An Epic Battle Is Raging Beneath The Market Surface

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by Tyler Durden
Wednesday, Sep 02, 2020 - 04:45 PM

Yesterday morning, we - together with Nomura's Charlie McElligott - explained why traders were furiously chasing the classic "Gamma crash up" in the market, which had become a "classic feedback loop" which we described on Sunday as follows: "calls spiking higher amid this gamma squeeze, leading to more buying of the underlying stock, leading to even higher call prices, even more call squeezing, even more delta-hedging and buying the underlying, which eventually spills over into more and more of the market, and so on until there is one massive marketwide meltup." This resulted in the highest VIX print at a market all time high since, drumroll, the day the market peaked in March 2000, when the dot com bubble burst. Was history about to repeat itself?

Cross-asset guru McElligott, picked up on this saying that Gamma hedging has become "the most important flow in the market, with the convexity of said short-dated “lottery ticket” options creating an 'all-or-nothing' binary-options market behavior into weekly expiries, seen in these increasingly exponential ramps in names like TSLA."

Slightly late to the game, Bloomberg published late on Tuesday "Tech Traders Say Options Hedging Is Firing Up Rally in Nasdaq" in which it also laid out the core dynamic that has been perplexing so many traders:

Rampant demand for call options in names like Facebook Inc. and Inc. has left derivative dealers on Wall Street dramatically short gamma, a measure of the change in an option’s sensitivity to moves in the underlying shares.

As the stock rises, the dealers need to buy more to hedge their exposure. With a large number of call contracts outstanding and “relative illiquidity” in some of these single-name shares, they have been forced to turn to proxies such as the S&P 500 and Nasdaq 100, according to Hennessy. In order to hedge, dealers have been buying implied volatility on these benchmarks too.

While one can debate the nuances of the trade, one thing is clear: on one side we have traders, hedge funds, retail daytraders, algos, and so on, bidding up calls while on the other side we have the Street - dealers and market makers - who in the liquidity vacuum of August, found themselves chasing the price action, being short vol, something that McElligott's described as follows:

Over the past few weeks, there has been a massive buyer in the market of Technology upside calls and call spreads across a basket of names including ADBE, AMZN, FB, CRM, MSFT, GOOGL, and NFLX. Over $1 billion of premium was spent and upwards of $20 billion in notional through strike – this is arguably some of the largest single stock-flow we’ve seen in years. “The average daily options contracts traded in NDX stocks to rise from ~4mm/day average in April to ~5.5mm/day average in August (a 38% jump in volume).

As the street got trapped being short vol, other names in the basket saw 3-4 standard deviation moves higher as well – on Wednesday FB rallied 8% (a 3 standard deviation move), NFLX rallied 11% (a 4 standard deviation move), and ADBE rallied 9% (a 3 standard deviation move).

The most natural place to hedge being short single name Tech volatility is through buying NDX volatility.  As such, there has been a flood of NDX volatility buyers with NDX vols up about 4 vol points in 2 trading days. And if NDX volatility is going up, SPX volatility/VIX will eventually go up too."

He summarized this dynamic as follows:

"it’s as simple as this: Street-wide, Dealers are short Gamma / short Calls off the back of the MASSIVE upside premium buyer (as in BILLIONS spent) who has been in the market over the past month or so in a number of mega-cap single-name Tech cos."

Today, we bring you the latest episode in this drama. In a note from Larry McDonald's Bear Traps Report, a Portfolio Manager echoes what we already described, writing that the "convexity skew picture on big-name equities like Apple AAPL has gone parabolically stupid. Apple closed near $129, while the cost of speculative upside calls is weighted heavily against the buyer. Someone must have reached out to Buffett today because he can make a fortune in selling AAPL upside calls."

This can be seen in the following chart which we posted in yesterday's market wrap:

The next obvious question is just how short is Street gamma?

To answer, the same PM shows a chart of the staggering move in Apple options skew in just the past week....

... and writes that "in the past week alone, Apple's out of the money calls have risen in implied volatility to be on par with the implied volatility of out of the money puts. Keep in mind, if a market maker is selling the call options themselves, they then have to hedge themselves by purchasing the underlying stock. More calls being bought at higher implied volatility levels means the dealers need to purchase more Apple."

Again, we know and have already discussed all of this. What may be new, however, is that this dynamic in options is increasingly important. Notably, as the PM notes, "much of it is due to a lack of liquidity rather than a waterfall of liquidity many presume is in derivative markets. Very few firms can provide liquidity, balance sheets are very tight. Between now and expiration the banks are getting called out of positions, market to market is so expensive."

This makes the massively outsized short gamma exposure meaningful "and the convexity very dangerous for a handful of market makers such as Citadel." He goes on to note that "even structured notes are risk" because "exotic notes are behind the scenes at the banks and there is way more OTC than the banks admit."

Cause and effect.

Putting it all together, we find that a combination of market euphoria, free options trading, and most importantly, few market-makers have sparked the fire. It also means that "a few large hedge funds understood this and have added fuel to the fire by pushing implied higher and higher and putting further pressure on the likes of Citadel and Goldman. With this process helping drive names like Apple and Tesla, this also makes sense why Breadth has been so terrible."

The punchline, for all those who have been looking at the market action in recent weeks in stunned silence, well you are not alone, because as the PM concludes, "while most of the market is fading lower we are seeing a battle between a few big hedge funds and banks who are getting shorter and shorter gamma."

Perhaps today's snapback lower in Tesla and Apple stock, which both saw their market cap plunge by more than $100 billion in just the past 24 hours, is the start of an unprecedented gamma avalanche as the epic battle waging below the market surface in vol land between a handful of speculators and dealers reaches its conclusion.

* * *

Two final points: as the Bear Traps report notes, amid the unprecedented dislocation, one hedge fund put on the following trade which makes money unless AAPL somehow more than doubles in the next 4 months:

Think of January 2021 expiration. The client bought the $200 call and sold the $250 call, 1 x 4, and got paid $3.50 to put the trade on. Apple was worth $1.5T at the end of July and today she stands tall at $2.2T. In order for the client to lose money, the stock has to breach $270 ($131 today), which would put the company's market capitalization very close to $5T, by January 2021, that is a little over four months away.

Apple aside, what does this mean for the broader market? Well, look no further than implied volatility - which again has been paradoxically rising, as a leading indicator:

We MUST keep an eye on implied volatility in these stocks in the coming days. When implied vol gets pumped on big names, it can be a great leading indicator for the stock. Implied vol will fall and dealers can reduce some of their hedges by selling the underlying. When a parabolic rally like we have seen in Tesla starts to reverse it happens in the fast-money options before the slow-money stock.

The conclusion: "Over the next couple of days, implied vol during the day should be a phenomenal leading indicator."