If you’re wondering whether the bounce in US equities which had the S&P trading within 3% of its February highs headed into this week caught a lot of folks flat-footed, under-positioned and otherwise off guard, look no further than the equity options space.
In and around “Liberation Day,” the relative price of out-of-the-money upside optionality collapsed for obvious reasons: The average US tariff rate was apparently set to increase 10-fold overnight, a left-tail escalation with the potential to trigger a global recession. Or worse. Suffice to say demand for melt-up protection’s negligible when markets are melting down.
The tariff shock and accompanying equity drawdown triggered an acute bout of risk aversion as investors de-leveraged and raised their cash allocations. No sooner had everyone trimmed their exposure than Donald Trump backed off his maximalist position, setting in motion a stock recovery which, were it not for the Moody’s downgrade, might’ve seen the S&P reclaim 6,000 early this week.
In a testament to the idea that many market participants missed the rally train, call skew’s “crazy bid” all of a sudden, to quote Nomura’s Charlie McElligott. The figures below (click to enlarge, as always) illustrate the point.
“For the first time since 2023’s wild ‘spot up, vol up’ chase-in era, we’re beginning to see the first signs that the ‘fear of the right-tail’ has turned into something with legs because so many missed the equities move and under-captured (at best) over the recent trailing short-term window,” Charlie wrote Monday.
Again, and for the uninitiated, steeper call skew is evidence of upside hedging — FOMO, to use the acronym.
Of course, if customers are getting long out-of-the-money upside, dealers are short that same upside. If you’re buying calls, someone’s gotta sell them to you. If that someone’s a dealer, they have to hedge those sold (short) calls, which in turn creates its own melt-up risk.
The figures above, also from McElligott with his annotations, explain the situation. Note from the top pane that dealer hedging flows will keep stocks pinned as long as spot doesn’t move too far from current levels. Think of the green bars as insulation.
The red bars, by contrast, give you a sense of where dealer hedging flows would exacerbate directional moves. Hence the green dashed “zoom” arrows in Charlie’s charts. If spot moves towards and/or through those upside strikes, dealers’ hedging activity will amplify the move, all else equal.
“Locally, dealer[s]’ gamma profile is ‘big yikes’ if we keep seeing spot push higher, because options dealers in both singles (Mag8) and index (SPX and QQQ) are increasingly short upside calls to customers who don’t have enough right-side on,” McElligott wrote, elaborating. That could mean “upside accelerant flows’ on a rally.”
