Volatility Supply/Demand Dynamics Are Completely Broken
Earlier today we discussed the “incredible anchor” that has emerged around the 4,400 level in spoos and as more traders inquire what is behind this strange attractor, Nomura’s Charlie McElligott has followed up on this writing that the 4,400 strike continues to choke markets and dealers on “long gamma” at the money with $7.1B accumulated there (although in a sign that market will likely keep grinding higher, 4450 $5.7BN has been built up at 4,450 and another $4.6BN at 4500 and growing)…
… and as McElligott notes, “we simply cannot break the tractor-beam, as the “strangle seller” laughs his way to the bank…for now”… but in an ominous observations, the Nomura strategist notes that the US equity vol complex remains to “incoherent” or even “broken,” as SPX realized remains cratered (10 day @ 9.2), versus implied vols staying really firm / effectively the entire VIX futs strip ref mid- / low- 20s.
What’s behind this dislocation? Well, as McElligott notes, “vol supply/demand dynamics are completely out of wack, which is on account of a number of inputs:
Dealers’ regulatory risk management realities, where stress slides show ever-increasing clusters of “rolling VaR events” over almost any lookback period—so you need to somehow be “crash positive” in a -3% / -5% move…but to do your job and facilitate client order flow, the only options you can really run meaningfully “short” is in near-dated expirations without having to pay through the nose away at horribly unecomical levels with another dealer and market maker.
In-turn, this causes further “daisy-chain” of crash demand and drives the outrageous skew and put skew extremes discussed previously to even more extreme levels (and at risk of “self fulfilling”), all of which creates a vortex of “short gamma” accelerant flow potential lower, on whatever macro shock catalyst which will next drive spot down—and with all sorts of downside catalysts on the “wall of worry” out there in coming months between Delta Variant closure potentials, Fed “Tapering,” “inflation overshoot vs slowing growth” etc which then drives client downside demand (currently see “Gamma Flip” level for dealers down through 4287 as of this morning, meaning the lower we go from there, the shorter the dealer gamma position)
The supply of vol from structural (and often-times systematic) sellers–especially forward vol out beyond a few weeks–too has been greatly reduced vs past, with some of the largest players, books and strategies having been infamously “wiped” from the buy-side in recent years (AUM greatly reduced at the very least), alongside a number large market-maker blow-ups due to same events, and the aforementioned dealer inability to be short tails of meaningful size or term
So this tight range with dealer long gamma pinning us at 4,400 now, as short-dated “strangle selling” flows are the only winning trade to be found—but ends up creating a synthetic stability which is shockingly unstable due to leverage accumulation from compression feeding low rVol allowing exposure to drift higher—against still 95-99%ile skew and downside put skew = “good times”
So heading into an NFP event which looks short-term “binary” from a Rates market perspective tomorrow, vs straddles not pricing much event risk in Eq Index Vol space, McElligott thinks that traders “really need to look at paying some theta / owning some index gamma…or think about the risk of a potential vol repricing in the barbell that is “rates sensitive” Equities (i.e. “growth vs value” or “tech vs financials”), where it’s most probable that we could see some of this “gap btwn rVol and iVol” dynamic get trued-up fast.”
As a tangent, the Nomura trading desk is noting a rate vol play or hedge into tomorrow’s NFP as LQD and its 6.5% implied vol by pushing Sep 135/125 Put Spreads, as of course investment grade credit carries meaningful duration / interest rate sensitivity risk.
The “good news” here, according to Nomura, for those that don’t want a move in SPX / SPY is that a lot of the dealer “long gamma” doesn’t look to be dropping off at tomorrow’s expiry, so that helps from an “insulation” perspective…although conversely, duration-sensitive QQQ shows a larger ~27% of the gamma set to drop (and 99%ile $Delta–so there is plenty to de-risk)…
… and ~29% of the economically-sensitive IWM gamma (where I’d note the $Gamma is -$564mm, just 0.9%ile—and $Delta is -$9.9B, really negative at 6.9%ile…yikes)…which just means potential for movement.
Thu, 08/05/2021 – 10:15