Remember when the catalyst for the relentless, seemingly inexplicable broad market melt-up in mid-February was revealed to be an overeager short-biased hedge fund, which had been caught in a “short gamma” feedback loop, forced to buy more S&P futures the higher the market went? Well, as RBC’s Charlie McElliggott writes, the “short gamma” feedback loop appears to have returned as yet another fund is now caught in the same trap, and the market will soon test just what the fund’s point of margin call max pain is, potentially taking the S&P to 2,400 – if not far higher – on short notice.
As McElligott laments, “It’s awkward to write about this…AGAIN” which however won’t stop him from doing just that, and explains as follows:
GUESS WHO’S BACK…MORE ‘SHORT GAMMA’ COCKROACHES, from RBC’s Charlie McElliggott
The same dynamic at play during our last equities ‘melt-up’ is seemingly back ‘in-play.’ Remember the hypothetical story on the multi-billion dollar open-ended futures fund which found itself ‘synthetically short’ size SPX due to its strategy where it sells multiple upside calls for every in-the-money long call? Well the macro ‘relief rally’ yesterday reintroduced that very same ‘gap risk’ which this type of strategy hates.
Well, we are now getting closer to ‘launch’ as the same situation is speculated to be ‘out there’ again. There was some covering in 2330s and 2370s yesterday, while most of the size seemingly sits at the 2400 level. As the market is sniffing out the upper strikes that such a strategy might be short, there is a self-fulfilling ‘short gamma’ as we push ever-closer to the pain-points. Of course, today’s +++ earnings run is only further feeding into the anxiety, with strong #’s from CAT, DD, BIIB, MCD etc squeezing futures higher. The fact of the matter is, the closer to actualizing these (short) upper strikes, the more likely we are to see that ‘itchy trigger finger’ on their delta-hedging. I would keep an eye out on 2380 / 85 levels for possible next ‘breakpoints’ which could induce further forced covering.
If we were to then push onward to / through the 2400 level, then it almost seems the whole market will ‘act short’ simply based on stops, as SPX / ES would be making new all-time highs, which could set-off ‘buy stops’ from shorts, or potentially drag new longs into the market on the momentum break. This is OUTSIDE of the potential ‘short gamma’ from the above trade(s). That said, the real chunky OI in both SPX and SPY options sits at 2425 / 2450 levels. A break to those levels would see serious ‘short gamma’ pain.
Mind you, this is all very relevant in relation to my current view that we are realistically still in the midst of a macro ‘range trade,’ especially in regards to rates / ‘reflation,’ as the commodities complexcontinues to really struggle as Crude falters and the Chinese liquidity driver fades. My message has been to watch said “reflation trap” then, as there is still significant basis to short “reflation” at the 2.35/40 level—especially with this US data dynamic of ‘soft’ data rolling and ‘hard’ data now biased towards ‘missing.’