There’s tension in the air across markets. Can you feel it?

I’ve talked at some length recently about the dynamics at play in the VIX space which, as Nomura’s Charlie McElligott put it, “remain[s] stuck in a state of almost chronic stress, like a slow-moving car accident.”

Have a look at vol-of-vol, which at least had the decency to recede a bit on Monday after hitting the highest since the post-December FOMC tremor.

That, McElligott wrote, is “the clearest indication that ‘all is not well.'”

There are two crucial pain points keeping this situation nervy — on tenterhooks, so to speak. The first is dealers’ short gamma position in VIX options, which is extreme.

VIX calls, you’re reminded, are en vogue as a catastrophe hedge for portfolios running high equity exposure. On the other side of those (long) calls are market makers who’re short a bunch of at- or near-the-money strikes, including 20 and 22 calls, as illustrated by Nomura below.

Dealers obviously have to hedge their own books which, as McElligott wrote, means “reach[ing] further up in strikes and buy[ing] more VIX futures” the higher the VIX goes.

Importantly, that’s not a choice on dealers’ part. It’s mandatory, and it means market makers’ real-time hedging has the potential to turbo-charge an upside VIX breakout.

At the same time (and this is the second pain point), the leveraged VIX ETN space has seen AUM balloon to multi-year highs. There too, you get a (de facto) short gamma dynamic in the daily rebalance which, in the case of an upside move in the (untradable) underlying (i.e., in the VIX), means mandatory buying of (very tradable) VIX futures.

The figures above, along with Charlie’s annotations, tell the story (click to enlarge, as always).

Note from the final annotation on the right-hand side that the potential for the leveraged VIX ETN space to make a bad situation worse is diminished a bit, but it’s still material. (Do take a moment to appreciate how hilariously perilous that setup was on the eve of “Vol-mageddon” in February of 2018).

All of the above speaks to the acute sensitivity vol’s displayed recently vis-à-vis spot equities. And we’re not out of the woods on this. Not yet, anyway.

“There is still ‘ammo’ if we were to get shocked-up to VIX 25 / VIX 30 where both VIX options dealers and leveraged VIX ETNs’ hedging and rebalancing needs would require tremendous price-insensitive demand for VIX futures and wingier VIX calls or lookalikes in SPX downside or shorting spooz,” McElligott said.