Global Quantitative and

Derivatives Strategy
27 August 2015

Market and Volatility

Commentary
Technical Selling - How Low Can It Push Equities?
In the report below, we discuss the technical selling from derivatives hedgers,
Trend Following strategies (CTAs), Risk Parity portfolios and Volatility
Managed strategies.

Quantitative and Derivatives

Strategy
Marko Kolanovic, PhD

AC

(1-212) 272-1438
marko.kolanovic@jpmorgan.com

Bram Kaplan, CFA

(1-212) 272-1215
bram.kaplan@jpmorgan.com

Arjun Mehra (AJ)

(1-212) 622-8030
arjun.mehra@jpmorgan.com
J.P. Morgan Securities LLC

See page 5 for analyst certification and important disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the
firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in
making their investment decision. In the United States, this information is available only to persons who have received the proper option risk
disclosure documents. Please contact your J.P. Morgan representative or visit http://www.optionsclearing.com/publications/risks/riskstoc.pdf.
www.jpmorganmarkets.com
This document is being provided for the exclusive use of DANIELLE BUTINDARI at JPMorgan Chase & Co. and clients of J.P. Morgan.

Marko Kolanovic, PhD

(1-212) 272-1438
marko.kolanovic@jpmorgan.com

Global Quantitative and Derivatives Strategy

27 August 2015

The current market selloff and spike in volatility is largely attributed to developments
in China and uncertainty about the impact of expected Fed hikes. However, much of
the Equity trading in the last few days was done by systematic investors that dont
rely on fundamentals. In this note we examine the impact of technical investors such
as CTAs, Risk Parity funds, insurance VA programs and derivatives hedgers.
In our Friday note we forecasted end-of-the-day selling pressure due to option
gamma hedging. We saw similar price impacts on Thursday, Friday, and Monday
(pushing the market lower into the close) and an upside squeeze on Wednesday. Our
estimate is that up to 20% of market volume was driven by hedging of various
derivative exposures such as options, dynamic delta hedging programs, levered ETF
stop loss orders, and other related products and strategies (note that levered ETFs
have gamma exposure of only ~$1bn per 1%, i.e., much smaller than that of
S&P 500 options). We estimate the cumulative selling pressure from options hedging
during the market selloff to be ~$100bn. Options gamma is expected to remain
substantially (in excess of $20bn) tilted towards puts while the S&P 500 is between
1850 and 2000 (Figure below right shows Put-Call Gamma assuming current open
interest and different spot prices). We expect high volatility to persist (should we stay
in this price range) and cause quick intraday moves up or down, particularly towards
the end of the trading day.
Derivative hedgers are not the only investors that fall into the category of priceinsensitive traders. In fact, there is a much larger pool of assets that is
programmatically trading equities regardless of underlying fundamentals. In the
current environment these investors are selling equities and will negatively impact
the market over the coming days and weeks.
Trend Following strategies (CTAs), Risk Parity portfolios, and Volatility
Managed strategies all invest in equities based on past price performance and
volatility (for a detailed description of these strategies see our reports: Momentum
Strategies Across Assets and Risk Factor Approach to Investing). For instance, in our
June market commentary we showed that if the equity indices fall 10%, these trend
followers may need to subsequently sell ~$100bn of equity exposure. These types of
price insensitive flows are starting to materialize, and our goal is to estimate their
likely size and timing. These technical flows are determined by algorithms and risk
limits, and can hence push the market away from fundamentals.
The obvious risk is if these technical flows outsize fundamental buyers. In the current
environment of low liquidity, they may cause a market crash such as the one we saw
at the US market open on Monday. We attempt to estimate the amount of these flows
from three groups of investors: Trend Following strategies (CTA), Risk Parity
portfolios, and Volatility Managed strategies. These investors follow different signals
and have different rebalancing time frames. The time frame is important as it may
give us an estimate of how much longer we may see selling pressure.
1.

Volatility Target (or Volatility Control) strategies provide the most

immediate selling as a reaction to the increase in volatility. These strategies
adjust equity leverage based on short-term realized volatility. Typical signals are
1-, 2-, or 3-month realized volatility. Volatility target products are provided by
many dealers, index providers and asset managers. Volatility targeting strategies
also became very popular with the insurance industry. After the 2008 financial
crisis, many Variable Annuity (VA) providers moved from hedging their equity
exposure with options to investing directly in volatility target indices (e.g., 10%
volatility target S&P 500). It is estimated that VA issuers have ~$360bn in
strategies that are managing volatility; some of these use options to manage tail
risk, some buy low volatility stocks, and some invest in volatility target
strategies. We estimate that strategies that are targeting a particular level of

This document is being provided for the exclusive use of DANIELLE BUTINDARI at JPMorgan Chase & Co. and clients of J.P. Morgan.

