes upon this:

(SocGen)

Now that’s an unshackled market!

(And do compare that chart to the “gravity” visual in the banner image for this article – see that red dot floating around in the upper-right-hand corner? That’s your astronaut.)

As far as how things evolve from here, SocGen last week warned that equities would probably need to rise between 8-10% before volatility would subside. Suffice to say we’ve moved in the wrong direction since then, with Wednesday marking yet another session that finds the Dow down in excess of 1,200 points.

Now, that threshold is higher. In the course of discussing what’s next on the “gamma front”, Cassot posits a trio of scenarios, one of which suggests that “aggregate gamma turns positive as a relative period of calm and high volatility levels attract systematic yield enhancement flows back”. He then notes the obviously, which is that when spot is careening around by +/- 3%, 4%, and even 5% on a daily basis, the environment is “not really conducive to this flow”.

One other scenario is that “equity prices recover quickly and strongly for the sustained low volatility environment to return in the earnest”. In order to see that, SocGen’s models suggest that the S&P needs to rise nearly 12%, while the Eurostoxx50 would need to move 23.5% higher.

The note from which those quotes are excerpted is time-stamped prior to the US cash open. As of this writing, the S&P is down around 4.5% on Wednesday.