Early Monday, in “Stocks May Enter ‘Prototypical Feedback Loop,’” I outlined familiar dynamics that could help US equities return to a kind of steady state drift higher, helped along by lagged mechanical re-leveraging from systematic cohorts.
That linked post featured a few short excerpts from Nomura’s Charlie McElligott, who kicked off 2022 by quantifying the scope of exposure adds from vol control and CTA trend over the past week.
One piece of critical nuance that’s often lost in this discussion is the idea that at least from the perspective of mechanical re-leveraging attributable to the vol control crowd, outsized moves, even to the upside, can upset the apple cart. Think of it as akin to the old “too much of a good thing” adage.
This is why options positioning is critical to the so-called “virtuous loop.” Classical conditioning as manifested in vol-selling into last month’s mini-fireworks helped get markets back into insulating long gamma territory. As Charlie put it Monday, “the standard ‘reflexive’ resumption of Vol-selling [and] hedge monetization following the temporary VIX spike creat[ed] very substantial ‘Delta to buy’ [and] has yet again seen the resumption of a market pinning ‘long Gamma,’, which further stabilizes the market from shocks and compresses swings.”
Implicit (and I made it explicit above) is the notion that a compressed distribution of daily outcomes is preferable when it dictates lagged exposure adds from vol control.
To the extent the vaunted gamma “pin” helps dampen swings, that effectively creates a latent mechanical bid which serves to support the market going forward.
In that context, you don’t necessarily want big upside swings. You’ve probably heard someone, somewhere warn about the perils of “SUVU” environments — “spot up, vol up.” Those setups are (usually) unstable and prone to tipping over as we saw, for example, in early September of 2020, when the summer tech surge briefly buckled under its own weight.
Smaller daily changes can thus be “the most constructive backdrop for stocks” to kick off the new year, McElligott said Monday, noting that larger swings, even if they’re on the upside, could mean selling from vol control.
A steady-as-she-goes market “avoid[s] the ‘shock’ of any index-level upside grabbing which would mean a return to that always-dicey ‘Spot up, Vol up’ backdrop,” he remarked.
