US equities could stabilize or, at the least, calm down, following a manic start to 2022.
On the heels of a multi-day rally that saw the S&P retrace more than half its peak-to-trough drawdown, dealer positioning was back near the neutral line Wednesday, suggesting hedging flows will serve to insulate the market from large swings as opposed to exacerbating the price action.
“Dealers [were] back into a shock-absorbing ‘Neutral / Long Gamma vs Spot’ position in both SPX and QQQ index / ETF options, which means greater stability,” Nomura’s Charlie McElligott said.
This is conducive to (but doesn’t guarantee) a controlled melt-up scenario. If realized daily moves settle into a more pedestrian range, realized vol can likewise settle, opening the door to a latent, mechanical bid from the vol control universe, which de-allocated materially during the rout.
Additionally, spot is nearing key trigger levels for CTA trend, another source of systematic selling in January.
This is crucial at the current juncture given poor liquidity. As detailed here on Tuesday evening, systematic flows that hit in thin markets can be perilous. Market depth is severely impaired on most simple metrics (figure below).
The situation would, one assumes, improve in calmer waters. Vol is mean-reverting after all, and it was always going to be difficult for spot equities to deliver on the large daily changes implied by spot VIX.
Obviously, stocks aren’t out of the proverbial woods. There are still a few key big-tech earnings reports to clear, and it’ll be a traders’ market for the foreseeable future given ambiguity around macro developments and the impossibility of forecasting the Fed’s reaction function.
But, given the proximity of CTA “buy”/”cover” triggers (figure below) and prospective (i.e., conditional) vol control re-accumulation assuming more subdued daily moves, the environment could be conducive to a melt-up over the next two or three weeks, with extra emphasis on “prospective” and “could.”
None of this is assured, and all of it is dynamic. These are snapshots, as it were.
The above should be considered with i) an apparent effort on the part of some funds to play catch-up to the rally and ii) puts conceptualized as dry kindling. As McElligott wrote Wednesday, when the latter bleed out, it generates a buy flow, as dealers cover hedges held against the puts they’re short.
This is all tactical in nature, of course. And it comes with an important caveat. If stocks were to run higher again, re-rating rapidly and unwinding the recent tightening in financial conditions, it could give the Fed more plausible deniability when it comes to tilting hawkish even as “stale” incoming data underwhelms due to Omicron.
“These new incremental ‘pivot flows’ which we expect to materialize are occurring just as the market stabilizes under a return to ‘long Gamma’ regime, which can then fuel [a] further rally alongside fundamental investors who have begun to tilt their exposures to play offense again,” McElligott remarked, before warning that “I could see this mechanical under-positioning squeeze tuckering out in a week, maybe two, because I actually still believe that for the next 300 point move in SPX, we are more likely to hit 4,250 before 4,850.”
