It has been a while since we had an update from JPM's "quant guru" Marko Kolanovic on key market support and resistance levels from the perspective of option gamma and key systematic strategies including CTAs, risk parity and volatility targeting, so we were looking forward to reading his latest report which came out earlier today. In it he reviews the latest flows and concludes that the suppressed realized vol regime we have enjoyed for the past two months may be about to shift, perhaps as soon as the coming Friday's option expiration.
From JPM's Marko Kolanovic
S&P 500 Cycles of Systematic Leverage
S&P 500 index options hedging usually adds to market volatility given the convexity of put options held long by clients. However, due to the market rally and clients’ option activity, these dynamics changed in March. The imbalance of options (gamma) turned significantly towards calls (over the past month, the average gamma imbalance was ~$12bn towards calls), causing hedging flows to suppress S&P 500 realized volatility. The collapse in realized volatility invited inflows from Vol Targeting and Risk Parity funds. Hedging of call options (usually sold by clients) and rolling of put options higher (usually held long by clients) also caused equity outflows of ~$50-$100bn. These outflows to some extent countered the inflows from other systematic strategies such as CTAs and Risk Parity. This was a likely reason why the market could not break out despite price momentum briefly turning positive last week.
As options are rolled this week, and following option expiry on Friday, most of the call gamma imbalance will roll off (~$10bn). This could add to market realized volatility (the market will be able to move ‘more freely’). The gamma imbalance tilts towards put options significantly around ~2000 level and could result in market acceleration on the downside if we reach those levels.
Volatility Targeting strategies have been increasing equity exposure on account of low realized volatility (Figure 3). The equity exposure of these funds is now above November levels (and only slightly below July levels). Should there be an increase of realized volatility (which we think is likely), these funds will sell some of their equity exposure (depending on the magnitude of a potential volatility increase, these funds could sell ~$30-$60bn of equities). Equity leverage of Risk Parity funds peaked in early April (surpassing even July and November levels), but has come down over the past 2 weeks (Figure 4). Equity exposure of these funds is moderately high (~70th percentile). Should there be an increase in asset volatility and correlations, these funds could sell ~$30-40bn of equities.
CTA funds closed ~$100bn of equity shorts in February, and have since maintained only slightly long equity exposure. While equity momentum turned briefly positive ~2 weeks ago, this did not trigger a broad CTA re-levering to the levels we saw in July (Figure 5). More sustained CTA inflows would materialize if the market could rise above ~2100 (totaling ~$80-$100bn), and more significant outflows would materialize below ~2025 (up to ~$100-$120bn). Finally, equity exposure of Equity Long-Short hedge funds, as well as Hedge Funds overall (HFRXGL) is also relatively high, in the ~80th percentile.
Given the above-average level of equity exposure of systematic strategies (as well as hedge funds), and artificially low levels of realized volatility, we think that the risk for the market from these flows is skewed to the downside.