‘Shockingly Unstable Synthetic Stability’

“Stability breeds instability.” That phrase (God bless it) never fails to pique market participants’ interest.

Modern market structure is highly conducive to creating the conditions for what I usually just refer to as “avalanches.” The avalanche analogy is visceral and eminently accessible — everyone knows what an avalanche is, and most people understand the mechanics. It’s a natural manifestation of stability breeding instability.

In the market context, we’ve taken to calling avalanches “fragility events,” and you can conjure a long list of culprits. From a risk management perspective, the key is that these events have become more common and that can create imbalances in the supply/demand for volatility.

This is, of course, a favorite talking point for Nomura’s Charlie McElligott who, in a Thursday note, characterized the supply/demand dynamic in vol as “completely out of whack.”

“The supply of vol from structural sellers — especially forward vol out beyond a few weeks — has been greatly reduced versus [the] past, with some of the largest players, books and strategies having been infamously ‘wiped’ from the buy-side in recent years,” McElligott wrote, recapping how we got to where we are. He cited high-profile market-maker blowups due to the same VaR shocks and again flagged dealers’ “inability to be short tails of meaningful size or term.”

These juxtapositions are awkward. Increased frequency of fragility events set against an onerous regulatory environment isn’t exactly conducive to… well, to doing business, to lapse briefly into colloquialisms. “You need to somehow be ‘crash positive’ in a -3% / -5% move, but do your job and facilitate client order flow,” McElligott remarked, adding that “the only options you can really run meaningfully ‘short’ [are] near-dated expirations without having to pay through the nose at horribly uneconomical levels with another dealer.”

The result, he said, is a “daisy chain” of demand for “crash” (and remember, that’s a noun in trader parlance). That demand perpetuates extremes in skew, setting the stage for a selling-begets-selling dynamic in the event some shock-down catalyst comes calling and drives spot through the dreaded gamma flip threshold, beyond which selloffs tend to be magnified by accelerant flows.

This setup becomes especially perilous when a number of critical macro questions remain unresolved or when there’s a bull loose in the china shop (e.g., Donald Trump’s trade war tweets). Right now, there are “all sorts” (McElligott’s words) of unresolved questions, including the timing of a Fed taper announcement, the trajectory of US growth now that the Delta variant is forcing some locales to consider various containment measures and, relatedly, stagflation risk.

But McElligott’s Thursday missive was more than just a recap of the perils inherent in modern market structure. He contextualized it with a “right now” example (if you will).

“The SPX 4,400 strike continues to choke markets and dealers on ‘long gamma’ at the money,” he said. The gamma pin (or, “tractor beam,” as he called it Thursday), leaves a strangle seller to “laugh his way to the bank.”

The problem, though, is that the resultant pressure on realized vol dictates mechanical exposure adds — or, more snow, to use the avalanche metaphor.

“Short-dated ‘strangle selling’ flows are the only winning trade to be found,” Charlie went on to say, cautioning that this “ends up creating a synthetic stability which is shockingly unstable… against 95-99%ile skew.”

On the bright side (if you like your markets a semblance of rangebound or if you’d just rather not see things get messy), McElligott noted that at least for SPX/SPY, the long gamma roll off at expiry isn’t large, which means most of the “insulating” effect should remain intact. That said, he did mention that with some 27% of the gamma set to drop off for QQQ and 29% for IWM (so, your equities duration proxy and also one of your equities reopening proxies), there’s at least some scope for the distribution of outcomes in spot to widen going forward.

McElligott’s Thursday note was also contextualized via Friday’s looming NFP report, but in the interest of ensuring this article doesn’t go “stale” as soon as the jobs report comes in, I couched everything in more general terms and left the rates discussion aside — for now anyway.