So close, yet so far.
From a cascading, selling-begets-selling, self-fulfilling drawdown, that is.
For a fleeting moment last week, it appeared as though equities were poised for a meaningful correction. The selloff that wasn’t would have been the first in… well, in a long time.
But alas, it wasn’t to be. Instead, a ~2.8% high-to-low move in S&P futures was recouped by midday Monday (figure below).
I suppose I should knock on wood or do a rain dance or engage in some other superstition to avoid triggering an immediate correction that dates this article before it’s even published.
Jokes aside, those wondering what acted as the circuit breaker last week probably needn’t look much further than investors’ classical conditioning, which creates its own, countervailing self-fulfilling prophecy. Dip-buying and vol-selling are immediately rewarded, thus increasing the odds that future “dips” are bought.
“What turned the tide off the lows Thursday and again on Friday?”, Nomura’s Charlie McElligott asked, in a Monday note, before answering his own question. “The same bulletproof conditioning that’s been established over the past decade,” he said, citing “selling of ‘rich vols’ into nascent volatility spikes as rVol ‘crashed up’ to implieds” alongside the immediate monetization of hedges. The feedback loop, he wrote, “reversed yet again from ‘vicious’ to back to ‘virtuous.'”
He cited specifics, recounting the action almost as if writing a screenplay. “Thursday afternoon, as stocks were again fading and tilting down the earlier lows, there was a critically important sale of what ended up being nearly 15k Nov ES 3600 Puts with another 5k behind out loud,” he said. That marked the lows, or thereabouts.
That trade, Charlie emphasized, was important to the extent it acted to alleviate some of the tension in the “broken” vol complex. “It supplied the market some ‘short crash,'” he said, flagging an “additional kicker” from market marker future-buying against their long puts.
You can write the rest of the script yourself. Vols relaxed, Friday dawned and when stocks couldn’t hold a selloff, “folks who were dynamically hedging covered shorts, while we rallied further into strikes that still held some Gamma into PM expiration as they picked up Delta again,” McElligott said.
After citing additional vol selling, he asked: “What are we left with?”
Well, as alluded to above, we’re left with a market that doesn’t sell off — not in any meaningful way. Although many of the stars aligned last week to set the stage for the rout that could’ve been, it was “Pavlov with the stick save,” so to speak.
Charlie struck an almost fatalistic tone. “Despite these inputs aligning, the ‘short vol’ kneejerk — along with the trained ‘monetization’ behavior of hedgers — killed the move, and before Vol Control de-allocation stood a chance to occur this week, despite the readiness to cut on any meaningful pullback due to the recent loading of exposure in conjunction with such a low absolute level of trailing realized,” he wrote, before presenting a table that showed what the bank’s vol control model projects if you hold current conditions static.
“But that’s irrelevant right now,” he said, almost shooing away the model’s “naive” projection.
“The thing that matters is getting an actual ‘drawdown’ which could” tip the dominoes, Charlie reiterated, calling that elusive selloff “increasingly infeasible in an environment where Vols are being puked indiscriminately per the muscle memory of traders in the ‘Fed Put’ era of short vol as yield enhancement.”
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