We May Be ‘On The Verge’ Of A Cascade

You can skip the “taper tantrum” (or, as some market participants branded it Thursday, “mini-tantrum”) narratives.

“THIS IS NOT A TAPER TANTRUM,” Nomura’s Charlie McElligott said, with the all-caps in the original. He called Wednesday’s Fed minutes a non-event. It’s hard to disagree. Market participants were expecting a taper unveil over the next four months.

The nascent turmoil in markets Thursday was about realized vol catching up to the pervasive angst evident in crash hedges, McElligott said, in a note warning that the tension between, on one hand, a rangebound market characterized by “deceased” realized vol and, on the other, “incessant crash signals from Implied Vol / Skew / Term-Structure / ‘Vol of Vol’ extremes” might be on the brink of resolving. And in a way that’s not particularly palatable.

Over the past week (or so), Charlie warned that juxtaposition might eventually result in a drawdown, as exposure extremes built amid the steady grind lower in realized vol proved to be another example of stability breeding instability, especially as supply/demand imbalances in the vol space kept things wound very tight in “crash” expressions.

Generally speaking, he suggested the window for something to go awry would come after OpEx, but on Thursday, he noted that his “crescendoing warnings about the ‘broken Vol market’ are frighteningly playing out in real-time,” and ahead of the expected sequencing.

Especially unnerving on Thursday, he said, was that the much-maligned “tail wagging the dog” dynamic appeared to be on the cusp of realizing “before the delta-one / second-order accelerant flows even kicked off.”

So, what’s happening? Well, McElligott ventured a (lengthy) guess on Thursday. Note that this comes on the heels of a multi-week “calm” facilitated by strangle-selling and overwriting, which helped pin spot, a conjuncture that “should” have held at least through Friday morning, before the post-OpEx “unclench” opened the door to a wider distribution of outcomes.

That story, along with the perpetually glaring extremes in crash expressions (exacerbated by the above-mentioned supply/demand imbalances in the vol complex) was “socialized,” Charlie said, possibly prompting the buyside to start paring risk ahead of expiry.

With that in mind, McElligott posited a kind of cascade. The following (from Charlie) is best quoted directly. These are his thoughts, and are best presented as such. Also, preserving his cadence and style is essential in this instance. To wit, from McElligott:

The Street has been “long Gamma” against their “short Vega” and “short Skew” positions—but the “short Vega” position began to squeeze as Dealers began to try and adjust their “crash” slides yesterday…but as Vol moved higher, that meant losing your Gamma (especially as spot blew through the largest “long Gamma” strikes yday)

And part of this is that aforementioned “buyside cutting risk ahead of the Op-Ex turn” catalyst, where the prior extreme “long Gamma” then “coming off” after Op-Ex could allow prices to finally unclench from this tight corridor we’ve been trading-in (again largely thanks to the strangle-selling “Gamma Hammer” flows of the past few months)—which means that now you don’t really have no choice, you cannot “wait around” to see if we stabilize “down here”

If you’re a buysider with high grosses and nets (markets at all-time highs) and you cannot cut your underlying “long Equities” exposure fast enough, as Dealers are straining and liquidity worsens (underlying liquidity is ALWAYS the error in the stress backtest, because it simply doesn’t remain constant)…and all ahead of *imminent* delta-one flows about to release from vol-control types….you have to go hit-out ES / buy UX or “crash” options

And if shorting S&P futures is the dynamic hedging option, this too is then coming with options Delta now getting PURGED now here too as we blow through the big S&P strikes at 4450 and 4400 on the way down (hell, we traded through 4350 earlier!)—which has put the Street in a worse position, bc their “long Gamma” was obviously so spot sensitive due to the strangle strikes which were pinning us, methinks

Well, that prior “long Gamma” is CRATERING now; with volatility jacking + spot blowing-through strikes, that explicitly means “less Gamma” which has kept us stuck in that extremely narrow trading band which has come in conjunction with the “Gamma Hammer’s sell strangles” strikes

This is kicking-off stress VaR—the Street has too much notional to insure, but not enough balance-sheet available to insure it (as per my consistent messaging about regulatory risk mgmt realities and a supply / demand mismatch which cannot be accommodated)—so they have to “daisy-chain” the vol complex further, with dealers and market makers rolling-out their VIX futures weekly upside into more “term” stuff…or just buying UXA…or selling-out Delta in Spooz

Now, the VIX futs curve is reflecting the stress, with front inversion / proper “roll-up”—which means the market is gonna have to keep pricing-in a worst-case scenario, bc you’re going to have to move prices to cover your “short Vega” in the front-stuff /3m-and-in (assuming Dealers have at least some “long Vega” in that 6m-12m area to cover some of their risk-slides—let us pray)

That’s a lot to digest, and there’s some repetition in there, but one key is obviously just that dealers are now short gamma (figures below), which means the potential exists for selling to beget selling.

The dominos can start to tip if that dynamic then forces up realized vol, dictating lagged exposure reductions that keep the market under pressure. Remember, that’s not a “decision,” as such. It’s a largely mechanical, unemotional “sell” flow. And it doesn’t happen immediately. It takes a few days for the proverbial switch to flip, as trailing realized gets pulled higher. Charlie noted that some “execution lag” is a built-in feature, as strats are designed to help avert a scenario where everyone chases down the same rabbit hole simultaneously, exacerbating the self-fulfilling nature of these VaR events, which are a fixture of modern markets.

As far as CTAs go, Nomura’s models don’t suggest imminent de-risking — triggers are well below spot in the S&P and big-cap US tech. But that’s obviously subject to change. And that’s the problem with modern market structure. It feeds on itself at virtually every turn. Everything is vol-sensitive and because volatility is inversely correlated to market depth, vol spikes tend to create a dearth of liquidity, which in turn leads to even more dramatic swings, raising the odds that spot suddenly careens through trigger levels associated with trend-follower de-leveraging.

All of this comes ahead of Jackson Hole, which is potentially problematic for a host of obvious reasons. As McElligott put it Thursday, the options for the buyside are “either cut your exposure, dynamically short Spooz into the downtrade, or pay crash Theta,” and “it all becomes more complicated next week, when there’s an actual ‘event risk.'”