Odd Lots - Lots More With Charlie McElligott on the Sharp, Strange Selloff

Episode Date: March 21, 2025

Last week, the US market sold off sharply. The S&P 500 fell as much as 3.6% on Monday alone, entering technical correction territory. Momentum trades were hit particularly hard and stocks that had been winners for years suddenly became losers, while ones that had been losers suddenly outperformed. Perhaps the strangest thing though, is that volatility didn't really surge as things sold off. The VIX — sometimes called Wall Street's "Fear Gauge" — went up, but it didn't even reach levels that we saw in 2024 or 2022. So what happened? And why was the selloff so short and kind of strange with the lack of vol? On this episode, we speak with Charlie McElligott, Nomura strategist, about what exactly has been happening.Read only: Hedge-Fund Momentum Bets Crater All at Once in Volatile MarketsThe S&P 500’s Meltdown Into a Correction Only Took 16 DaysOnly Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox — now delivered every weekday — plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

This is Tom Keene, inviting you to join us for the Bloomberg Surveillance Podcast. It's about making you smarter every business day. I'm Paul Sweeney. We bring you complete coverage of the U.S. market open. We cover stocks, bonds, commodities, even crypto, all the information you need to excel. And I'm Alexis Christophers. Bloomberg Surveillance also brings you the analysis behind the headlines. We do that through conversations with the smartest names in economics, finance, investment, and international relations.

We do all this live each and every weekday that bring you the best analysis in our daily podcast. Search for Bloomberg Surveillance on Apple, Spotify, YouTube, or anywhere else you listen. On the East Coast, listen at lunch. And on the West Coast, listen as soon as you wake up. That's the Bloomberg Surveillance Podcast with Tom Keene, Paul Sweeney, and me, Alexis Christophores.

Subscribe today, wherever you get your podcasts. Bloomberg's Surveillance, Essential Listening, each and every business day. Bloomberg Audio Studios. Podcasts, Radio News. It's good. It's good. You know, markets are fun and, you know, as we said,

springs here. Yeah, markets finally got interesting. Oh, man. I mean, I have so many thoughts. Oh, good. All right. If you can't tell from my normal stream of consciousness operation. You know how I know it was bad, Joe.

Go on. It was one of those weeks where we talked about. about negative gamma quite a lot. What's gamma again? Interestingly, we didn't talk that much about standard deviations, which is kind of funny. Normally, those two kind of go hand in hand, but not last week. It was weird.

What's gamma again? I feel so dumb because I know we've talked about gamma, and it's just one of those things. Like, what is it again? Should we get you a refresher? Yeah, I need one of those Guide to the Greeks books or something. Or like a little, like, laminated card that I can like. Someone should do a coffee table book.

Yeah. Yeah. Guide to the Greeks. I like Greek stuff these days, you know, because I'm into like ancient history and everything like that. I know what Alpha is. I know what Beta is. After that, I started to get a little dicey. I did a deadlift.

I'm both the most popular trader and most successful trader at Citadel. Fed is going viral. Barges. This is an after-school special except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Black gold. These are the important questions. Is it robots taking over the world?

No, I think that, like, in a couple of years, the AI will do a really good job of making the Odd Lots podcast. One day that person will have the mandate of heaven. How do I get more popular and successful? We do have The Perfect Guest. You're listening to Lots More, where we catch up with friends about what's going on right now. Because even when the Oblots is over, there's always lots more. And we really do have The Perfect Guest. Oh, the definition.

I feel like I've done this before. for. But gamma, gamma is the option sensitivity to the change in delta, and delta is the option sensitivity to the underlying price. So gamma is like the change of the change. It's a function of the underlying price, but it's second order. And I guess negative gamma, that's when delta is in the opposite direction to the stock price movement. So delta goes down if the underline asset price is going up, and then it becomes less negative if the underlying asset price is falling. And we usually see people talk about this during market sell-offs because all the options traders have to basically sell or buy stuff to hedge all that changing exposure. And the

suspicion is always that that hedging activity are pushing the market in one way or the other. I think that's it. Okay, I did it. Charlie, you should You should write a book, a coffee table book on the Greek letters? I'm liking this like Spartans versus Romans history vibe we're going. Yeah, that's very you. I feel that's very good. Yeah, yeah. It resonates.

