The Equity Nirvana and Doom Loop Cycle

A general thesis on options-induced volatility.

This article was originally published at vigtec.io/learn

The back story on me is that I’m focused on quantitative-based market structure trading (and maybe some macro-overlays kinda…sorta…when they make sense, which they don’t right now). I’m also involved in some software development stuff. I’ve built and sold a couple SaaS companies and I’m now building another one (while also operating a prop trading shop). My prop shop started building apps for our own use in 2017. Those apps have since morphed into vigtec, a web and mobile platform which is an ecosystem of tools like market indicators, charting, options strategy analysis, and much more, built to help you find your market edge and squeeze the juice from the market.

We use vigtec for ourselves every day and now other people can use it too. We’re actively working on it day in and day out and hope that we continue to get user feedback and it’s able to keep growing. vigtec is now beginning to get to a place where we’re allowing other people to build on top of the platform and make their own tools to share with others to use. But enough about that, let me get to the point of this post.

We have a general thesis (AND IT’S A ‘THESIS’) about the current market structure and volatility dynamics that started in 2017. This thesis is that there are now only 2 regime cycles existent in the market that ping pong with back and forth with massive consequence:

1. Equity Nirvana
2. The Doom Loop

I’ll seek to address them here in a what?/so what? layout below.

WHAT?:

Equity Nirvana

Equity Nirvana and Doom Loop Cycle Example via vigtec’s Live Charts

these are prolonged periods of what feels like a constant “skulduggery-like” buy-side bid market structure action (bottom left to top right in charts) that have no price auction back and forth. These periods are hallmarked by suppressed volatility and non-existent selling action in equities that occur because of a combination (or all of) the following:

• Indiscriminate buying from passive indexation products in one time frame (OTF) periods.
• Stock buybacks (another form of vol suppression).
• Short vol targeting via VIX, proxies, and futures.
• Federal Reserve monetary policies promoting and encouraging vol suppression.
• Short selling “phantom bans” (most free trading apps don’t promote/support selling short).
• Negative interest rates for savers, pushing yield seeking to the riskiest part of the curve (think boomers needing 5%) that should/would be in yield instruments buying tech stocks.
• High-yield Junk debt nationalization (this is new as of April 2020).
• Free trading apps that promote options trading, of which, is predominantly call-buying activity.
• An option market that’s larger than at any time in history (thanks to free trading apps) and is now overwhelming the underlying securities market. ~ This call buying behavior ignites a positive gamma feedback loop in the sense that options dealers sell calls for securities and then must buy the underlying security to delta hedge their exposure for the calls (there’s a great deal of existing research on this effect. ~There are findings exposing that there are more calls being sold than actual underlying securities available in circulation, which effectively makes the gamma squeezes even more violent and hard to wrap your head around.
• Price is regularly experiencing overnight gap/ramp/camp action from futures trading that creates massive fair value gaps (FVGs) in the regular trading hours indexes which isn’t explored by price auctions and is left behind in the price auction system. (**these FVGs become ‘tag-targets’ for algorithmic trading systems when Doom Loops start).
• Until Doom Loops start, there are no price reversions to the mean. This is defined as “gorpy” action as it’s aesthetically just a wobbly upside drift. Typically price will remain over the bull/bear pivots and VPOC thresholds on daily time frames, never exhibiting bearish activity at all.

Equity Nirvana Example via vigtec’s Live Charts

But don’t take my word for it. Seems that this is no longer a secret and it’s now encouraged by all to take advantage of easy money. Check out this quote from a Barron’s article from December 10, 2020.

Although Equity Nirvana feels ‘oh-so-good when it hits your lips’ as Frank the Tank from the movie Old School says…it does have very uncomfortable side effects. It’s a lot like drugs in a sense. The euphoria is great but the come-down is brutal and you need more and more of it in order to sustain the high. The come down for Equity Nirvana is what we call The Doom Loop.

