August can be an unruly beast for markets. The seasonal is daunting and liquidity is generally poor. Those two things are related.
But, for now anyway, dealer hedging activity could help insulate equities from large daily swings.
After a month of bloodletting in puts and concurrent clamoring for upside optionality in calls as equities ran away higher in an environment where positioning among key investor cohorts was extremely light, dealers are in long gamma territory across all three US benchmarks, according to Nomura’s Charlie McElligott.
The figures (below) are a snapshot — this is dynamic, not static. “A move lower back into ‘short gamma’ remains a local risk, particularly with QQQ (Nasdaq) not far from the current flip line, as we would lose the recent stability,” Charlie said Tuesday. You can see that in the middle frame.
For now, though, dealer hedging and market making activity will work to insulate markets — dips are effectively “bought” and rips “sold.”
“The current move back into long gamma versus spot for US equities index / ETF options is a big deal as it squelches volatility and compresses the absolute range,” McElligott wrote.
Regular readers are well acquainted with this dynamic and, increasingly, so are market participants in general. When dealers are short gamma, their hedging activity tends to amplify moves in both directions — they sell into selloffs and buy into rallies, effectively operating as liquidity takers.
That exacerbates the price action, feeding the kind of outsized downdrafts and eye-watering rallies which some argue are a pernicious fixture of modern market structure. The figure (below) gives you a sense of how this tends to play out.
In a positive gamma regime, dealer hedging behavior “compresses absolute return ranges, adds liquidity and squelches volatility, while the alternative ‘short gamma versus spot’ risks acceleration flows, which remove liquidity, feed into market moves and expand ranges and volatility,” McElligott went on to write.
This is a critical part of the self-feeding flows-volatility-liquidity feedback loop.
Recall that the vol control universe may be poised to take the baton from CTAs in the ongoing, systematic re-allocation to equities which helped drive last month’s rally. The more well-behaved the market — the more compressed the daily range of outcomes — the more conducive the environment will be for the “realization” (if you will) of that latent bid from the vol control crowd.
I should add the usual caveat: There are times when a single headline can “shock” spot back through (i.e., below) gamma flip lines. This is a fragile stability. And, as we’ve seen time and again, the cruel irony is that even when it proves durable (i.e., becomes entrenched), nothing breeds instability down the road quite like stability now.
A nice reference to Hyman Minsky eh?
H-Man so if “When dealers are short gamma, their hedging activity tends to amplify moves in both directions — they sell into selloffs and buy into rallies, effectively operating as liquidity takers.”
I can assume the opposite when dealers are long gamma, they will buy into selloffs and sell into rallies. Does this mean they are liquidity adders rather than takers?
Not to go to far into the weeds but Occam’s Razor suggests long gamma is + for equities and short gamma is – for equities.
My understanding is that gamma is agnostic — it merely amplifies or attenuates. Short gamma amplifies — good for gains, bad for losses and bad for the CTA/vol control crowd. Long gamma attenuates — bad for gains, good for losses and good for the CTA/vol control crowd. (To the extent any of this is true and accurate, h/t to H, my only real trainer in this respect).