Why do selloffs accelerate?

In modern markets, the answer to that question is very often found in the interplay between volatility, liquidity and systematic flows.

Market depth tends to diminish around acute vol spikes, and illiquid markets are conducive to gap moves, which is to say more volatility. Large, abrupt moves can push spot through key levels both for dealers (vis-à-vis hedging needs) and managed futures strategies (i.e., the CTA trend universe), triggering mechanical flows with the potential to exacerbate the price action. Vol spikes which persist can trigger latent de-leveraging from vol-control cohorts, which is to say additional sell flows that manifest over subsequent days or even weeks.

By now, most sophisticated investors are well aware of that so-called “doom loop” and how the attendant “accelerant flows” work, it’s just a matter of where the key levels are.

Although the risk of a meaningful downdraft made worse by those flows is currently low for reasons discussed here on any number of occasions over the past four or five weeks (skew has re-steepened a bit, but not enough to indicate big underlying longs that necessitate the kind of protection-buying which can become dangerous in the context of selling-begets-selling dealer hedging on a big selloff), it’s worth noting that there is some potential for dealer positioning to conspire with CTA de-leveraging on a break below SPX 4650.

The figure on the left above shows dealers’ gamma profile, and the table on the right shows the CTA asymmetry for a given move in spot. (I never thought I’d have to say this, but recent reader feedback suggests I do: You can enlarge the charts simply by clicking on them.)

“The local options dealer profile is kinda ‘meh’ — we’d need to push through 4700, which then requires a 4650 break to really get spicy through 4600,” Nomura’s Charlie McElligott said Friday.

As a caveat to that generally benign assessment, Charlie noted that “as so often tends to be the case, dealer Greek positioning ‘flips’ are somewhat at risk of overlapping CTA deleveraging levels if we were to get a more pronounced pullback in spot.”

So, again, 4650 SPX is a level where you could start to see some escalatory price action to the downside, given the potential for dealers to flip into a short gamma regime just as CTA sell flows get triggered.

To be clear (and I assume this is obvious) McElligott isn’t calling for any sort of dramatic event. The above is just an update on potentially relevant spot levels. Nothing more, nothing less.