Two weeks ago, when the market seemed stuck in a constant, daily meltup ahead of the March option expiration "quad witch", Nomura's Charlie McElligott had an explanation for the relentless bid in stocks which took place even as investors were consistently dumping shares for 12 consecutive weeks: in addition to another record year for stock buybacks and various daily short squeezes, it was the "extreme" dealer gamma that was providing support for the S&P, because the higher the market rose, the more risk dealers had to buy to hedge positions.
Since then, things have changed drastically, and not only is the S&P once again below its "sextuple top" of 2,800, a level it simply refuses to breach consistently since last October, but companies have also entered the buyback blackout period, as the most active buyer of stocks is on the sidelines for the next month as Q1 earnings start coming in.
But the biggest difference may be that as stocks continue to slide from YTD highs, the dealer pressure to keep buying is no longer present, and as JPMorgan writes in an overnight note, following the March expiry and the market’s ~2% sell-off on Friday (exacerbated by the Wedneday slide), the S&P 500 put-call gamma imbalance has moved close to flat.
This, to JPM's Brad Kaplan, suggests that the long gamma position dealers have been running for most of the past couple of months has likely lightened (now close to neutral), and their hedging activity is proving less support or headwinds to market volatility. The sensitivity of the gamma imbalance to changes in spot prices is shown in the chart below.
So if gamma is no longer a factor in the market's upside - as today's selloff indicates - that means that it will be a factor in the downside. And indeed, as JPM concludes, we could see a meaningful put gamma imbalance (dealers short gamma) "if the S&P 500 were to sell off to ~2725 (-3%)", at which point the trajectory to a retest of the December lows becomes clear, especially since the latest round of global central bank easing has by now been fully priced in markets around the globe and - absent launching QE4 - there are no surprises left up the Fed's sleeve.