Charlie McElligott Returns: ‘This Is How Overpositioning Tips Over’

Stability breeds instability. All you need is the proverbial skier’s scream for an avalanche.

By the beginning of July, short vol flows “had stuffed Dealers on market-insulating Gamma,” Nomura’s Charlie McElligott wrote Wednesday, after returning from summer holiday.

On July 2, the bank’s estimates showed SPX $Gamma in the 96th%ile and QQQ in the 97th, which served to “pin” equities in a narrow range, thereby compressing realized vol (figure below).

As realized collapsed, the systematic universe mechanically added exposure.

Recall that on July 12, in “A Little Something For The Bears,” I noted that on Deutsche Bank’s metrics, systematic exposure was catching up to discretionary positioning. At the time, I deployed Charlie’s catchphrase: “Volatility is your exposure toggle.” Deutsche flagged more aggressive positioning from vol control funds and CTAs.

On Nomura’s models, “gross exposure across the overall CTA cross-asset portfolio” in late June and early July ranked in the ~97%ile, a state of affairs McElligott attributed to “both grossed-up Bond shorts and Equities longs.”

Meanwhile, the bank’s vol control model had accumulated what Charlie described Wednesday as “enormous exposures” over the trailing three-month period, adding some $75 billion in equity exposure through July 2.

That set the stage. “In standard ‘Minsky Moment’ fashion, this stability then set the table for instability,” McElligott wrote. As I put it over the weekend, all you really need is a catalyst or, perhaps more aptly, an excuse — some “shock” that triggers and equity selloff and, more importantly, a vol spike. At that point, the Jenga tower wobbles or, as Charlie put it, “you get an abrupt de-grossing of an outlier large exposure in unemotional / mechanical fashion.”

Sure enough, the three-day selloff (Thursday, Friday and Monday) flipped dealers short gamma, while Nomura’s CTA model suggested aggregate net exposures were trimmed by a cumulative ~$40 billion since mid-month.

“This three-day deleveraging saw the gross exposure of the Equities portion of the CTA portfolio collapse from mid-70s %ile rank at the start of July down to just 17th%ile by Monday’s close,” McElligott said, adding that the bank’s vol control model implied some $12.5 billion in selling over two sessions, as the uptick in realized vol (first figure above) triggered delayed exposure reductions.

On Tuesday afternoon, I suggested that, for everyday market participants, there probably wasn’t a whole lot of utility in parsing the quick rebound from Monday’s dramatics. Pavlov is alive.

McElligott on Wednesday wrote that Nomura’s desk saw downside hedges actually monetized on Friday, with little or no follow-through. “The post GFC muscle memory is to immediately ‘sell vol-spike rips / buy the dip in spot,’ as the selloffs are just too fast to linger more than a day or two anymore,” he remarked.

But, he added some critical nuance. “Crash up” is still essentially no-bid, while demand for “crash down” is insatiable. (For those who’ve asked, note that “crash up” and “crash down” are nouns in trader parlance.)

“Somewhere, somebody remain[s] short a lot of Puts,” Charlie wrote, adding that when vol compresses against that backdrop, the market maker is likely “covering their hedges in Futures shorts” as the index gaps higher.

Finally, he noted that the optic (i.e., extreme downside put skew against almost daily record highs on the benchmarks) creates incessant hand-wringing — ostensibly, the juxtaposition suggests something must be wrong. That optic increases already insatiable demand for “crash down” which, McElligott observed with a chuckle, “perversely stops out those trying to sell” the rich skew. That, in an environment where those willing to sell tail hedges are an increasingly rare breed thanks (again somewhat ironically) to the frequency with which fragility events, vol shocks and, colloquially, days like Monday, now occur.