When we commented on the dramatic reversal in market positioning as a result of yesterday's market plunge, we said that in addition to the sudden lack of dealer gamma, much of which vaporized after Friday's, OpEx, and which had provided a buffer to any substantial selloff pressure...
... the next big catalyst was whether or not systematic investors (vol targeters, risk-parity funds and CTAs) would join the liquidation frenzy. To do this we cited Morgan Stanley's QDS director Chris Metli, who calculated that the systematic liquidation notional amount could soar to $60BN which would "generate a self-fulfilling downward move in QDS’ view" if the S&P closes on Monday below 3,235.
Well, despite a valiant effort to lift the market into the last hour of trading, stocks closed at the lows... and well below the 3,235 "systematic puke" catalyst.
So on Tuesday morning, Nomura's Charlie McElligott also picked up on this potential selling catalyst, writing this morning that "the next battle within Equities is systematic deleveraging SELL flows as trailing realized vols windows are “dragged up” and dictate exposure reduction (Vol Tgt / Risk-Control fund selling, CTA selling everything “Global Eq” yday while too we see Russell nearing “sell trigger” level) against now stabilizing BUY flow from the options-market, as downside protection is likely to be monetized by clients which will in-turn see Dealers have to BUY futures as they turn from short-to-long Puts."
Confirming what we said yesterday, namely that systematic selling is "now in play", the Nomura strategist writes that this is where things get complicated for Equities “buy/sell” flows, "because as “vol” triggers will mechanically see passive-deleveraging from systematic “risk control”- type strategies in standard “second-order” lagging-fashion, it’s also highly probable that the Options-space will see increasing monetization of downside protection (especially as Net Delta has gone “negative”) which will mean counter-buffering BUY flows."
But before we get into the possible bullish flow offset, McElligott advises us that based on his model, "CTAs deleveraged almost everything “Global Equities” on Monday, selling Eurostoxx, DAX, FTSE, CAC, Hang Seng, Hang Seng CH and KOSPI yday."
Meanwhile, even as the key market-moving SPX and NDX CTA trigger levels remain well below S&P spot - for now - McElligott says to pay particularly close attention to where the Russell closes as that could spark the next level of selling, as "today we see the risk of CTAs deleveraging in Russell futures IF we were to close below 1624, taking the signal from +100% to just +15% in the process."
As he elaborates, commenting on the Russell 2000 trigger level, "that one is almost always a canary in the coal mine when it triggers. And it’s well below the trigger now."
Yet even in the current puke, a white knight may be emerging, with McElligott pointing out the "potentially very significant and stabilizing “BUY flow” which could be unleashed via the options-market and help to counter this “price-insensitive / passive / mechanical” selling from systematics."
Currently, yes, Dealers are in the “short Gamma” zone and that added to the move to the downside yesterday, as they generically-speaking were sellers the lower we travelled because again, the were short the downside wing to clients (and the general “Wall of Puts” down at 3250, 3200 and 3150 which got “rich” yday). But as these “short puts” turn to “long puts” for Dealers as they’re monetized by clients—particularly in “weeklies” which have to be traded very dynamically per the IV—Dealers will then need to “buy” the market (futs) to get right.
Said otherwise, while dealers are now well short gamma (the breakeven level is just above 3,310)...
... if they monetize downside protection, it will likely stabilize the market, thanks to the "wall of puts" in S&P options. As the Nomura quant concludes, "as downside protection is monetized by clients (particularly weeklies) dealers will turn from previously "short puts" to "long puts", which will see the, buying S&P futures."