Yeah, I know. It resonates. It could have something to do with the beard. Well, if you just think about it with regards to who is long and who is short an option at a certain level. And that's so much of what we're asked to do in our job is to get a sense for where these potential acceleration points or potential gravity points, are. And you're looking at the whole spectrum of strikes across the S&P index options. And you're then

doing your kind of risk calculations and your Greeks calculations and you net out all of those strikes. You have to identify calls sold, calls bought, puts sold, puts bought, multi-legged tracks. It's quite complex. I think in the past, there's a lot of false narrative because people made kind of two core assumptions on dealer positioning before you had the actual exchange tagged the data, which now gives you the actuals. Those two prior assumptions are the dealers are short puts to hedgers and long calls from overriders, these VRP volsellers that you hear so much about these days that create dynamics where the market is trapped in long gamma, right?

Because we're constantly, dealers are constantly getting stuffed from these premium collectors. Yeah. But short gamma matters because that's where you get these potential jump-off points, where you, you blow through a level or a dealer is short, a strike, and then you get that prevailing. market move is fed into. So that matters. In case you can't tell, we are here with Charlie McGilligate. He is, of course, a strategist over at Nomura, the person to talk to when it comes to this

kind of market technicality. And we are recording this on March 19th. We're either stupid or brave for doing this, like, right before a Fed decision. I'm going to choose brave because the bar is fairly low. Now that is. So my view is, like, there's been. so much volatility lately, Tracy, regardless of what happens in the 48 hours between now and then, there's enough to talk about.

Yeah, for sure. Okay. So speaking of what happened last week, you mentioned specific points at which the sell-off can accelerate. And I think in your notes, you had like 5,650 and 5,000, 560, something like that, as your points on the S&P 500, at which point the sell-off could accelerate. We did get to a low of like 5,500 on the Thursday, but we saw stocks recover.

Why did that happen? So there was two large short gamma strikes in the S&P index options, diaspora for dealers, and I think it was, I think it was 5,600, and then 55-65-p, a particular level, which is part of this large listed trade in the market that is well socialized out there that at the end of this month, so not this week's

options expiration, but the end of this month, the March quarterly exists and is part of something called a put spread caller where a call is sold out of the money to then help finance this put spread in the market. And that 55-65 is a short strike, which means that in this case, it looks like short gamma. I think the fact is about that, however, and thus this idea of at this point in the month where it's still a few weeks out from happening, it could, in fact, potentially behave as you would think,

as this acceleration point through it. Once you did, you kind of bounced around. It held three or four times, and it kind of cracked through it. The thing is that the market knows that this trade gets rolled and rebalanced, I should say, into the next quarter's trade at the end of this month.

And you know that there is going to be a ton of Vega for sale as part of this. And so then this strike in some ways actually ends up looking quite dissimilar from your typical idea of short game as this acceleration point, depending on where the market is at the time of expiration, which will affect what the client does with those strikes and sets the new put spread collar. But I think the larger conversation that I want to have about VAL is that much of the incoming has been about why is VAL actually seemingly unresponsive. Yeah. So the VIX, like, I know the VIX went up, but I think it went to like 29 and you compare that to like, it was above 80 in 2020. And even in 2022, it was like 36 or in the 30s. VAL was really quiet. Even in 24. Yeah.

So August 2024 got nearly to 40. Anyway. Yeah. So the. last time I was in here was after that August shock. And that was it proper, as I kind of framed it at the time and still well, the world was aggregated around this soft landing viewpoint. And all of a sudden, in the span of one day's worth of data, but it was really even a week of data. Well, the fixed got to 65. Yeah. And that was because we repriced the left tail. All of a sudden, there was a hard landing risk because the labor data shocked us, you know, that U-rate jump and then the NFP miss. the difference this time around is that since the election, right, Donald Trump is the personification of a gamma agent. You are the only person I know who describes Trump as a gamma agent.

Everyone has their terms. Right. But I mean, a living personification of gamma. And I think, look, his mandate is to break status quo. Right. And we talked that last August shock about the idea that the concept of a carry trade, because we were being asked about, the end carry on wine, which is kind of like this false narrative. But the idea of any sort of carry trade or positioning high sharp ratio trade, right,

high risk-adjusted return is that you need a period of low volatility to kind of aggregate that position, to build that leverage into the trade because it keeps working. The vol is low. The price keeps working higher. That builds the leverage in the system. That hence builds the risk, right? Stability breeds instability. In this case, Donald Trump, even if the market was.

misidentifying the macro of his policies at the time, which we should talk about. Oh, you're just never going to get that risk buildup? Well, in this case, starting November, you know, when it really took shape, and I think the market had been sensing, certainly since kind of the summer, skew was seepening. Skew matters, right, just as a relative measure of kind of demand for downside versus demand for upside. Put skew, which is like deep out of the money downside relative to not the money put, was jacked 90-something percentile because of all of the potential chaos agent.

