This article is written by our research collaborator, Mr. Andrei Nita, CFA L2, on the subject of current market developments.

The recipe for a rip your face bear market rally

Over the last month, stock markets had one of the largest synchronized declines on record, with SPX -17%, and QQQ registering -27%. There have been no significant bounces over this time period.

While my macro-economic derived view over the US market is still bearish, I see a significant opportunity for a tactical trade. Let me explain why this is the case and why all the quant guys might not see this coming.

During this leg down for SPX from 4632 to 3858, participants started to buy hedges aggressively when SPX was around 4300s. Those hedges consisted in SPY puts. With expiration mostly in May (but also significant volumes were seen for June exp) with strikes around $400, and VIX calls with similar expirations and strikes of 30 to 35. At the time of these purchases, these options were deep OTM providing leverage to the buyers (as delta was significantly less than 1 and Vega was small as VIX was in the 20s). One could also argue that these were tail event hedges, a tail event that came to fruition in only 2 weeks. As the market approached the 4000 SPX and VIX was above 30, these options became ITM and participants were fully hedged.

Hence, there was no further demand for protection from investors and they chose to reduce risk by de-grossing. Therefore, there was steady pressure from the sell side which was eventually exacerbated by the dealers who had to gamma hedge as those options became ITM. All of this action is taking place without any real spike in VIX (VIX spikes when people rush to buy puts to hedge, but market was already prepared for this as previously stated). 

SPY Analysis

Quant oriented investors are blindly following the doctrine that market bottoms happens only when VIX spikes. The same logic is built into most of the algos. Hence the common wisdom right now is that this leg down can’t be over (in the short term) as there was no VIX spike at the lows. Perhaps, the lack of Implied volatility premium (VIX which is the proxy for Implied Volatility, being significantly higher than Realized Volatility) is the element which we don’t have in place to have a perfect set-up for a bear market rally which would make even the perma-bears become bulls.

With consensus being short IWM and QQQ, and having for instance $300M in Negative Gamma exposure from the dealers only for $300 May QQQ puts, there is a big fuel reserve waiting to be reversed by this Friday when the majority of options (hedges) expire. When investors sell their puts, dealers have to reverse their delta/gamma hedges so they buy the underlying from the spot market, creating significant buying pressure.

Additionally, we just saw a decrease in vol of vol (2nd price derivative) getting into negative territory, which is usually a bullish sign at least in the short term. Shall this volatility signal trigger some buying which will be afterwards fueled by the massive puts unwinding heading into OPEX remains to be seen if that is the case. But the odds are significant for such a scenario considering that the bearish sentiment is at levels seen at 2008 and 2020 lows.

Andrei Nita, CFA L2