Buy for the Turnaround Tuesday bounce?

I just wanted to put out a quick note this morning. The markets are obviously very chaotic this morning and they have taken on a risk-off tone. The VIX Index has spiked above its upper BB, and its term structure has inverted. Both are indications of high fear.
 

 

Should traders step in and buy for a Turnaround Tuesday bounce? Here are bull and bear cases.
 

Bull case

The market was already at a near oversold condition based on Friday’s close. Today’s price action is likely to push short-term breadth indicators into deep oversold territory. Using the 2017/18 melt-up template, the market bottomed when it hit what will likely be similar oversold conditions as today.
 

 

Based on this indicator alone, we could see a Turnaround Tuesday bounce that nimble traders could buy into.
 

Bear case

On the other hand, such a massive selloff will affect dealer positioning. Their consequent hedging of option positions has the potential to create a wave of price insensitive selling to offset their books. Kevin Muir has begun a useful series to explain the effects of option greeks on the market. Starting with Explaining OpEx Drift, differences in gamma regimes can exacerbate volatility.
 

 

Moreover, as dealers’ gamma books shift from positive to negative, expected returns change from positive to negative. In plain English, it forces selling to balance their option books. The market may have hit that inflection point today.
 

 

In a second post, Kevin Muir explains the effects of vanna:

Vanna is the change in delta due to a change in volatility.  Got that?  Yeah, I know, these option traders love giving fancy names for complicated second derivative-type measurements.

Here is why vanna is important. As volatility rises, the dealer will have to sell equity futures to hedge their book, everything else being equal:

For example, if Trump came out tomorrow and said, “if elected, I will lower corporate tax rates by another 500 basis points.” And let’s say Bernie was the Democrat’s candidate. He then responds with, “if elected, I will raise corporate tax rates by 500 basis points.” Now, let’s assume a dead-heat between the two candidates. Most people would contend there should be zero change in the level of the stock market with this development. After all, both outcomes are equally likely. However, I would suggest the market should be lower in such a scenario. Dealers would be forced to increase the volatility of their book as the projected move either way would be larger. This would result in vanna selling to hedge their positions.

In real life, dealers usually mark their books’ volatility higher from an event that causes a sudden increase in price movement. This morning’s Chinese flu is a perfect example. With the gap lower, volatility has increased. As dealers increase their volatility assumptions to reflect this new reality, they have to sell more deltas. This can sometimes feed on itself with their selling causing underlying prices to fall, which then causes volatility to rise which causes even more selling.

In other words, more hedging induced selling.
 

It’s not over

What you decide to do with any of your positions is up to you. It all depends on your time horizon, and your risk profile.

From a longer term perspective, I have pointed out that excessive bullish positioning and risk taking provided the fuel for the most recent market melt-up. Does anyone thing that it could be all unwound and the market will bottom after a one-day selloff?

My analysis yesterday (see A market stall?) showed that major market declines are usually marked by a decline of the Fear and Greed Index from an overbought reading to below 60. The index just cratered to 48 today.
 

 

My inner investor remains bullishly positioned, as he believes that this selloff is only a blip. Anyone who can’t stomach a 5-10% correction shouldn’t be committed to equities.

My inner trader is inclined to tactically take partial profits on his short positions today for two reasons:

• The possibility of a Turnaround Tuesday is a very real possibility
• Increased market volatility dictates some degree of prudence to reduce position sizes

How you react is up to you. Your mileage should vary depending on your own circumstances.

Disclosure: Long SPXU