So fall is getting more expensive. So Val was already quite expensive going into this scenario, even if maybe the macro catalyst went wrong way. And I think there's two big things that happen. So let's talk about this past week. It really was past three weeks. Yeah. You had crowded narratives and crowded thematic positioning with a lot of leverage.

Right. That is what the prime brokerage data shows and frankly still shows like gross exposure, your longs and your shorts in aggregate, still kind of 90-something percentile, was 100 percentile. Coming into the year, though, we also had high nets. So you had a lot more long than short. Either way, a lot of leverage in the system. Give us like a little zoom out, basically from mid-November to, as you said, about three weeks ago it started turning.

I think the peak on the S&P is February 19th or something like that. Yes. But talk to us just about that sort of kind of an upcrash in the wake of the election, people loading into everything risky from crypto to Tesla and everything. False narratives. Yeah. What was going on there? And then how extreme did that get?

Yeah. I mean, that's the perfect segue here. Because like in the sense that the post-election narrative and remember, the rates sell off beginning in September when the market really got their arms around, seemingly some of this polling that was showing much more credible kind of Trump lead. The rate sell off, meaning yields going higher, was about this idea that regardless of who won, but particularly of Trump won, that we had become, both sides had become economic populace and that fiscal dominance was this overriding theme where like we don't have a tolerance for pain

as a society. We saw the kind of the steroidal impact of fiscal stimulus in the post-COVID world, which kind of was the tiebreaker for finally getting an inflation shock, as we all experienced. So this idea that he was going to take an already strong economy and overheat it with DREG, with tax cuts, and these other stimulative measures completely had the market thinking about further extension of U.S. exceptionalism, right? This ability to outperform rest of the world for a whole number of reasons, which is a separate podcast, but like positioning was like long U.S. assets.

Europe was going to be cutting sooner because they were feeling the brunt of the slowdown force more so there. China had all sorts of issues, right? Rest of world struggling U.S. exceptionalism and part of U.S. exceptionalism, not just kind of like global hegemon, strongest economy, deregulation, all these stimulus measures in the pipes, was also, too, this idea of tech innovation. And tech innovation was the story of last year and the last two years with regards to AI, right? Yeah, it used to be Fang back in the teens, right? So this idea of mega-cap tech, all those things that made people, you know, that completely dictated stock market last year, like Mag 7, Mag 8, 35% of the S&P 500, 50-some

percent of the NASDAQ, concentration of all of these kind of tech and disruption themes in the market, that was a big part of the U.S. exceptionalism trade. Well, guess what? Those trades are really crowded. They're really loaded into, and two shocks happened. The first shock was the market, and this is why I started going out and talking about hedging for downside in February, was this idea that the market, I think, was misunderstanding the phasing or the sequencing of a Trump economic plan, which was you've got to do the painful stuff first

in order to get to the stimulative stuff later. And that spread, that time spread, you know, you had to kind of try to engineer a slowdown to then be able to get the rate cuts via the disqualive. inflation that he is trying to create, which ultimately, you know, this idea of like fiscal contraction to potentially then fiscally expand, you can even say. The other shock that's lost in the wash here, and this wasn't just a Trump gross scare, right? We already gross scare every Q1 into Q2. That's an artifact of the post-COVID economic rule. We had a good piece from Neil about, Neil Dut about that. Anyway, keep clear. Yeah, so that matters, right? You know, that was part of

my thesis. Like, look and see the trajectory. We have these overheated animal spirits. it's Q1 numbers, and then the seasonal adjustments kick in, and we have a gross scare in Q2 or into Q3. But the other element here was the deep seek story in tech innovation, in that market concentration. And guess what? Those names aren't just massive parts of index and massive thematic parts, retail investors and hedge fund longs and things like that.

