The Case For A ‘Violent’ Stock Squeeze

It’s all about oil right now. I suppose that’s obvious, but for what it’s worth, the short-term correlation between S&P futures and front month crude is almost perfectly negative.

It won’t stay that way, of course, but suffice to say a continuation of the current trajectory in commodities would almost surely presage severe stagflation. That’s what equities are reacting to, not so much the unhedgeable risk of a nuclear exchange between Moscow and Washington.

“Anecdotally, I kept repeating to clients that we’re going to walk in to see crude limit-down (say on a profit-taking avalanche) at which point, we could expect to see Spooz +3.5% or more in sympathy,” Nomura’s Charlie McElligott wrote Wednesday, noting that although there are no signs of such a breaking point in oil just yet, equities are looking for a rebound on ostensibly conciliatory remarks out of the Russian foreign ministry.

Why could stocks squeeze violently on even the most tentative signs that the Kremlin is backing down? Well, it’s simple. It comes back to the very same dynamics that continue to foster what most investors and journalists describe as “inexplicable” intraday swings.

“Stocks are so deeply immersed in negative gamma and, critically, extreme ‘short delta’ for options dealers from downside hedging that this would mean violent rallies which have to be ‘bot into’ as dealers cover shorts in futures,” McElligott wrote. Have a look at the visuals (below).

Coming into Wednesday, $Delta for SPX / SPY was 0.2%ile. It was 0.0%ile for QQQ.

Any positive catalyst that gets the proverbial ball rolling (e.g., a big drop in crude prices, especially one predicated on real progress to resolve the conflict in Ukraine) has the potential to ignite the tinderbox.

“Any rally would have potent kindling for a short-squeeze from said negative Delta, as all those downside puts are torched as we rally away from lower strikes, and the coupled short hedges from dealers in futures will be bot back / covered,” McElligott went on to say, adding that “close-to-close vol was already acting tired because everybody is so hedged into the Fed’s ‘hawkish regime change’ and, now, a global ‘stagflation shock’ from the Ukraine war.”

If implied bleeds (from exhaustion), it could be “an absolutely huge deal for further ‘Vanna’ support into next week’s options expiration, which would absolutely add velocity to any rally,” Charlie added, again noting that any squeeze would be based on, and turbocharged by, progress towards a ceasefire in Ukraine or a dovish hike from the Fed, respectively.

Of course, all of that is near-term. Over the medium-term, rallies are likely to be sold into considering extreme ambiguity around the Fed’s reaction function and how policymakers would view any attempt on the part of stocks to reclaim record highs given the read-through for financial conditions which, you’re gently reminded, need to tighten, not loosen.