The risks we highlighted last week, excessive positioning, an almost parabolic extension in the Nasdaq 100 (NDX)and rising volatility, notably with the CBOE NDX Volatility Index (VXN) soaring and the VXN-VIX spread at historical extremes, reached boiling point in the last week. The extreme speculation within growth/momentum/tech stocks that has dominated the pandemic trading environment, most markedly within short term call option trades (dubbed the Robinhood effect), collided head on with a dose reality as two way price action returned to the market. Following the aggressive rebound off the March lows and the much-reported phenomenon of increased retail participation in financial markets, Goldman Sachs reported that for the first time in history the average daily volume of single stock options being traded exceeded volumes on the shares themselves, with the volume of calls traded more than triple the average in 2017-2019. This record call option buying prompted market makers to hedge their exposures, buying the underlying stock, which contributed to the upside acceleration we have seen in recent weeks and in turn sucked in more buyers along with the continued need for market makers to hedge their exposures. A virtuous buying, hedging, buying feedback loop. This effect coupled with increased demand for longer dated options to hedge exposures into the upcoming election contributed to the extraordinary magnitude of the simultaneous increases in the NDX and the VXN we and many others flagged. This virtuous loop came to an abrupt end last week as the NDX logged one of the largest 2-day declines in the last 30 years. The Robinhooders may have received an important reminder that just as momentum works on the upside, it also works on the downside. Moreover, typically much more quickly on the downside as crowded positions are unwound and everyone rushes for the same exit at once. In markets seldom do we travel in way forever, and a 2-day meltdown does not a trend make. However, these underlying speculative dynamics are important to understand the kind of trading environment that has persisted with the divergence of financial markets from the real economy and the financially engineered perpetual bid (rational or not) that comes from unconventional monetary policies coupled with the persistent low rate environment.
The week ahead could prove pivotal and deliver a key test of the resolve of this cohort of retail speculators. It might not take much to topple sentiment further given the rampant speculation we have seen, particularly as last week’s sell off highlighted another fragility of the present trading environment, with high cross asset correlations leaving very few places to “hide”. Global COVID cases topping 27mn and India’s mounting crisis, with an overwhelming surging caseload could see some headline angst. Any follow through of dollar strength, particularly with a dovish ECB meeting on the cards (the virus resurgence, and inflation disappearance reinforcing this view), may be crucial for potentially precarious sentiment amongst dip buyers and could well fuel another bout of risk aversion. Furthermore, with cryptocurrencies, another retail favourite, under pressure the recent euphoria across risky assets faces a timely test. Perhaps a precursor for the months ahead as the upcoming election and mounting geopolitical tensions leave plenty of room for increased volatility.