Think about their impact in the leverage DTF space, which is just absolutely grown massively. That's a source of synthetic negative gamut in the market, which on their end of day rebalancing into an up day, they've got a ton to buy at the end of the day. And 80% of those assets happen to be concentrated in kind of like concentric tech disruption circles. So you add in this massive rethink on what had been the perpetual motion machine

of AI CAPX and that deep seek shock. And Vivida trades down 17% kind of after that realization that weekend of what we're looking at. All of a sudden, a massive valuation shock in an earnings repricing effectively. Tracy, did you? you see this from Eric Belcunis yesterday, Vista Shears filing for an animal spirit ETF A-N-I-M and a 2-X animal-spirits ETF wild, which will hold the five fastest-growing 2-2-X single-stock ETFs at any given time. Isn't that just called momentum?

Yeah. But that's not, that momentum isn't enough. It's momentum with leverage. And guess what? There will be options on it, too. Yeah, that's crazy. So there's synthetic negative gamma and actual real negative gamma. So the final point here is you had these two shocks to what consensus was, consensus positioning, and consensus narrative.

Now, all of a sudden, this realization that phase one is going to have to engineer a slowdown to get the stimulative stuff that Trump wants to do. Yeah, isn't that weird? Like, why are we crashing economic growth to boost economic growth? Well, because I think in this case, like, there is something credible to the idea that the deficit spending was a market concern, right? I mean, think about what rates were doing last year when we were talking about fiscal. dominance. What's ironic here is that you then get punished for trying to address it. So look at Europe, for instance, and this is like a big trade in the market right now. It's like very simplistic, but this is the way that asset allocators think can move, right? Who's fiscally contracting and tightening and who's fiscally expanding and stimulating?

Europe, right? Trump said, look, we might be talking about the end of Bretton Woods post-World War II Pax Americana here, right? We're no longer going to protect you for you to buy U.S. dollar assets. and use our currency. So guess what? Europe has to go out, create this financing. And with that, all of a sudden, now they are a fiscal expander after years of being the source of It's a real regime shift. It's a real potential regime shift, even though I think this ultimately creates the conditions where if you do kind of crash the economy and you can't stick the landing on this engineered recession, then you inevitably have to fiscally expand. And that's why I think a lot

these long Europe, long China trades will be quick to move their feet. I can't say this is a tectonic, permanent structural shift yet because the worst it gets for us and we get punished and you have fiscal tightening and market sell off and all those bad things that create a negative wealth effect, which in the short term help get the disinflation to get the Fed cuts. Right. Right. To get the stimulus through. Right. This is all part of this kind of second order of thinking that you need to be looking into. Okay, so we had a wild but not disorderly sell-off. Sounds like my high school report card. But I imagine it was still painful for certain investors. So we just mentioned momentum. Like, that must have been painful. Multi-Stratz must have had a hard time because we saw a lot of

the overperformers underperforming and the underperformers suddenly overperforming. How was it? Give us some, like, market color. Well, in some of those, I mean, you look at the biggest multistrats that have been 100% of the net alternative investment, or hedge fund inflow over the past X number of years, right? So like long short isn't where it's at anymore. It's about the market neutrals. And that's just speaking to like their equities components. But of course they have these other risk diversifying strategies with incredibly tight risk management, tight stops.

And that's how when you apply a lot of leverage to these small controlled market neutral gains, You then get these incredible annual returns that those biggest shops have been posting. But the fact of the matter is crowding happens and leverage on top of crowding happens. And then shadow leverage happens with leveraged DTFs. Leverage on leverage. And vault control, target volatility, and CTAs and all that stuff is synthetic negative gamma in the market. So even where, you know, there's a very well publicized loss with regards to index ARB, you know, at one of these funds or whatever, I think that was probably negatively impacted.

that they have to model out the flows across the diaspora of things out there at the end of the day to do their index ads and deletes, well, they were probably getting screwed with by a lot of the leverage ETF flows at the end of the day that are completely nuking and creating these big overshoots and these big negative gamma type moves. So the long story short is that for the month of February, let's say, talking with people deep in the inside senior traders and whatnot, these were losses, one month losses that people had not experienced that have been there, you know, four or five type years in places that just don't lose money. just stop you so effectively. Now, it is a tribute to the model, however, that there's no blowups. There's no LTCMs here. I mean, yeah, they didn't make money. They might have had a worst month or in the start of March was also, you know, going the wrong way too, but you're not going existential here. Yeah. So that actually speaks to the model working. The bigger issue, and I think the bigger thought process takeaway here is that when you have trades over a period of time are built

