Good Morning,
- Dealers have pushed further into negative gamma, suggesting that the recent volatility is likely to continue.
- Similar to last Friday, yesterday's decline was primarily fueled by a new wave of demand for longer-dated Put contracts. This forced dealers to hedge their side of the trade by selling a delta equivalent of SPX futures, which injected enough bearish flow into the market to send the cash index tumbling.
- As the demand for longer-dated Puts forced dealers to sell yesterday, SPX had a rare break below our bottom PV band.
- Today, that new lower range sits just below the 5050 strike, which leaves limited room for any further downside. However, given the broader setup, we can't rule out another break lower, especially since Vol control funds and CTAs are likely on the verge of a more significant deleveraging event.
- The 1-month volatility has broken back above the 3-month vol again, albeit by only 0.1 points. That said, for a rules-based model like a Vol-control strategy, it doesn't matter if it's higher by an inch or a mile, as long as a crossover has occurred.
- This marks a major shift for any funds using a volatility-scaling strategy, as it indicates that the 1-month volatility will now act as the primary factor in adjusting equity allocations, which is typically when the more significant selling occurs.
- Already, Vol control funds have sold a total of $19 billion in equity exposure in just the last five trading sessions, with around $7 billion of that occurring just yesterday.
- As long as dealer stay in negative gamma, we expect these selling flows will continue to increase, as these funds will be forced to rebalance out of equities, in order to balance out their risk exposure.
- As we mentioned yesterday, we cannot stress enough how dangerous of a setup this is from a positioning standpoint, especially now that CTAs are finally starting to participate in the selling. That said, although some other flow desks attributed yesterday's decline to CTAs, we don't believe that was the case.
- However, if equity markets continue to decline towards the end of the week, we anticipate some more aggressive deleveraging to take place. Combined with volatility control fund rebalancing, this environment has all the necessary factors for a purely systematic market selloff driven completely by machines.
- Remember, in a high risk environment, complacency kills!
For access to the full report, please click here!
-Craig Peterson
