Melt-up, crash down and (likely) crash up.
That’s one sequencing possibility in US equities, according to Nomura’s Charlie McElligott.
In a Thursday note, McElligott reiterated that for the time being, stocks remain largely pinned, as “SPX / SPY options continue to choke the market on long ATM gamma.” Absent some catalyst, this effectively consigns stocks to a slow, upward drift to 4,500.
There hasn’t been a 1% move in weeks (figure below) and realized vol is “deceased,” as Charlie put it.
What does that mean? Well, for one thing, it dictates a latent bid from the vol control crowd. Assuming spot moves are confined to 0.5% on either side, Nomura estimates “a potentially enormous ‘buy’ flow being generated by the Vol Control universe over the next week,” McElligott said Thursday.
Assuming that pans out, overall vol control exposure to equities would rank close to the 90th %ile historically, Charlie went on to say, adding that CTA re-leveraging into this grinding, in-trend market has left the bank’s CTA model with gross exposure in the 82nd%ile.
But, consistent with a dynamic that’s been in place for so long now that it’s becoming something of a fixture, demand for downside crash remains insatiable. As Charlie put it Thursday, “dealers [are] in horribly uncomfortable territory in the case of a potential gap lower in spot.” He flagged 1m SPX option downside Put Skew in the 98%ile and 6m in the 99%ile, as well as a VVIX/VIX ratio in two-standard deviation territory (figure below).
For now, a large downside move seems highly unlikely — McElligott called the prospect of a 5% move “outrageous.” Earlier Thursday, JPMorgan’s Marko Kolanovic expressed similar doubt around the likelihood of a large one-day swoon absent some left-field catalyst.
However, for Charlie, a post-OpEx environment where gamma resets, freeing the market from the current choke-hold, could get interesting in the event the notorious daisy-chain/domino dynamics come calling.
There are some “if”s in there, and this is a sequencing story, so you have to look out beyond next week.
That said, McElligott “currently see[s] a substantial ‘short gamma’ potential building on a downside move through the neutral line at 4,288 [with] ‘peak’ short gamma around 4,150 [and] ‘delta vs spot’ turning negative below 4,336.” That latter bit “matters,” he wrote, adding that “there’s a ton of length there as a source of de-risking flow.”
As noted above, vol control exposure would be extreme coming out of Op-Ex assuming the market stays pinned between now and then, dictating a large add over the next several sessions.
“With realized volatility so low now, and this accumulation of length by Vol Control about to kick into overdrive, a -2% day could easily accelerate into something much ‘crashier,’ in light of the aforementioned positioning for the Dealer community on a downside move,” Charlie wrote, before driving it home:
In fact, projected daily deleveraging scenarios in the VC model (w/ current conditions held constant over a 1.5-2.5 week period, which I acknowledge is ‘less than optimal,’ LOL), a -1.0% / -1.5% / -2.0% day in and around this post Aug 20th Op-Ex period would theoretically kick off an enormous notional amount of estimated Equities exposure to be reduced, largely on account of 1) this previously stated potential / anticipated very substantial Equities exposure accumulated by then, and 2) the extraordinarily low realized vol profile we are immersed within, making us susceptible for an impulse deleveraging / VaR shock.
Of course, any such event would almost surely be seen as an opportunity. Invariably, investors’ classical conditioning would kick in, with dip-buying fueled by $5 trillion in “sideline cash” and accompanying vol selling into “richness,” thereby starting the whole cycle over again.
The title of Charlie’s Thursday piece: “Let’s get weird.”
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