How sustainable is the nascent correction in US equities?

At the fundamental level, a lot obviously depends on rates and, in the current context, what happens at the long-end of the US Treasury curve.

From a flows perspective, it’s all about the muscle memory that says you monetize downside hedges (and long vol winners) on any selloff (or vol expansion), no questions asked. As Nomura’s Charlie McElligott put it Wednesday, “playing for downside is just a continuous tactical play,” unless and until the data actually turns.

Fighting that can be frustrating because it’s self-fulfilling. It perpetuates its own success. Traders are “super quick to monetize… which causes contra rallies in spot as delta is bought back,” McElligott wrote. “Rinse, repeat.”

Notwithstanding a bit of comeuppance for put-sellers (and revenge for call-sellers) over the past week or two, selling puts, straddles and strangles has worked impossibly well this year, in part because people keep doing it. The related flows help make it profitable and around we go. “The almost endless supply of vol from options sellers will continue to make it extremely challenging to sustain selloffs,” Charlie went on.

As far as the feared “accelerant” dynamic wherein dealer hedging can create a “selling begets selling” spiral, he pushed back on what he described as “noise” around short gamma risk as things stand. He cited put-selling on Tuesday, which in turn conjured futures buying, calling it “more of the same” vis-à-vis the “quick to monetize downside” mentality described above.

The figure shows there is some risk of accelerant flows around the 4300 strike and then again down around 4200. In the same vein, there’s a large VIX dealer short strike at 20.

As a quick aside, the “some reports” annotation on the left-hand chart probably refers to other sell-side estimates showing the largest net SPX gamma short in at least four years. One desk described a snowball effect, exacerbated by CTA flows on the downtrade.

That’s not “wrong,” it’s just that it (self-evidently) depends on spot. As the chart on the left shows, dealers are short down at 4300. The spot reference is 4330.

Ultimately, Charlie seems to doubt the sticking power of the selloff. “As I always say, ‘realized vol tends to collapse under the weight of its own implied expectations,'” he wrote. “With UX1 ~18 and implying ~1.1% daily SPX moves” in an environment where such moves are still a relative rarity, the odds may favor “under-realizing” and a “reflexive ‘buying-back’ of exposure from anybody who operates under a target volatility framework.”

I’d be remiss not to note that on September 14, McElligott predicted the recent selloff and vol expansion quite explicitly. If you hang around these pages, you were there for it+. “There is hope for at least some local vol chop and spot movement coming down the immediate pike!”, he said that day, exclamation point and all. S&P futures dropped ~5% high-to-low over the next eight sessions.