Nomura’s McElligott: This Is ‘The BIG Thing We Need To Watch For’

Investors are increasingly prone to grabbing for upside index exposure.

It was cheap (previously, folks were narrowly focused on upside in reflation-linked trades or else downside hedges), and then got cheaper during the GameStop saga, which roiled markets for a few ridiculous sessions before fading away and joining GameStop’s business model in relative obscurity.

Now, though, “we’re seeing investors grab for ‘crash-up’ in index too,” Nomura’s Charlie McElligott wrote, in a Thursday note. Following the Reddit-inspired gross-down/net-down tremor, “funds got scared about the tape running completely away from them,” as the market rallied, he said.

What does this mean, beyond the obvious? Well, it potentially puts a floor under the VIX. Implied has remained somewhat “sticky” anyway for reasons documented in these pages on too many occasions to count. Now, McElligott says it’s “more likely to reprice higher into a tape breakout higher.” This grab for upside exposure (“crash up” hedges, if you like) is manifesting in vol-of-vol.

If you’re looking for potential warning signs (or, if that’s too strong, we can just say “yellow lights”) a return to any kind of glaringly “SUVU” regime would be a candidate.

“I think the BIG thing we need to watch for then is a potentially imminent return to [a] ‘spot up, vol up’ market where investors keep grabbing at upside, which would probably be your signal to reduce risk under the prospect for a short-gamma ‘crash up, crash down’ accident with [the] potential to gap down under the weight of its own delta,” McElligott said.

This is reminiscent of the conjuncture that prevailed late last summer, when the VIX (and VXN) rose with the S&P (and NDX), only for big-tech to ultimately tip over in early September. I use VXN and NDX below not necessarily because it’s the best way to show the current situation, but rather because it was pretty dramatic in the lead-up to the September tech swoon.

Simultaneously, McElligott reiterated points made in a note last week, when he documented why the VIX is “broken.”

“Dealer inability to be short -term, -tails, -crash, -skew or –gamma in meaningful size from a VaR risk-management/regulatory stress-testing perspective [means] buyers of hedges have to lift offers at the very least,” he wrote Thursday, describing the supply/demand imbalance, and adding that implied vol is becoming a “favored hedge.”

That’s in part due to investors fretting about whether bonds can be a reliable hedge with yields already low, the reflationary environment threatening to push them higher, and fears of a “tantrum,” all raising the specter of diversification desperation in an equities drawdown.

“Perversely, [it’s] this extreme steepness in term-structure, which has the entire Vol world playing this with ‘roll-down’,” Charlie added. “This is the reason that twice now in the past week, we’ve seen laughably small moves in spot Spooz generate full Vol point+ moves in VIX futures, as panicky short-cover flows follow from said ‘roll-down’ players, as well as the fact that short-dated options are the only thing which Street dealers are able to be short in the first place.”