Two weeks ago, when we observed the flush in markets as a result of technical selling following the breach of key CTA levels which in turn precipitated a selling feedback loop as extensive negative gamma positions had to be unwound, as selling forced more selling, Nomura's Charlie McElligott cautioned that a similar snapback is possible to the upside if only there was sufficient bullish sentiment to push US equity futures above key selling levels.
So following this morning's newsless meltup, this morning McElligott is out with a note declaring "mission accomplished" as said feedback loop has indeed emerged, and as he writes "the knock-on bleeding-out of Equities Vol Dealers’ crash hedges is accelerating into this morning’s VIX expiry, with unwinds now helping further accelerate the move higher Equities futures overnight (S&P futs +0.8% overnight)—“mission accomplished” ; )
The catalyst behind said hedge unwind is the previously noted recent re-emergence of the infamous "50-cent" VIX trader, who forced dealers to take opposing positions to his/her Call Wing positions, which due to positive gamma and dealer vega balancing, were forced to keep buying stocks the higher the market rose, and the lower VIX dropped, to wit:
These “crash” hedges are so “outsized” simply due to the massive scale of the “50 Cent” August VIX Call Wing positions, which Dealers are short—and thus they have been forced to get long a lot of S&P Vega via VIX futs, S&P downside or just “shorts” in Spooz to offset this exposure
As McElligott also reminds us, prior to the July return of “50 Cent,” this massive “lottery ticket” demand in the VIX “Call Wing” had disappeared after Feb ’18 saw the effective extinction of the leveraged VIX ETNs’ “Short Vol” position, which thereafter drove a broad collapse in VIX futs / options volumes. However, as the Nomura quant notes, "now after the Summer ’19 return of the entity’s hedging program to the VIX options space, the implications of this flow are particularly outsized, especially in-light-of Dealer VaR constraints / risk limits specifically into this peak of Summer illiquidity and thus, low market capacity to digest it all."
Which brings us to today's meltup: as the “50 Cent” call wing decays with all of the strikes looking to be out of the money into this morning’s expiry, Dealer hedges need to be unwound and / or covered, particularly noting their “short gamma” position in VIX futures options.
And, in a repeat of the insane move by we observed back in February 2017 when the Catalyst Fund's Hedge Futures Strategy Fund almost singlehandedly moved the entire market higher by several percent when it was caught in a "gamma trap", in classically-perverse “negative convexity” style, dealers are now forced to sell more Vega (VIX futs) the lower VIX goes; and “BOOM,” that in McElligott's eyes is largely why we’ve seen a “TWAP seller” look over the past 3.5 sessions in UX contract, losing ~5 vols in the process:
There's more. As McElligott repeats what he warned just yesterday, the implications of the "mechanical melt" in the VIX complex have then not just acted as catalysts for “Higher Stocks” since last week, but potentially too, near-term going-forward as well. Here are the details as per the Nomura quant:
- This grinding move lower in VIX futs will too further incentivize monetization of “long vol” positions (particularly the still-massive net long Vega position from VIX ETNs) as an additional catapult/amplifier for “Higher US Equities” near-term
- The normalization of front-VIX contracts LOWER too means that a re-steepening of the VIX futs curve (out of the recent inversion) which will gradually signal for the return of Systematic “Roll-Down” strategies as an additional “Volatility Seller” flow to the market with bullish second-order impact upon Equities
- And as we like to focus-upon here, these “short VIX / short vol” flows will increasingly too then drag trailing realized vols lower, which as a critical “allocation- / leverage-” input to Systematic “Target Vol / Risk-Control” strategies will ultimately drive further re-leveraging and / or “short covering” into their Equities positions
Speaking of CTAs going long again, while Charlie did note yesterday that his CTA model’s Eurostoxx position re-leverage from the prior +56% signal all the way back-up to +100%, joining SPX, NDX, CAC and ASX, today he points out that remaining CTA model shorts at "risk" of covering locally from here, and sending risk even higher, include:
- Russell 2k (currently -100% Short, would begin to cover at 1542),
- Nikkei (-100% Short, would begin to cover at 21053),
- DAX (-73% Short, would begin to cover at 12085),
- FTSE (-73% Short, would begin to cover at 7226),
- Hang Seng (-100% Short, would begin to cover at 26991),
- Hang Seng CH (-100% Short, would begin to cover at 10345)
- KOPSI (-100% Short, would begin to cover at 266)
Finally, with this morning’s Spooz bounce, Nomura sees SPX options Dealer Gamma elevate back in a very “neutral to long” status, thus acting to stabilize and insulate Spooz into a “less chase-y” trading environment which can then further engender restoration of sentiment. Indeed, as shown in the chart below, the higher we move above the SPX spot breakeven of 2918, the faster the meltup will become.
Of course, this near-term meltup does not mean "all clear", and as we described yesterday, and as McElligott cautions today, "September poses its own set of challenges and should continue to keep directional trading “tactical” in nature."
The biggest risk here remain both the Fed and ECB where “dovish expectations” remain exceedingly high and thus risk a perceived “hawkish disappointment,” which could then dictate US Rates (higher yields) and USD (higher) price-action all acting to “TIGHTEN” financial conditions. Together with the resumption of the corporate “buyback blackout” around mid- September into Q3 EPS season (~75% of S&P 500 corporates will see their purchase windows close by 9/17/19), any “macro shock as catalyst for lower Equities” (e.g. September Fed or ECB disappointment) scenario risks the following sequencing:
- a drop in spot back into Dealer “Short Gamma” zone, which too then could converge with…
- the increased potential for recently / currently RE-leveraged “Long Equities” positions (or at least covering “Shorts”) from Target Vol / CTA Trend accounts which could then too see a forced DE-leveraging upon a large enough drop—ESPECIALLY in-light of…
- the mid-Sept gradual loss of the “Buyback Bid” and…
- VIX September seasonality, which is the 2nd best avg monthly return for the volatility index in its history