Charlie McElligott’s ‘Toggle’ Motto: Why A Broken Vol Market Matters

Over the past week (maybe two), Nomura’s Charlie McElligott has been keen to emphasize that the vol market is “broken.”

There are a number of factors which, when taken together, underpin his contention that an “accident” could be in the offing.

One way or another, most of those factors come back to a supply/demand imbalance.

Read more: The VIX Is Still Screaming ‘Accident,’ Nomura’s McElligott Cautions

In a Thursday note, McElligott reiterated the “broken” characterization, on the way to reminding folks why this matters.

Although there are numerous catchphrases you could attribute to Charlie, he describes one oft-repeated line as his “motto.” Regular readers will be familiar.

“As my motto goes, ‘volatility is the exposure toggle’ in modern market structure risk management,” he wrote Thursday. “Whether a discretionary/active manager on VaR, a risk-parity fund, a systematic CTA Trend fund with a specific vol target, a variable annuity with downside protection triggers [or] tactical allocation models from roboadvisors,” everyone is conceptually operating under the same regime, he said.

This harkens back to much longer discussions he’s had over the years expounding on the extent to which, 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.

As he put it in early March of 2020, “we ALL operate under frameworks which allow for greater leverage deployment into trending markets, and conversely, dictate de-grossings into ‘VaR-events.'”

This observation becomes seemingly more germane all the time, as the self-referential dynamics embedded in modern market structure manifest in what often feel like increasingly dramatic instances of cascading price action.

Speaking to this on Thursday, he reiterated that “the size of a position is set to be inversely proportionate to the instrument’s volatility.” So, you don’t necessarily need any signal from the actual price of an asset. This is a “tail wagging the dog” market, after all. Volatility is the exposure toggle, and when exposure is pared, that creates its own price action, which can feed back into volatility, especially if market depth is impaired, which it has been since the February 2018 VIX ETN extinction event.

Taking a trip down memory lane, McElligott reminded folks that following “Volmageddon” (or “Vol-pocalypse,” if you prefer), the “enormous intra- and inter-day volatility” over the subsequent weeks marked a stark change of pace from the low vol bubble years presided over by Janet Yellen.

And yet, Charlie noted that “the CTA signal for the S&P 500 itself barely moved, as price really chopped but had largely recovered [the] initial shock losses [in] a relatively short period of time.”

That said, the universe of vol-sensitive allocators de-leveraged massively “on the basis of the volatility move and two-and-a-half months later, the S&P was -7.5%, even though the ‘fundamentals’ hadn’t changed materially,” he added.

The read-through, in case it’s not clear, is that when volatility is the toggle for exposure across all manner of investor cohorts (and arguably for all investor cohorts in one way or another), a broken vol complex is potentially perilous.

For now, stocks are benefitting from a background re-leveraging bid emanating from vol-control strategies, which continue to add exposure as realized moves lower (despite implied remaining elevated, which is the whole point here). But that could change in the event the daily range for stocks (i.e., the distribution of outcomes) were to open up due to, for example, the vaunted gamma “pin” losing some of its pull.

“Equities options show a significant 32% of SPX/SPY $Gamma set to run-off post OpEx, with 53% of QQQ, 54% of IWM, and 50% of EEM coming off as well,” Charlie remarked Thursday, adding that this is important “when $Delta is so extreme ‘long'” and sentiment is ebullient, on many indicators anyway.

But the main takeaway (and the purpose of the above) is to explain, as McElligott himself put it, “Why all this blabbering about a ‘broken’ Vol market matters.”

It’s the “toggle” motto. It’s always the toggle motto. Tell a friend.