Ever since Brexit, traders - and mostly bears - have been scratching their heads over not only by the S&P500's tremendous rally but also but the market's seeming ability to immediately digest through any incremental negative news, both economic and geopolitical and rebound immediately from a support level at around 2,150. And while there has been speculation of central bank intervention to prop up the S&P any time it approaches this key level (something which several years ago would be considered ridiculous but now is all too possible), it turns out there is another - perhaps even more unexpected - reason why the market remains "pinned" in its historic trading range of 2,150 to 2,180.
Here it the explanation from JPM's head quant, Marko Kolanovic.
Lets look at the recent collapse in US equity realized volatility (realized volatility over ~3 weeks of only 4.5%). Over the past 14 trading days, the market did not move more than ~50bps on any given day, and on 8 days it moved ~10bps only. Figure below shows S&P 500 making “Uturns” and virtually staying unchanged most of the days since July 14.
Naively assuming a normal distribution of returns, one would expect this scenario to happen once every ~10,000 years. The fact that we see this type of behavior demonstrates market inefficiency—in this case driven by hedging of option exposure. Quite literally, the market was pinned. Over the past 3 weeks, the amount of call options exceeding put options (in terms of gamma exposure) averaged almost $40bn (per 1%), which is the largest call to put gamma imbalance ever observed.
In addition to a very large amount of S&P 500 index and ETF call options struck at ~2150 level, we want to point to an unusual call ratio trade (1 by 3) in which an investor sold call options on S&P 500 futures with strikes in ~2175 range. This added about ~$10bn of gamma and helped create a “dead zone” from 2150 to 2180 in which option hedging creates a drag on any S&P 500 moves.
As this collapse in realized volatility is not a fundamental change in volatility regime, we expect realized volatility to increase (this increase in market volatility is shaping to be a consensus view, as indicated by steep contango of VIX futures). Option exposures that are pressuring volatility should roll-off, and investors should increase leverage and set protection closer to the current market level. This will set the stage for a more rapid increase in volatility. We have seen these switches between extreme low and high volatility that manifest themselves as high volatility of volatility (e.g., note that that the current “once in 10,000 year” market calmness came after a Brexit day move that was “a once in 50,000 year” move for EuroStoxx 50 index).
Whether central banks will respond with even more of the same to this upcoming "increase in volatility", remains to be seen. Looking at today's market action, with 2,150 in the cash index suddenly in jeopardy, we may get the answer very soon.