McElligott On Market’s ‘Reservoir Dogs Standoff’

The standoff in eastern Europe is a “buzzkill” for what may have otherwise been a market melt-up into OpEx.

That’s according to Nomura’s Charlie McElligott, who on Thursday noted that a similar, Reservoir Dogs-style standoff is afoot in the equities space.

“Equities continue to grind everybody in both directions,” he said, noting that with the dealer short gamma backdrop still in play, directional moves have the potential to overshoot, as hedging flows magnify the price action both ways.

Relatedly, demand for downside hedges creates more second-order kindling. “Deltas associated with options positioning remains historically negative / ‘short,'” McElligott went on to remark, noting that dealers will be net sellers of futures to maintain their own hedges even as the same setup “provides massive ‘covering fodder’ on rallies away from OTM Put strikes.”

The figures (below) give you a sense of things.

Do note, though, that “neutral” wasn’t that far overhead as of Thursday morning (figure on the bottom left), and futures seem keen not to drift too far from the 200-DMA.

At the same time, CTAs and vol control ostensibly don’t have much left to sell. Systematic de-leveraging has taken CTA Trend’s net equity exposure down to just the 4th% ile (figure below). That cohort shed around $84 billion in global equities over the past month, according to Nomura’s model.

Vol control, meanwhile, de-allocated to the tune of $105 billion over three months. Vol control’s exposure to US equities now sits below the 16th%ile.

That’s quite the mechanical purge. On Thursday, McElligott said CTA ‘cover’ triggers are still some ways away — between 3% and 5% above spot, which drifted lower in early US trading.

Still, the story remains largely the same. If spot ever does manage to settle back into a more subdued range (from a daily change perspective), realized vol can recede, triggering a latent bid from the vol control crowd.

Currently, one-month and three-month realized sit in the 99th%ile on a one-year lookback (figure below).

Vol control is “so de-allocated that [a] natural reset lower / mean-reversion in smaller daily SPX ranges will drive mechanical buying too,” McElligott remarked, calling both vol control and CTA potential sources of “synthetic Short Gamma” which could act as accelerants into a rally.

Finally, rounding out the standoff, hedge fund nets still sit at one-year lows, while flows continue to be very supportive. Remember, flows into global equity funds are actually running ahead of last year’s pace, which is really saying something considering 2021 was a ~$1 trillion year.

Once the Ukraine tensions fade (and hopefully they do, because war is bad), attention will shift back to Fed policy. On that front, McElligott described another standoff of sorts.

“The ‘Fed Put’ still exists, although substantially lower OTM and prob < 4,000 SPX, hence plenty of room to fall with no FOMC policy shift,” he wrote. “But at the same time, the Fed is also selling Calls ~ 4,700 / 4,800, because any rally back to those levels would see an impulse easing in financial conditions that is outrageously counterproductive for their hawkish efforts.”