Marko Kolanovic, PhD

(1-212) 272-1438
marko.kolanovic@jpmorgan.com

Global Quantitative and Derivatives Strategy

27 August 2015

volatility or managing to an equity floor could have $100-$200bn of assets.

Assuming that, on average, these strategies follow a 2-month realized volatility
signal, we can estimate their selling pressure. 2M realized volatility increased
over the past week from ~10% to ~20% (i.e., doubled), so these strategies need
to reduce equity exposure by up to ~50% to keep volatility constant. This could
lead to $50-$100bn of selling, and it likely started already this week. There is
often a delay of 1-3 days between when a signal is triggered and trade
implementation, and positions are often reduced over several days. We think this
could have contributed to the unexpected selloff that happened in the last hour
of Tuesdays trading session. While these flows may continue to have a negative
impact over the next few days, they would be the first to reverse (start buying
the market) when volatility declines.
2.

Trend Following strategies/CTA funds have an estimated ~$350bn in AUM.

We modelled CTA exposures in our May and June commentaries, and estimated
flows under different scenarios for asset prices. In particular, under a 10% down
scenario in equites we estimated CTAs need to sell ~$100bn of equities. In our
model, the bulk of selling was in US markets, some in Japan and relatively little
in Europe. S&P 500 futures did underperform Europe (by ~3%) and Japan (by
~2%) over the last two trading sessions (European hours), which may indicate
that CTA flows have started to impact equity markets. The rebalance time frame
for CTA strategies is typically longer than for volatility control strategies. CTA
funds may act on their signal in a period that ranges from several days to a
month. We believe that selling from CTAs may have just started and will
continue over the next several days/weeks.

3.

Risk Parity is one of the most popular and (historically) successful portfolio
construction methodologies. Risk Parity allocates portfolio weights in proportion
to assets total contribution to risk (a simplified version, called Equal Marginal
Volatility allocates inversely proportional to the assets realized volatility). In a
survey of quantitative investment managers (~800 clients in US and Europe), we
found that ~50% prefer a Risk Parity approach (vs. 15% for traditional fixed
weights (e.g., 60/40), 20% Markowitz MVO, and ~20% active asset timing).
Estimated assets in Risk Parity strategies are ~$500bn and ~40% of these assets
may be allocated to equities. Risk Parity portfolios may also incorporate
leverage, often 1-2x. Risk parity funds often rebalance at a lower frequency
(e.g., monthly, vs. daily for volatility target) and use slower moving signals
(e.g. 6M or 1Y realized volatility). The increase in equity volatility and
correlation would cause Risk Parity portfolios to reduce equity exposure. For
instance, 6M realized volatility increased from 11% to 15% and a modest
increase in correlations would result in approximately a ~20% reduction of
equity exposure. Based on our estimate of Risk Parity equity exposure, this
could translate into $50bn-$100bn of selling over the coming weeks.

This document is being provided for the exclusive use of DANIELLE BUTINDARI at JPMorgan Chase & Co. and clients of J.P. Morgan.

Global Quantitative and Derivatives Strategy

27 August 2015

Marko Kolanovic, PhD

(1-212) 272-1438
marko.kolanovic@jpmorgan.com

Figure 1: Trading signals

Figure 2: Intraday performance on Mondays open

20

S&P 500 2M Volatility

~40% Deleverage of
Vol Target Strategies

15
S&P 500 6M Volatility
~20% Deleverage of
Risk Parity Strategies

10

1870

1860

1850

1840

5
1830

0
Feb, 27 Apr, 03 May, 08 Jun, 12

Jul, 17

S&P 500 Average

Aug, 21 12M, 6M Return
CTAs Sell Signal

-5

1810
9:30:00

Source: J.P. Morgan Equity Derivatives Strategy.

7% S&P 500 Futures Limit

1820

8% Drop Indicated by Stocks

9:30:51

9:31:41

9:32:31

9:33:21

9:34:11

9:35:01

9:35:51

Source: J.P. Morgan Equity Derivatives Strategy.

Figure 3: Put-call gamma imbalance by strike

-5
S&P 500 Put-Call Gamma ($Bn)

-10
-15
-20
-25
1750 1810 1870 1930 1990 2050
Source: J.P. Morgan Equity Derivatives Strategy.

Based on the above, we estimate that the combined selling of Volatility Target
strategies, CTAs and Risk Parity portfolios could be $150-$300bn over the next
several weeks. Rebalancing of these funds may appear as a persistent and
fundamentally unjustified selling pressure as these funds execute their programs. In
addition, there may be a positive feedback loop between all of these sellers Gamma
hedging of derivatives causes higher market volatility, which in turn leads to selling
in Risk Parity portfolios, and the resulting downward price action invites further
CTA shorting. All of these flows pose risk for fundamental investors eager to buy the
market dip. Fundamental investors may wish to time their market entry to coincide
with the abatement of these technical selling pressures.
A good example of how price-insensitive sellers can cause market a disruption/crash
is the price action on the US Monday open. We believe that technical selling related
to various hedging programs, in an environment of low (pre-market) liquidity indeed
caused a flash crash on Mondays open. S&P 500 futures hit a 5% limit down preopen, and then a 7% limit low at 9:31 and 9:33. The inability of hedgers to short
futures spilled over into large cap stocks that were still trading and could be used as a
proxy hedge. Had it not been for the futures limit down event, the selloff would
likely have been worse as indicated by the price of the index implied by individual
stocks. Figure 2 shows the S&P 500 futures, SPY ETF and S&P 500 replicated from
the largest stocks that were trading near the market open.
4

This document is being provided for the exclusive use of DANIELLE BUTINDARI at JPMorgan Chase & Co. and clients of J.P. Morgan.