on the status quo of U.S. exceptionalism, right? That is effectively a carry trade. And we had leverage built into the system for 15 years of QE. We had leverage built into the system from modern monetary theory and the outright money drops that we've done over the past five years. Joe, that's your fault. So, yeah, my way. Yeah. So, I mean, all of these things created this ugly de-leverging effect, even at market neutral shops, the good news is it wasn't a vol feature. It wasn't a vol event because we were already hedged. That's why skew was high. Implied vol was high. Although put skew was high. So it didn't become a vol event, which is where you get some of those accelerant flows to kick in. On this note, I have a slightly weird question, but could we ever get

to the point where the volatility complex is so large and so in demand that you're just never going to have a volatility event like we saw in 2018, something along those lines, because everyone is paying through the nose for downside protection. Well, I mean, ironically, it's when you're well hedged that you then have a condition where you can create the crash, right? Which means that dealers are short all these puts. I guess you have to have sellers on the other side, too. That's the big thing, that we've conditioned the behavior, whether it's, you know, Fed stepping in, that moral hazard dynamic, or nowadays politicians, fiscal stepping up, whether it's Silicon Valley Bank and 70 different new five-letter acronym liquidity special features in the market that put out fires. And that's why the

back test on vol selling strategies and the AUM and VAL selling strategies just keeps working. Like, you sell the panics. And that's what, ultimately what ends up happening when you have this short-optionality dynamic in the market, whether it's dealer's short, real downside hedges, or it's It's CTA trend, flipping from along to a short and having to sell more the lower it goes, or target volatility funds is like a hedge overlay doing the same thing. Or leverage DTFs, you get the point now. What ends up happening is that it's the option sellers that stop the problem because they come back in, they give dealers back their gamma, they sell option out of they sell rich vol,

the market stabilizes, ranges compress. You need to keep feeding volatility. Volatility is mean reverting. And if you can't keep having daily one and a half percent moves, which is a big ask, you need persistent new bad news. Otherwise, realize volatility compresses, ranges compress. Vol sellers feel more confident. They fill in. Dealers get long gamma.

We stabilize. People start covering their monetizing their hedges. They take those off. That creates delta to buy. The market starts rallying. People buy short-dated upside. It squeezes it. That's the cycle that we're on, like this really short-term ecosystem.

But volse sellers are, I would say, the bigger players now than hedge buyers. And that's a real footprint of the past 20 years ever since QE, where the previous buyers of volatility were real asset managers, like long onlys and things like that. After QE, a lot of those folks, big pension funds, became sellers of volatility. Yeah, this was Bill Gross's thing when he stood up on stage and said, everyone sell volatility. That's like the only trade right now because nothing is happening. Right. Nothing's happening.

You have to bet on nothing. Until now. Yeah. Maybe. Maybe. Until now, maybe. One other point I would make on volatility. The reason that it got so wacky in August, for instance, was the fact that conditioning

that says sell the rich vol. And remember, like the non-farm payroll and u-rate data was that Friday. And we crashed hard. But everybody was so conditioned that we closed the market that day with anybody in the ball space saying, I want to be short vol, short delta. I want to sell this rich vol, but still think the market normalizes. because we can't maintain this richness and volatility. Well, then the Niki opened down 12%

because it was like a kind of a hot leverage trade at that time. And it was the second day that got people stopped out. The other point here, too, was that that day of Friday, one of the largest vol players in the market, thinking that they were doing themselves a solid and hedging by buying VIX calls, ended up creating their own demise in a sense. Because that created some of that short, VIX's convexity that then really went wild over the span of the next day and a half and created a

bigger issue within the Vol complex. So this is the idea that when you have buyers of hedges, they actually create the conditions for the crashes. Right. Well, I guess we'll see what happens with the Fed meeting. And we'll see if there's like a big regime shift because it's eventually, right, maybe, maybe something will change. Maybe, maybe one day mean reversion will come to an end. Volatility is mean reverting normally. Maybe. But we're not in normal times, so we'll see. Lots more is produced by Carmen Rodriguez and Dashel Bennett

with help from Moses Ondom and Kail Brooks. Our sound engineer is Blake Maples. Sage Bowman is the head of Bloomberg podcasts. Please rate, review, and subscribe to Odd Lots and Lots More on your favorite podcast platforms. And remember that Bloomberg subscribers can listen to all our podcasts ad-free by connecting through Apple Podcasts.

Thanks for listening.