The ‘Controversial’ Stock Narrative That Isn’t Controversial

US equities are again vulnerable to “accelerant” flows which could exacerbate directional moves.

It’s a familiar tale. And, crucially, it’s not a tall tale.

In an article dated August 22, Bloomberg described the notion that stocks have become a derivative of their own derivative as “a controversial narrative.” With apologies, it’s not controversial. It’s an observable fact.

Obviously, options positioning and associated hedging flows aren’t the sole determinant of equity prices, but what is? Anyone who adopts a deterministic cadence while parroting some version of the “Ultimately, stock prices are a function of [XYZ] line” is either lying or, far more often, simply doesn’t know what they’re talking about.

If your investment horizon is “forever” like, say, Warren Buffett’s, I suppose you could argue nothing much matters at all — that as long as corporate America is still a thing, stocks are a decent investment. Most people want a little more out of their “narratives” than that, though, even as I’ll confess that the older I get, the more amenable I am to the same sort of amorphous Buffett aphorisms I so readily lampoon. (Don’t worry: I’ll still lampoon them for readers as long as I’m alive.)

If you assume stock prices can everywhere and always be explained by, for example, profits and the discount rate, you’ll find yourself bereft when asked to explain how a “textbook” (to employ an overused description of this summer’s rebound) bear market rally ran so far, so fast.

Nomura’s Charlie McElligott, who’s never bereft, on Wednesday emphasized that “in the options space, positioning and hedging flows are again proving to be so critical.” Dealers are back “deeply” in short gamma territory across a variety of key macro options vehicles, he said. The figures (below) are from a Tuesday note. The “flip line” for SPX/SPY was 4,118 as of Wednesday. It was (basically) unchanged for QQQ. These are dynamic levels.

As the bolded red all-caps from McElligott suggests, this is conducive to a wider distribution of daily outcomes tied to hedging flows.

In these conjunctures, dealers become liquidity takers (as opposed to liquidity providers). They tend to sell into weakness and buy strength, exacerbating price action and “creat[ing] overshoots in both directions,” as Charlie put it.

Over the past two weeks, the selloff in equities benefited downside expressions, and puts are in demand. Some $7 billion in premium was spent on large-lot transactions over the past week alone, according to Nomura (figure on the left, below).

The potential knock-on effects are important to consider. “Bunches of freshly-opened puts which dealers are short to clients picked up a ton of delta,” McElligott wrote. “Hence [the] need to short enormous futures to stay hedged as the market is moving lower.”

Those hedges could become dry kindling in a squeeze scenario. The figure on the right (above) gives you a sense of things.

You can look at this two ways. One one hand, things are unstable and the Fed’s already ad nauseam “No pivot for you!” talking point is a drag on sentiment headed into tough seasonality and with plenty of macro event risk capable of delivering a “shock down” catalyst.

On the other hand, “market rallies of magnitude could risk short squeezes in systematic positions, which will continue to be a risk in light of such extreme short gamma / short delta dynamics within the options market,” McElligott said Wednesday. He was reiterating a Tuesday note which flagged a tentative setup for “‘squeezy’ overshoot-type rallies despite the recent bearish turn, now that we’ve seen an impulse acceleration in downside hedging over the past week on the spot selloff, which means huge ‘negative $Delta’ as hedge-unwind, squeeze ‘fuel,’ but with dealers in short gamma territory, which means mechanically having to chase.”

At the same time, CTAs have been selling, and on Nomura’s models at least, the signals are max short. “Yes, they can still grow notionally larger on account of further price and / or vol inputs” but there are “no more ‘levels to sell’ in the high-profile equities futures positions,” Charlie remarked, before alluding to the prospect of re-leveraging from trend followers in the event a sizable short squeeze managed to push spot back up through ‘buy’ (or ‘cover,’ if you like) levels.

The point here isn’t to make predictions about the near-term trajectory for equities. Rather (and this brings us full circle), I wanted to emphasize that there’s nothing particularly “controversial” about the idea that stocks can act like a derivative of their own derivative — that options positioning and flows can drive (and on some days, almost dictate) spot outcomes.

Nor is there anything debatable about the notion that systematic flows more generally can have an outsized impact on markets, especially thin markets in an era when cross-asset liquidity is deteriorating over time.

Incidentally, Buffett understands all of this better than anyone. After all, building a massive equity portfolio atop an insurance float is tantamount to being short a giant put to all of humanity and using the premiums to fund a long-only hedge fund.