It's Been "Controlled Demolition" Until Now: S&P Breaks Key Level

Nomura's Charlie McElligott notes that equities 'short gamma, extreme short delta' just points to the regime shift with Fed in "Financial Conditions Tightening" mode...

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...where strength is sold into / short-dated Puts are bought to press into selloffs then closed same day; but institutional traders are also 'day trading' rallies with call buying and closing - perpetuating intraday swings and new world order of range-trading.

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All of this short-dated optionality is extremely convex and needs to be hedged actively, further contributing to the large intraday swings and ranges, as this persistent “short gamma” sees market trend moves overshoot thanks to dealer hedging.

McElligott notes that the lean remains “short index iVol, short delta” in the meantime... because markets know The Fed is captive the next two months, having to respond asymmetrically to the risk of inflation “upside” prints, into what should be the peak of inflation.

With the markets flailing around in response to various headlines, the S&P vol term structure (shown below) remains in a backwardated state, showing that short-term protection remains in demand.

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S&P500 At the money implied volatility term structure. Source: Interactive Brokers

Short-dated implied volatility near 28% equates to the market pricing in a 1.7% daily move, which is higher than our gamma-driven forecasts of 1.3%.

To this point, SpotGamma believes the selling has been been “controlled demolition” and has respected major options level.

There is a lot of volatility, but that seems to be within the confines of what is being priced in. We’ve not seen that wash-out, “panicky” type selling that often comes with capitulation. The risk of this event is certainly elevated, but the trigger would have to be something quite material to catch this put heavy market by surprise and bring a significant >2% down move.

There was a considerable chance of the market could stage a strong short-covering rally up into the 4400 level, but the news this morning and the break below 4300 has rendered that idea invalid for now.

With this in mind, over the longer-term SpotGamma continues to give edge to the market taking steps lower, with 4200 the major level on break of 4270.

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4050 remains where we see significant longer-term support.

Finally, Goldman notes that markets are pricing a return to normal for Growth with NDX showing substantially lower vol risk premium than SPX.

The de-rating of long-duration Growth stocks in 2022 has driven very high NDX volatility year-to-date; the NDX’s 31% realized vol has been 11 points over the SPX’s 20%.

Nevertheless, with investors shifting focus away from Growth stock valuations toward the Fed and geopolitical risks, the implied vol spread between the NDX and SPX has actually fallen recently.

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This has left a record discount in the NDX’s implied minus realized volatility premium compared with the SPX’s; we see NDX put options as an attractive hedge against further rotation away from Growth stocks.