Equity markets have been crazy. In my caveman view, we just left a world where volatility markets were searching for vol buyers. The “job to be done” in options was to find a way to accumulate options without bleeding out. Selling had become too popular.
At this moment, I suspect risk groups of discretionary capital have put yellow police tape on the option sell button. The market is now bidding for sellers so that’s probably the side that offers compensation. Do this at your own risk of course, shorting vol or anything for that matter is hard because it’s hard to time but also because it has diabolical math — if you’re wrong your losing position becomes bigger while your equity shrinks (when longs lose money the losing position becomes a smaller percent of your equity). Managing trades is often harder than knowing the good side.
In any case, here are 2 good discussions of what just happened:
The (equity) volatility machine is down (4 min read)
Alexander Campbell
🎙️Solving The Mystery Of The Market Sell-Off (Odd Lots podcast)
Description
The S&P 500 has plunged more than 5% over the past couple of trading days. The Nasdaq 100 is down 7%. The Nikkei fell an astonishing 13% on Monday and then triggered a circuit breaker as it climbed up 10% on Tuesday. Meanwhile, measures of equity market volatility like the VIX have soared to their highest levels since the pandemic crisis of 2020. So what’s behind all these dramatic moves? There’s a long list of culprits, with market participants blaming everything from the Federal Reserve being behind the curve, to the deteriorating labor market and softer-than-expected payrolls data on Friday, as well as the unwinding of the yen carry trade, the bursting of the AI bubble, and the reversal of short-volatility trades. In this emergency episode of Lots More, we speak to Charlie McElligott, cross-asset macro strategist at Nomura, about what caused the selloff and how long it might last.
There are some highly interesting framing here:
“When you say that, like, stuff was already getting a little hairy last like, what were those early signs? Was it just Wednesday during the Fed decision? What were you starting to see?”
Charlie: Well, there’s different time horizons for sure. And I think one of the things that we absolutely have to discuss is the signal from skew. Skew is this relative measure of demand for downside versus demand for upside…but without a doubt, when you began to see skew relentlessly, stay bid. When you began to see the volatility of volatility, stay so bid, even as stocks were trying to stabilize.
[Kris: Charlie’s point is a real-time example of how options include intel that you can’t find in stock prices. It was the point of last week’s Munchies Option Analytics For All]
He links the behavior of option skew to macro. He suggests that the tightening response to the Covid stimulus then fiscally-driven inflation led to investors reducing their exposure to risk assets. In such an environment, put skew flattened and the call skew popped as investors responded to the Fed’s hawkishness by reaching for calls to maintain reasonable upside participation.
So the last two years, kind of prior to the last six months, we were in this super bizarre place to a lot of people, with positive spot/vol correlation. Vol was going higher as the market was rallying because people didn’t have the exposure and were being forced to chase.
Data was beginning to soften. Inflation was starting to come off. The Fed was kind of opening the door to the end of the tightening cycle, and you were under positioned, so you’re grabbing into calls, and that same positive spot vol correlation on sell-offs meant that vol would grind lower, because you are in this really virtuous backdrop for vol selling, right? So down days were opportunities to sell vol.
And at the core of everything that has kind of happened over the last week, in particular, last few days has been about that kind of come-to-Jesus moment for the short vol trade of the past two years.
You had this dynamic where flat skew was a feature of quantitative tightening, and at the March kind of extremes, we started beginning to see skew steepen again, pretty impulsively. And that was the signal that, you know, we were going to resume back to this prior world of a negative spot vol correlation.
Terrific line here:
Volatility is the exposure toggle in modern market structure,
Charlie continues:
…that being the case, sustained periods of low volatility, where I would say that, the big shift, from a macro catalyst that occurred over the past few weeks was back to this idea that we had been consensually and comfortably in a low vol narrative, as the market was forced into a soft landing consensus last year, right? People were… fighting, fighting, fighting for the recession that never came. Ultimately, we kind of got stopped into this really comfortable backdrop, soft landing.
The Fed would still be supportive. Treasury did a little work around the edges to ease financial conditions and lighten the load of the Treasury sell-off and the long-end rate volatility in the fall. That low vol backdrop was really facilitating this massive growth in the short vol stuff that’s been out there, and the AUM growth.
And it’s not just short vol, it’s premium income ETFs, it’s VRP, it’s dispersion strategies, short correlation trades. It’s QIS at banks, their proliferation, especially being used by multi strategy hedge funds, which are big users of those products. All of that stuff created the short vol supply.
And here’s kind of the kicker to me, with regards to that soft landing outcome, which was consensual. We had had a kind of assigned a zero delta of a hard landing. But we had been saying for quite a long time, market had been fixated this mark. This economy goes as far as the consumer goes, and the consumer is a function of the employment data. And when in, you know, less than a month span, we’ve seen six of the last seven major US labor releases at magnitude downside surprises. You kind of got the whites of the eyes of this trade where, well, holy moly, like, maybe that’s not a zero delta.
Digging more into the options as drivers of the stress:
We’ve been conditioned to see these opportunities to monetize downside hedges, or say, VIX, upside convexity in this span of hours…You have, like, a couple of hours max to monetize those hedges before reflexive vol sellers reappear, before the dip buyers reappear.
A lot of people ended the day Friday thinking that they could be short vol, and maybe short delta, because the vol moves were so magnificent. The issue then became that they got their fingers blown off on the Monday reopen. You can lose money trying to do that based on prior backtests on these vol squeezes when Asia crashes overnight, But when Asia crashed overnight, those people woke up and there was more bid for tails and VVIX (vol of vol) went absolutely bonkers.
This vol squeeze, this vol outperformance on a beta-adjusted basis was unlike anything we’d seen, I’m telling you. Like past covid extremes, past Volmageddon or LTCM. Some of these metrics were unbelievable, whether it was VIX relative to SPX, whether it was VVIX relative to VIX, whether it was skew relative to at-the-money vols. All these different metrics, 100th percentile.
This was a vol event.
Charlie goes on to talk about the role of macro which he thinks is secondary to the vol markets in this case despite all the Japan talk. He also discusses what the relaxation of the stress looks like but is not saying it’s over. All the vol metrics he mentioned have been heavily bid going into the market closes indicating there are still large accounts (he suggests dealers) buried under short convex positions.