Marko Kolanovic, PhD

(1-212) 272-1438
marko.kolanovic@jpmorgan.com

Global Quantitative and Derivatives Strategy

27 August 2015

Risks of Common Option Strategies

Risks to Strategies: Not all option strategies are suitable for investors; certain strategies may expose investors to significant potential
losses. We have summarized the risks of selected derivative strategies. For additional risk information, please call your sales
representative for a copy of Characteristics and Risks of Standardized Options. We advise investors to consult their tax advisors and
legal counsel about the tax implications of these strategies. Please also refer to option risk disclosure documents.
Put Sale: Investors who sell put options will own the underlying asset if the assets price falls below the strike price of the put option.
Investors, therefore, will be exposed to any decline in the underlying assets price below the strike potentially to zero, and they will not
participate in any price appreciation in the underlying asset if the option expires unexercised.
Call Sale: Investors who sell uncovered call options have exposure on the upside that is theoretically unlimited.
Call Overwrite or Buywrite: Investors who sell call options against a long position in the underlying asset give up any appreciation in
the underlying assets price above the strike price of the call option, and they remain exposed to the downside of the underlying asset in
the return for the receipt of the option premium.
Booster : In a sell-off, the maximum realized downside potential of a double-up booster is the net premium paid. In a rally, option losses
are potentially unlimited as the investor is net short a call. When overlaid onto a long position in the underlying asset, upside losses are
capped (as for a covered call), but downside losses are not.
Collar: Locks in the amount that can be realized at maturity to a range defined by the put and call strike. If the collar is not costless,
investors risk losing 100% of the premium paid. Since investors are selling a call option, they give up any price appreciation in the
underlying asset above the strike price of the call option.
Call Purchase: Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlying assets price is below
the strike price of the call option.
Put Purchase: Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlying assets price is above
the strike price of the put option.
Straddle or Strangle: The seller of a straddle or strangle is exposed to increases in the underlying assets price above the call strike and
declines in the underlying assets price below the put strike. Since exposure on the upside is theoretically unlimited, investors who also
own the underlying asset would have limited losses should the underlying asset rally. Covered writers are exposed to declines in the
underlying asset position as well as any additional exposure should the underlying asset decline below the strike price of the put option.
Having sold a covered call option, the investor gives up all appreciation in the underlying asset above the strike price of the call option.
Put Spread: The buyer of a put spread risks losing 100% of the premium paid. The buyer of higher-ratio put spread has unlimited
downside below the lower strike (down to zero), dependent on the number of lower-struck puts sold. The maximum gain is limited to the
spread between the two put strikes, when the underlying is at the lower strike. Investors who own the underlying asset will have downside
protection between the higher-strike put and the lower-strike put. However, should the underlying assets price fall below the strike price
of the lower-strike put, investors regain exposure to the underlying asset, and this exposure is multiplied by the number of puts sold.
Call Spread: The buyer risks losing 100% of the premium paid. The gain is limited to the spread between the two strike prices. The seller
of a call spread risks losing an amount equal to the spread between the two call strikes less the net premium received. By selling a covered
call spread, the investor remains exposed to the downside of the underlying asset and gives up the spread between the two call strikes
should the underlying asset rally.
Butterfly Spread: A butterfly spread consists of two spreads established simultaneously one a bull spread and the other a bear spread.
The resulting position is neutral, that is, the investor will profit if the underlying is stable. Butterfly spreads are established at a net debit.
The maximum profit will occur at the middle strike price; the maximum loss is the net debit.
Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels, and are not indicative
trading levels.

This document is being provided for the exclusive use of DANIELLE BUTINDARI at JPMorgan Chase & Co. and clients of J.P. Morgan.

Marko Kolanovic, PhD

(1-212) 272-1438
marko.kolanovic@jpmorgan.com

Global Quantitative and Derivatives Strategy

27 August 2015

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Marko Kolanovic, PhD

(1-212) 272-1438
marko.kolanovic@jpmorgan.com

Global Quantitative and Derivatives Strategy

27 August 2015

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Marko Kolanovic, PhD

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marko.kolanovic@jpmorgan.com

Global Quantitative and Derivatives Strategy

27 August 2015

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