McElligott On Potential For ‘Squeezy’ Year-End

Market participants exhibited signs of “constructive” behavior during an otherwise dour start to the holiday-shortened week in the US.

Traders closed out downside expressions as US equities moved to session lows during Monday’s ugly cash session, Nomura’s Charlie McElligott said, in a Tuesday note. Puts were sold to close and there was some interest in calls. Said differently, traders shed protection, monetized hedges and a handful evidenced a disposition to play offense.

On the heels of the second worst three-day swoon for the S&P since May, the market is “in much better shape” from an index vol perspective, McElligott remarked.

“SPX / SPY consolidated is now nearing the ‘neutral Gamma vs spot’ level… while also now positioned ‘long Delta vs spot’,” he added, noting that tech could get “very chase-y to the upside” in light of cleaner positioning on the heels of the big deleveraging impulse. The same appears to apply to small-caps. “‘Short Gamma’ and ‘short Delta’ could see [a] vicious rip higher during these periods of headline calm [with] large deleveraging ‘cleared’ as we make the new-year PNL / risk turn,” he wrote.

When it comes to positioning, note that the spike in realized vol over the past three weeks (familiar figure above) brought about a huge reduction in systematic equities exposure on Nomura’s models.

I mentioned this first thing Tuesday morning, but Charlie subsequently updated the numbers.

On the bank’s estimates, CTAs’ aggregate net global equities futures exposure was pared by more than $80 billion over the past month, leaving positioning in just the 24th%ile (figure below).

Meanwhile, vol control de-allocated nearly $100 billion over the same period, a 6.6%ile one-month reduction that put overall equities exposure in just the 23%ile.

What does that mean going forward? According to McElligott, both CTA trend and vol control “are likely to be substantial sources of mechanical demand for Equities” over the next several weeks, provided, of course, stocks can’t continue to realize the large daily changes implied by spot VIX.

If that assumption proves correct, implied vols “will likely continue to bleed,” he said, which will pull realized vol back down, incentivize additional hedge monetization and “create Delta to buy, in a virtuous feedback loop for higher Equities.” There are “plenty” of CTA short signals “exposed to covering” assuming spot recovers, McElligott wrote.

Obviously, all of this assumes no dramatic turn for the worst on the COVID front, although that caveat has become so standard that I almost forget to mention it. Like noting that another Chicxulub impactor would change the outlook materially.