‘You Are Now Free To Move About The Cabin’

The volatility expansion window is now open.

The question is whether discretionary investors look to push the bearish envelope.

Dealers were in negative gamma territory vis-à-vis US equities following Friday’s options expiration, according to Nomura’s Charlie McElligott. “You are now free to move about the cabin,” he quipped, describing the loss of substantial “gravity” which had worked to keep spot equities pinned of late.

The gamma “unclench” opens the door to, but doesn’t guarantee, a larger distribution of daily outcomes. In simple terms, the tails are fatter. The scatterplot (below, from Nomura) illustrates the point.

This is a delicate juncture. Jackson Hole is on deck, liquidity is thin and the mechanical flows which helped drive the US stock rally from the June lows may be mostly exhausted.

“Those systematic and mechanical ‘buy’ flows [are] either largely spent, or at risk of actually becoming supply a few weeks out, if Vol was to reset higher for a sustained period of time,” McElligott said Monday. Note the emphasis on “if.” A lot hinges on this week.

CTA “buy” trigger levels are well above spot, but “sell” triggers are well below. The latent vol control bid for equities, which I’ve discussed exhaustively over the past couple of weeks, is still in play given the ongoing reset lower in three-month trailing realized, but it’s partially contingent upon how things develop going forward too. Stocks need to remain well behaved, and that’s where the gamma unclench comes in — a wider distribution of daily outcomes as dealers potentially sell into weakness (or buy into rallies) could amplify swings.

The key, McElligott suggested, “is going to be the willingness of active / discretionary traders to again ‘lean into’ the market and resume shorting here and now while the post OpEx ‘window for vol expansion’ is open,” he wrote.

There’s a psychological impediment — namely, a two-month rally that caught under-positioned funds woefully flat-footed, forcing them to chase stocks higher, or grab for upside optionality, to capture whatever they could. “There’s some scar tissue to sort out,” as Charlie put it. The figure (above) is a helpful visualization.

For risk assets, the worst-case scenario from Jackson Hole would find Jerome Powell explicitly suggesting that market pricing for the terminal rate is far too low. That’d require Powell to muster the kind of “stark and clear” messaging advocated by Larry Summers.

Consistent with points discussed here on Monday morning, McElligott noted that “the absolute pain trade as per the increasingly vocal ‘bearish equities’ community who is coming out of the bunker these past few days after a dark two months, would be a Chair Powell who simply chooses to highlight that the outlook remains increasingly uncertain,” eschewing any inclination to hammer home the Fed’s disdain for easier financial conditions or tip a higher terminal rate.

Such a noncommittal outcome would doubtlessly be perceived as dovish, especially relative to hawkish messaging from other Fed officials. It would, in all likelihood, “see this nascent ‘selloff’ in equities get reversed and crushed,” via the resumption of a summer rally which, as Charlie noted, “almost nobody ‘wants’ right now” in the context of the inflation fight.

Powell won’t risk that. Not on purpose, anyway. But, as we saw in July (and as we’ve seen countless times previous), Powell’s message is often lost in translation. In some cases, what the market hears is the polar opposite of what the Chair was presumably trying to convey.