Market Update: We’re All Short Gamma

(Quick post from the road)

This is a difficult juncture.

For the past few weeks, market breadth has been deteriorating and new lows expanding, as most indices have been grinding higher. Typically, these are signs one sees before a market corrects or rolls over.

We have also started to see price weakness in some areas where investors often reach for risks: the Russell, pockets of emerging markets and EM ccys, MLPs, Agency REITs, treasury curve flatteners, high yield bonds and even vol has ticked up a little. There were a few points last week when you wouldn’t have been blamed for feeling it was just a handful of tech stocks holding the whole market up.

On the positive side, we have entered the strongest season for risk taking. Fundamentals at home and abroad are solid. Earnings on the whole have been good. Significantly, gold and gold miners appear to be cracking. This year has been characterized by strong rotations disguised at the onset of corrections, and this could just be another one. Lastly, I should add, the pain trade still feels higher.

But perhaps the trickiest part right now is investors’ short-gamma mindset. When you’re short an option, the size of your exposure increases as the market moves against you. To hedge or reduce your exposure you are forced to continuously buy if the market goes higher, and continuously sell if the market goes lower. In other words, you’re chasing, rather than fading.

The short-gamma mindset happens every year at this time as the final stretch intensifies performance anxiety, but especially so in big up years. If you are lagging–as many are–and the market powers higher, you have to be in. The FOMO is overwhelming. Some guys will play the laggards, others will want to make sure their end of year balance sheet shows healthy positioning in 2017’s winners. Either way, they chase.

But there is only one thing worse than lagging all year and then missing the end of year push higher: lagging all year and loading up for the end of year push just before the market finally corrects. If this has never happened to you have no idea how mercilessly savage this can be. And since we haven’t had a correction in so long, if one were to come it’s easy to imagine it being larger than the garden variety sort.

In essence, it feels as if traders are short at-the-money straddles and are poised to chase any sharp move that lasts more than a day. Be careful. Now, got to hop.