As explained in yesterday’s note the most likely cause was feedback loops arising from options. Commission-free trading in US equity options and strong bullish sentiment have caused options positioning to become very skewed on the call side (far more outstanding calls than puts). All these long call options sit on the books of market makers which are then short these calls. They would lose money if the underlying stock continued to go up. Therefore, these market markets hedge their short call positions (delta hedging) by buying the underlying stock (in these cases Apple and Tesla). If the notional outstanding amount becomes big enough the delta hedging activity by market makers become a too share of the normal trading flow in the underlying stocks and thus suddenly they activity causes price impact hence the increased intraday volatility in the chart above.
In our Saxo Market Call podcast this morning we have slides explaining some of these dynamics and more. The technical concept in options called gamma explains the rate of change in the delta of the options. What likely happened yesterday was that the gamma exposure so large that when prices fell the delta of all the call options held by retail investors fell fast and market makers reduced their positions of underlying creating a negative feedback loop. Based on estimates of this gamma exposure and the curvature of this net position means that we believe the technical reasons for the sell-off are no longer present.
We are still positive on equities
Short-term and going into the weekend it will be interesting to see whether US retail investors can muster the strength to set in motion a rebound. Regardless of the potential rebound today and the technical sell-off yesterday, we remain positive and constructive on equities. Yesterday’s initial jobless and continuing claims showed significant improvements which caused the New York Federal Reserve to update its Weekly Economic Index tracking US GDP growth in real-time. For the week ending 29 August the index now estimates US GDP growth at -4.4% y/y a significant improvement from the -11.5% y/y in late April. If the rate of change in this index is positive (i.e. the negative GDP growth gets less negative week by week) the rebound narrative is well alive, and equities will continue to outperform bonds. While the macroeconomic uncertainty is still high the support from the fiscal side is still enormous with France announcing additional €100bn in stimulus and South Korea over the weekend announcing the country’s largest stimulus programme in many decades. All this fiscal stimulus will flow through to the broader economy.