The Blow-Off Top: "More S&P Delta Was Bought In Last 2 Weeks Than At Any Point Since 2007"

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by Tyler Durden
Monday, Oct 09, 2017 - 14:02

Last week, BofA chief investment strategist Michael Hartnett summarized the current market as follows: the "best reason to be bearish in Q4 is there is no reason to be bearish." He also observed that tha market's "blow off top" phase, which he dubbed the Icarus Rally previously, had been activated and was approaching its final thrust, with BofA's Q4 targets for this final push in risk assets as follows: S&P 2630, Nasdaq 6666, 10-year Treasury 2.85%, EUR 1.15.

And yet, some have argued that Hartnett's designation is not accurate, as there simply is not enough exuberance and euphoria to defined this phase of the market as a blow off top. Which, of course, is also debatable: for one, CNN's frequently noted Fear and Greed index closed last week at a level of 95, indicating of near widespread euphoria.

Then, over the weekend, Morgan Stanley's Chris Metli, executive director of the bank's Quantitative and Derivative Strategies (QDS), showed another indicator of just how deep in the blow off top phase the market was.

Metli notes that in the aftermath of last week's NFP report, which was hopeless distorted by hurricanes, yet in which investors focused on the one-time spike in hourly earnings (largely a function of overtime pay in the utilities sector, at least according to the BLS), the more bullish sentiment and positioning, particularly at the index level in the options and futures markets, makes the outright buying of equities riskier now, and as a result "QDS suggests investors sell equities and rotate into long call options – in other words, stay long to participate in a blow off top, but don’t leave your left tail exposed."

Metli lists the following three reasons why traders should be concerned, of which the first one was most notable, namely that "Investors in the SPX options market have bought more delta in the last two weeks than at any point since at least 2007."  In other words, investors are now finally buying into the rally, but not via stocks, but via levered, upside calls, a stampede which typically takes place when investors are confident there is virtually no downside risk left. It usually precedes periods of sharp risk corrections.

Metli then notes that as a result of these flows, "in an up 5% move end users of SPX options (i.e. non-market makers) would be the longest equities since at least 2008… while they would be the least well protected in a down 5% move since at least 2008."  Andd while all would not be lost - since there has been deeper OTM tail protection bought – "there could be an air pocket in the 2400 to 2500 range before that protection kicks in."

Finally, the MS Futures team has noted that the net long builds have started to reach notable levels in several global markets. And, yet again confirming the scramble to buy equities no matter the cost, S&P futures have reportedly seen over $27bn traded on the offer versus the bid over the past two weeks – on par with the record amount bought in late July, notably before some hiccups that occurred the following month.

What should traders make of the above data, and is it time to sell everything and quietly exit stage left? Here is Merli's conclusion:

Within equities the biggest pain trades remain a) higher vol and b) a pro-cyclical and pro-value rotation (away from Growth, Tech, and Defensives).  There are signs that a rotation towards Value has started, and in contrast to the hiccups in Growth/Tech seen over the summer, this rotation could have legs as it appears to be driven by an actual shift in the macro environment.  This could support value, cyclicals, and equities broadly over the next month.  But the closer the end of the year gets, the more worrisome those rotations will be – instead of a year-end chase, investors who have had good performance could start to protect their gains if investments go against them.

Finally, for those who are hoping to top tick the market and short it at the "Icarus Rally" peak, Morgan Stanley warns that "picking the top in a blow off rally is difficult", and adds that "the best strategy to participate in the upside while limiting exposure to the downside tail is simply to replace stocks with call options." In other words, the best way to hedge against a blow off top is to... participate in it.