CHG Issue #158: The Third Law

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Kris Abdelmessih recently wrote about how the GME short squeeze created a situation where you were getting unusually high odds (roughly 4 to 1) of the stock settling between $20 and $30 on the June 21st expiration with the stock trading at $25 at the time. The flows from Roaring Kitty (aka Keith Gill) and his followers created the squeeze which effectively moved the "line" for the market creating this opportunity. This situation provides us a great opportunity to explore how market forces are acted against in variable ways in the financial markets which creates different market outcomes.

Kris is a SIG alumni and is second to none in making complex options trading approachable to the average person. My path at SIG was different than Kris' but we seem to think about the market in similar ways which is probably a result of our common heritage. Kris has a depth of experience in the options markets that I just don't have but reading his post I instantly recognized the underlying logic of Newton's third law in how he reasoned through his trade.

If an object A exerts a force on object B, then object B must exert a force of equal magnitude and opposite direction back on object A.

The thing about applying the third law in practice is that it is not linear. First order thinking is not enough, second order thinking is also not enough. You simply need to understand that the law exists and see how the flows work through the system. In the GME example RK acquired a position and then publicly disclosed it which created a short squeeze. The GME market makers had to take the other side of this flow and they hedged that flow by bidding upside call skew. They could have hedged in many different ways such as buying the stock, and maybe this was them realizing his flow was only good for a temporary pop and not sustainable, or maybe it was something else. Whatever the case, it revealed what Kris reasoned out from his process: that going with RK this time around was getting better odds than going against him. A pig can pass through a python in many different ways, understanding how the python digests the pig is key to finding alpha in the market.

The dispersion trade has been getting attention recently as NVidia continues to wreak havoc in the markets. Implied correlation for the indices is historically low because of the narrow breadth of the rally which was first represented by the “Mag 7” and has now become the “Mag 1”. Alex Campbell (Bridgewater alum) does a great job explaining implied correlation so we don't need to here, but we will use his work as a springboard to reason through how the forces of the dispersion trade are working through the market and how they may be changing the "line" in the markets.

It is usual to see the implied volatility of the equity index fall as the index price rises. When the correlations of the stocks in a portfolio fall it lowers the volatility of that portfolio so the fall in volatility can be due to the direction of the market AND it can be due to falling correlations of the index constituents. If only a few highly volatile stocks explain the majority of the returns for the portfolio the correlation decreases which can also lower the overall volatility of the portfolio. The interplay between index volatility and the correlations of the index constituents is a very important force in the financial markets.

It's not just that NVidia makes up all the performance of the S&P 500 it's also that the rest of the index is performing so poorly which pressures implied correlation lower. NVidia can swing around with a 60 vol and the other 90% of the S&P can swing around with a 20 vol while being negatively correlated to NVidia and that drags down the index volatility.

The narrow breadth of the rally is leading to a situation where both the direction of the market and the correlation of the market are combining to pressure volatility lower. Alex frames it this way:

What if we told you that, because of the way NVidia is dominating the S&P, this correlation term was getting artificially suppressed by the very people gambling on it, in a way that would (eventually & inevitably) blow up Time to Hedge?

The market makers in NVidia are likely struggling to run balanced books as the flows are all tilted to the upside with high vol. It’s like if the everyone is betting on the 49ers in the Super Bowl the bookies will either need to offlay their action or move the line. ?If they are short vol on NVidia they can get exposure to NVidia vol through S&P 500 options however how vol and correlation interact can change what sort of exposure the NVidia market makers may desire. For example, if the flows in NVidia reverse it would be logical to assume that the S&P implied correlation would increase which would benefit long vol positions in the index. However, if the flows stay the same the index implied correlation would continue to be pressured lower which would hurt long vol positions in the index. Therefore, if a NVidia market maker hedges their short vol exposure using the index by getting long index vol they are implicitly betting that correlation will increase. The difference between implied and realized correlation can be thought of as delta or directional risk as in this case if the flows in NVidia reverse (the stock drops) all else being equal you would expect implied index correlation to increase which would benefit long vol index positions, especially to the downside. I may have lost some of you there but bear with me, it will hopefully make sense in a minute.

If we look at the historical implied volatilities of the index and NVidia we can get an idea of how attractive it is to use the index to hedge NVidia risk. Andy Constan shared the chart below on X which shows that relationship and how NVidia implied vol has consistently been lower than the current break-even level over the past five years. That means it is not attractive to hedge NVidia with index vol because NVidia vol, which the market makers are probably short, is lower than it should be relative to the index. This makes intuitive sense as there are no free lunches in the market, especially for market makers. It also means it is incentivizing market makers to be short correlation or bet on the status quo continuing. This is what I think Alex is referring to in the quote above.

We often talk about reading the markets to identify the players acting on the market and the above analysis is just another element of this. Reading the market is about observing how flows work their way through the market and recognizing when those flows create favorable odds. Professional investors will argue that edge does not reside on closing sheets, meaning that favorable odds are not available for long, and while this is mostly true, it misses the edge that comes from being able to read your opponents. This sort of edge sits on closing sheets all the time and for long durations. It is similar to the edge available to macro traders who basically front run pension and endowment rebalancing flows.

The market generated information from the S&P 500 futures market indicates that the marginal buyers taking the market higher are the laggards. The laggards are the last to move in any market cycle and their domination of market activity indicates that we are in the late innings of this cycle. At the same time the correlation markets are encouraging investors to continue betting on more of the same until the flows change and the line changes.

The option implied probability distributions confirm this reasoning as we see how the modal outcome has shifted to the right and is narrow (or the market implied probability of no change are high). In the case of GME we saw how the flows created a situation where the probabilities were skewed to entice people to get long, but in the broader market we see how the flows are creating odds to entice people to bet on change because the market is offering favorable odds on change.

The forces and counterforces in the markets today are making the market-implied probabilities for the status quo increasingly higher; or in other words the market is giving you odds to bet on things changing. The markets are not finding counterforces to the flows and are therefore enticing those flows to bring balance to the market. As this continues it is like plugging hole after hole in a leaky damn, the pressure continues to build and the distribution gets skinnier and skinnier offering better and better odds to the tail outcomes. This is why Alex said it would eventually blow up; or as Hyman Minsky put it:

Stability is Destabilizing Hyman Minksy

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