Don’t look now, but there’s a regime shift afoot in the equities index vol space.

I know, I know: You’ve heard that before. And these shifts “always” peter out, where that means instances of steeper skew witnessed over the past 18 or so months invariably proved fleeting.

But this time might be different. “Investors finally capitulated in recent months towards high nets [and are] long enough to necessitate [a] resumption of demand for puts and downside hedges,” Nomura’s Charlie McElligott said Thursday, editorializing around the “violent” steepening in index options skew illustrated on the left, below.

The figure on the right gives you a sense of the knock-on effect: A rekindled spot-vol relationship.

If it sticks (i.e., if the demand for downside protection persists), it opens the door to more pronounced selloffs in the event something comes along and shocks spot equities lower.

Why? What are the mechanics? Isn’t that counterintuitive? Shouldn’t the market be safer when underlying equity exposure’s well-hedged?

Most market participants — including many ostensible “professionals” — still can’t answer those questions. Fortunately, McElligott’s always happy to recapitulate when the opportunity arises.

“It seemed counterintuitive to many folks last year when I was hammering it home [but] the incredibly flat skew of the past 1.5 years actually made it more difficult to get a large selloff,” he wrote. “To generate the conditions for a crash-down, you needed steep skew,” because that’s indicative of client demand for hedges, which in turn means dealers are short that downside. In a selloff, they (dealers) have to short futures (or buy vol) to stay hedged themselves. It’s those flows (the dealer hedging flows) which can act as an accelerant.

The figures above speak volumes. Negative gamma regimes are associated with outsized spot moves and elevated implied vol (left) while positive gamma regimes are conducive to steady-as-she-goes rallies (right).

“As always, the impact [of] vol regime shifts on spot markets tends to metastasize via dealer hedging flows [where] ‘long gamma’ equals stabilizing insulation and range-compression [while] ‘short gamma’ feeds momentum and [creates] range-expansion potential,” Charlie went on.

The implication: If this regime shift holds — and that’s a big “if,” particularly given the overhang from mechanical vol-selling — markets could begin to “look more ‘escalator up, elevator down’ as we move forward,” McElligott wrote.