WHAT?:

The Doom Loop

These are periods that are the exact opposite of Equity Nirvana. Doom Loops are exactly what they sound like: they feel like “utter merciless doom” for the longs. Doom Loops are periods of rampant realized volatility, indiscriminate selling, liquidation, and anywhere between 3–7 sigma intraday trading ranges that don’t stop for 3–5 weeks. These periods are hallmarked by wild index volatility, violent short squeezes, “good-collateral” indiscriminate liquidations, and cross-asset volatility:

• One-time frame (OTF) buying and selling for ETFs and Pensions which acts as a steroid effect in Equity Nirvana cycles inversely acts as a Molotov cocktail in Doom Loops. One-time frames are the indiscriminate algorithmic buying in the specific periods each day during Nirvana.
• They’re equally (and logically) indiscriminate in their selling in the daily OTF window during Doom Loops, which is why during these times you see mass liquidations from 2:48–4:00PM ET.
• Options markets have overtaken the securities markets, so the flows in options drive everything. Therefore, the same positive feedback loop in options flips on the downside. Although retail rarely stops buying calls, it’s the institutions via index ETFs that flip during a Doom Loop and this is what causes the VIX to spike (as puts overwhelm calls).
• The VIX spike nukes the volatility suppression crowd. They’re torched and have to cover thus providing fuel for higher VIX extensions.
• Higher VIX causes many VIX-attached derivative overlays to be readjusted, rebalanced, or worse, liquidated.
• VIX attached derivatives as well as regular derivatives are also normally attached to some futures concoction in many ETF/ETN products. Therefore, as the derivatives are readjusted, rebalanced, or worse, liquidated, the futures markets are hit with volatility and create large overnight gaps down as global intertwined markets react in a domino fashion to the selling during the U.S. RTH sessions.
• With the options market, you add fuel to the already lit fire. Gamma exposure (GEX) in this environment flips as the trading ranges expand. During the Nirvana cycle, GEX = buy the dip and sell the rip as retail/institutions buy calls and then sell them to rotate further out or collect profits. During the Doom cycle, GEX = sell into weakness and buy into strength as the dealers rebalance delta exposure as the put buying/selling overtakes the call buying, which exacerbates intraday volatility even further. Think of this as the gas on an already lit fire.
• Pensions and institution thresholds get tested/breached. Most large institutions and pensions have thresholds that must be adhered to per their prospectus, documents, etc. When these levels are hit, even more selling comes into the marketplace as they liquidate as required — again indiscriminately. This also dramatically impacts things such as high-yield junk bonds.
• Flight to the USD: In times of illiquidity, everyone flocks to collateral. Gold is sold for margin calls. Treasuries are liquidated for margin calls. (*FWIW Bitcoin isn’t collateral. It’s a spec instrument so it’s always liquidated ahead of these cycles as it’s usually a canary of excess liquidity running dry.) Ultra-short duration bonds are often sold for margin calls if required (even CDs can see liquidation). What does everyone want in times of illiquidity? Well… liquidity. So, there’s a flight to safety in the USD that exacerbates index volatility in a similar way that the options market does. It’s more fuel to the fire in a Doom Loop.
• Oh…and fear. Naturally fear is an exponentially more powerful emotion than greed. Humans, although quite a decreased proportion of the overall market than they once were compared to the machines, still do drive a great deal of market action (especially at the retail and HF level). These Doom Loops erase months’ worth of gains in several weeks filling FVG after FVG that were left behind to the downside in a doom vortex (e.g., in the case of March 2020 over 3 years’ worth of gains were lost). No matter what the buy-n-hold crowd says, to hold one’s water in these Doom Loops is easier said than done.

The Doom Loop Example via vigtec’s Live Charts

Ultimately, the Doom Loop is just the exact equal and opposite reaction to the Equity Nirvana cycle. It becomes far more violent due to the indiscriminate nature of the algorithmic market, the fact that the vol suppression schemas are so widely used and institutionally accepted, and the organic (intended/unintended) growth of the options market as a result of free trading apps.

