In “Playing The Game,” I noted that one risk to somnolent summer markets is the potentially unstable accumulation of equity exposure from the vol control universe.

Regular readers are familiar with the dynamic: As the range of daily spot outcomes compresses, realized vol recedes, dictating mechanical re-leveraging from strategies that allocate based on volatility.

That process, I reminded folks on Tuesday, is “escalator up, elevator down.” The figure below illustrates the point using Nomura’s estimates for vol control’s implied equity allocation.

The steady grind higher in 2023 is a mirror image of the concurrent grind lower in realized vol.

That exposure is vulnerable to de-leveraging in the event of range expansion or, colloquially, in the event stocks were to snap out of their summer slumber and start moving around a little bit.

In a new note, Nomura’s Charlie McElligott called that “the largest risk locally for equities in the absence of some sort of macro shock.”

“Such an impulsive grab into equities exposure when base vol is sitting at such an absolute low level means that it will not take much of a vol move to elicit a large mechanical de-allocation flow,” he wrote.

The figure above gives you a sense of things. As long as the average daily move for stocks stays within a 0.5% range on either side, vol control can still be a boon, despite an equity allocation that now sits in the 94%ile on a three-year lookback.

However, once hypothetical daily changes expand beyond 1%, the de-leveraging starts — or would start, in theory, based on the model.

As McElligott explained, using the 1.5% average daily move as an example, if sustained for a week, such swings could trigger more than $40 billion of selling from vol control. Based on today’s estimates, a daily range that averaged 3% for two weeks (a scenario it’s fair to call far-fetched) would result in $125 billion of mechanical de-leveraging.

Do note: This is for illustrative and educational purposes. The point is to highlight the dynamic, not to make any sort of prediction about the odds of a selloff, and anyway you still need that vol catalyst — some spark to get stocks moving.