I’m a bit of a broken record sometimes, but only (or mostly, anyway) because in the absence of evidence that key dynamics are getting the attention they deserve, I feel somehow compelled to take the mantle.
Not that the entire universe is listening to me or anything. After a half-decade, mine is still a “cult following,” so to speak. Like Donnie Darko. Or Brick. Or Rocky Horror Picture Show. I wouldn’t have it any other way. Look out across the universe of so-called “alternative” finance portals that’ve achieved some semblance of name recognition or popularity over the past dozen years. What do you see? I see a collection of tabloids, some of which have drifted so far afield that you can’t even find any coverage of markets and the economy on some days. One of the most popular such portals now regularly covers the weather.
In any event, on Monday morning, while documenting the latest commentary from one widely-followed sell-side strategist, I wrote that,
[I]t’s important to note that when it comes to explaining the wide distribution of daily outcomes, “classic bear market action” is apt, but doesn’t tell the whole story. Wild swings are, almost without exception, the product of mechanistic flows, hedging dynamics and the myriad self-feeding loops embedded in modern market structure. Importantly, that doesn’t mean no humans are involved. Blaming “the machines” is also too simplistic. Conceptually speaking, many of the dynamics we identify with “modern” market structure have existed for decades in one form or another. They’re just more efficient now, where “efficient” doesn’t necessarily carry a positive connotation.
I was speaking specifically to recent price action and particularly Friday’s “out-of-nowhere” surge.
In his first note of the new week, Nomura’s Charlie McElligott wrote that “US Equities Options positioning data makes sense of the flows behind a large part of the Friday rally.” He spoke directly to the dynamics I alluded to in the excerpted passage (above).
“The prior ‘extreme short’ Net $Delta ripped substantially higher off the lows, thanks to a mix of Call buying (singles and some index), Put selling (index) and of course a function of the general spot rally as well,” he said, on the way to quantifying the implied change both for SPX/SPY and QQQ.
He then touched on the specifics which informed my own, more colloquial, take (from “Snowballs In Hell“) on the two-way risks staring down any brave soul who dares adopt a directional bias into this week’s deluge of top-tier US data and BoE/ECB meetings.
Puts, you’ll recall, have been en vogue of late, especially among retail investors who this month discovered that stocks can go down as well as up. What happens to those will be a key determinant for spot.
“Whether or not we see an actual wholesale closing-out of and/or rolling of (expensive) Equities Puts… will likely dictate whether we face-rip rally or, conversely, risk further breakdown,” McElligott said.
It’s critical that folks understand why that’s the case. I get questions about this fairly regularly, and I often refer readers to Kevin Muir (of “The Macro Tourist” fame) as he’s done some step-by-step educational podcasts. McElligott on Monday presented both sides of the equation in fairly straightforward terms.
On the melt-up side:
A sustained spot Eq rally will see Vols reset lower and drive a virtuous “Vanna” effect, as OTM Put Delta will bleed, with Dealers then having to cover their short hedges in futures, which then further “feeds-back” and incentivizes more capitulation / outright closing-out of some of these downside hedges, especially now that underlying portfolio size is much smaller.
And on the melt-down side:
However, with such an enormous amount of negative / short $Delta still outstanding, those Puts which remain open or will be rolled down- / out- can keep us open to more Dealer hedging violence–i.e. the “energy” remains for more “negative Gamma” trading on a resumption of the push lower in Spot Equities, with the potential for Dealer shorting into another down-trade, as those Puts would pick-up Delta again.
Hence my contention from Sunday that (and I’m quoting myself here) average investors, Reddit day-traders and “everyday” people in general haven’t a snowball’s chance in hell of trading tactically in this kind of environment. It’s a total crapshoot.
The good news is — and Charlie mentioned this too — vol is mean reverting. It’ll be very difficult for spot to realize the daily swings currently implied. Any relief on that front (i.e., smaller daily moves) can eventually compress realized vol, triggering a latent, mechanical, “background” bid from vol-control, just as buybacks resume.
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