The New Market Reality: ‘Each Day Is Its Own Ecosystem’

Last week, following one of the most dramatic intraday reversals for US equities in history, I reminded readers that “these are your markets,” so to speak.

Contrary to the protestations of some quant funds and the HFT lobby (and you can take “lobby” figuratively or literally), modern market structure isn’t everywhere and always conducive to efficient liquidity provision. In fact, you could pretty easily argue that it’s contributing to the structural impairment of liquidity across assets.

Most readers are familiar with the feedback loop between volatility, systematic flows and liquidity. Vol and market depth are inversely correlated. When markets are volatile, liquidity is impaired, and impaired liquidity means wider spreads and thereby more volatility. Gap moves can trigger systematic, unemotional flows, which in turn exacerbate directional swings.

It’s far from clear that any of that is desirable. Many argue it’s wholly pernicious, particularly when set against the post-financial crisis policy backdrop. Risk parameters were set and models calibrated based on artificially suppressed volatility and assumptions about correlations and rates that depended on the persistence of benign macro outcomes.

Within this broader discussion are a number of more specific dynamics, which are optimizing around themselves to create a scenario in which, as Nomura’s Charlie McElligott put it Tuesday, “each day is its own unique ecosystem.”

It’s no longer possible to place the blame for this solely with retail investors. They’re not the only ones exhibiting what Charlie called “extreme short-dated options trading behavior” centered in part on daily expirations.

“The largest institutional players and desks now play the 0-1 days ’til expiry stuff” too, he wrote Tuesday. The figure (below) shows short-dated options as a share of total volume.

As McElligott was quick to note, on some recent days, US equities ETFs “have seen upwards of 35-40%+ of the total options traded of the 0DTE variety!”

He described the mentality and associated modus operandi. “If you don’t monetize puts and/or cover dynamic shorts on the ‘down days,’ you’d be force-covering on ‘stop-ins’ into a pain-trade rally,” so monetizing downside into weakness and negative market catalysts is a must.

Of course, everybody realizes that, which means the next move is to front-run the expected knock-on. Once the downside gets monetized, you pile into same-day upside optionality not just to play the squeeze, but in fact to facilitate it.

“When we get that ‘gap-down’ catalyst, not only do we see a massive impulse of positive $Delta from puts being sold, but we also then get positive $Delta surge from ultra-convex 0-1 days-til-expiration calls” from market participants attempting to “exploit the hedge unwind and short-covering,” McElligott wrote.

Dealers are forcibly enlisted in this daily circus, and although I’m sure you could find metrics which suggest liquidity isn’t necessarily suffering as a result of the ongoing fireworks, I’m equally sure that this sort of thing doesn’t help when it comes to the structural impairment mentioned above.

Although the participation of systematics depends on trigger levels (i.e., momentum and technical signals), and while I suppose you could argue that the daily back and forth can perversely keep things in a “range,” I’d gently suggest that the more conducive the environment is to exaggerated toing and froing, the higher the risk of an overshoot in either direction that pulls in systematic flows.

The long period of macro calm and attendant forward guidance from central banks acted in concert with modern markets to foster the conditions for periodic “avalanches,” as stability bred instability. In 2022, the macro calm is gone, as is forward guidance. Now, instead of the eerie accumulation of snowfall just waiting for a skier’s scream, “each day is just a reset,” as Charlie put it. A “reload” might be an even better way to describe it.