In my opinion, the Fed and the Treasury are keenly aware of this cycle and adamantly try to avoid the shift in regimes from Nirvana to Doom at all costs because it’s becoming harder and harder to stop the Doom Cycles without resorting to exponentially more outlandish monetary and fiscal policy that continually borderlines the surreal/bizarre. For example, in April of this year they just simply said ‘fuck it’ and came out and bought the HYG ETF directly and are now the largest holder of it because had they not, the Doom Cycle in motion at that time would’ve tested the 1880 ES level, which could’ve put the entire financial system in a death spiral.

SO WHAT?:

As you can see from the above text and charts, there’s no mention of EBITDA, P/E, FCF, P/R, rotations, NAV, MPT, IPO, SPAC, etc. Why? Because they don’t really carry much merit in a world that is driven by periods of excess liquidity (Equity Nirvana) vs. periods of an absence of liquidity (Doom Loops).

When products are indiscriminately bought in a Nirvana cycle (and it’s simply not logical to assess real world measurements to indiscriminate machine purchasing .exe programs) then there’s no measurement/analysis necessary other than “is there liquidity or the perception of excess liquidity at this time” (delivered via the mechanism of the Fed put). Hence the ‘stonks always go up’ memes and statements. Why? Because in a sense, when there’s excess liquidity, based on the staples of the Equity Nirvana cycle, they will…go up. Inversely, when there’s a point/period where the liquidity is insufficient, the Doom Loop starts to eat the markets and the hunt for liquidity is on. And this is done level by level to the downside.

So, is it as simple of an answer as whether the Fed and Treasury have supplied the markets with enough excess liquidity to ignite and ride the Nirvana Cycle? Not so fast. It’s not. It’s arguable to say that the Fed’s mandate now is vol suppression and ensuring that there’s excess liquidity. But ultimately the market is simply too dynamic and to passive/automated for this to be the case. It’s not that the Fed pulled the liquidity from the markets in February 2018, December 2018, or March 2020. That wasn’t the case. It was that the market simply became an ouroboros — it consumed itself. In each case so far, the Fed induced excess became so great that the market collapsed from a lack of liquidity availability at the elevated levels. This kicks off the Doom Loop and as the velocity gets going, the snake eats the rest of the tail.

Each time the Fed and Treasury have to come back with a liquidity floor “PUT” even more baffling/bizarre than the last cycle, which ultimately initiates a new Nirvana cycle and…rinse and repeat. This time, it appears that we’re inching potentially closer to this overall Nirvana/Doom regime shift cycle conclusion that appears to have started in early 2017 and may end here in early 2021. But that’s just conjecture…because theoretically it can continue as long as there’s belief in the latest floor “PUT” that’s thrown under the market.

What does all this really mean at the end of the day? Well, everything…or nothing. I’m just all about knowing the game that I’m playing personally. Here’s why I say that with this little example as it gives you an idea of just how volatile this regime shifting has become and how old MPT models can’t function while these regimes do their thing (and these are just rough approximations so relax).

Here’s a buy and hold scenario if you placed $ in the SPY in early 2017:

• Up 20% by early 2018
• Up 3–5% after XIV implosion
• Up 25% in summer 2018
• Down 5% by Christmas Eve 2018
• Up 40% by early 2020
• Down almost 10% by mid-March 2020
• Up 55% by end of 2020

Reaching for your vomit bag yet? This isn’t just in SPY (which should historically be a little volatile, but not like this…this resembles an ICO or pot stock). If you overlay this same time period on other assets like banks, semis, small caps, credit, etc., they’re shockingly even more exacerbated.

It’s imperative to realize at this stage of “investing” that you’re not playing a game of “investing.” You’re playing a game of “liquidity” and to win you need to understand and identify the regimes. If you do this well, you can dampen the volatility to your portfolios and also outperform more easily.

Parting shot…why I am not a ‘macro’ analyst? Look at this…macro made sense until end of 2017. You can say it’s well…bifurcated from the markets (and I won’t insult your intelligence by showing you 20 more just like this because all the macro charts of global economics change at the end of 2017/beginning of 2018).

Happy investing,

JG – Founder, vigtec