‘Yikes’: McElligott On Black Friday Selloff

A dramatic selloff on Wall Street pushed US equities to the brink of key levels associated with so-called “accelerant” flows on Friday.

“We’re nearing ‘short gamma versus spot’ for dealers in SPX / SPY options,” Nomura’s Charlie McElligott said, as dazed market participants struggled to process incoming headlines from South Africa, where the emergence of a new COVID variant triggered a barrage of travel restrictions, upending risk assets and forcing traders to rethink rate hike bets.

4,574 was the level to watch in S&P futures, McElligott said, noting that the market was “slipping away” from the long gamma safety zone and moving perilously close to dealers’ short strikes on client hedges.

Notably, negative convexity effects were already in play for the QQQs, and especially for small-caps (figures below, from Nomura).

That may partially explain why losses on the Russell felt gratuitous, even considering the fundamental rationale for small-cap underperformance as COVID risk flared.

“With regard to… sentiment, there’s an obvious psychological impact,” Charlie wrote. “People who’ve been playing for the year-end positive seasonality trade in equities — myself included — are getting increasingly frustrated because after a rollicking bull move in October, the S&P has gone absolutely nowhere since November 1, while late-comers have had their hands blown off,” he wrote.

That, in turn, could reduce risk appetite in December if the buyside heads into the bunker in order to protect the year as opposed to playing offense in an effort to catch benchmarks.

Vol-of-vol exploded Friday. The figure (below) speaks for itself.

McElligott called that “full yikes mode.”

Given the abrupt about face, McElligott suggested it’ll be important to “pay a lot of attention to negative convexity strategies” which have increased their exposure over the last several weeks amid the steady decline in realized vol.

A few more days like Friday and folks might start thinking about return of capital again, forgetting about return on capital until we know more about the latest mutant.