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Feedback Loops

On certain days, the S&P 500 may undergo significant and rapid movements, either in an 'Upside Squeeze' or a 'Rapid Decline'. These intense moves are often attributed to dealer feedback loops. Feedback loops are like a chain reaction that most often occur when the market is in negative gamma, and is a result of dealer hedging activity. We will highlight these feedback loops from the perspective of negative gamma.

Positive Feedback Loop (Upside Squeeze)

A market rally -> reduces put values -> making dealers buy stocks -> implied volatility declines -> leading dealers to buy more stock -> encouraging participants to close puts and buy calls -> prompting more dealer buying -> thereby reinforcing the rally in a positive feedback loop.

A positive feedback loop can be identified by extreme positive market internals such as VOLD Ratio ≥ 5, ADD +2000, broad market rally/growth outperformance and a large move lower in implied volatility.

Negative Feedback Loop (Rapid Decline )

A market decline -> increases put values -> making dealers sell stocks -> implied volatility increases -> leading dealers to sell more stock -> encouraging participants to close calls and buy puts -> prompting more dealer selling -> thereby reinforcing the decline in a negative feedback loop.

A negative feedback loop can be identified by extreme negative market internals such as VOLD Ratio ≥ -5, ADD -2000, broad market decline/growth underperformance and a large move higher in implied volatility.

These feedback loops lead to market extremes, causing sustained overbought or oversold conditions. These days pose a considerable challenge for trading; if you happen to miss the initial move, the market offers limited opportunities to get into the trend and you generally don’t want to play counter-trend due to these feedback loops and the increased probability of trend continuation.

August 29, 2023

Let's analyze the events of August 29, 2023 and look how we can best navigate a squeeze scenario. On this day the SPX experienced a sharp upward move, breaking free from its negative gamma trend that has been in place since August 2, 2023. This change, which was largely triggered by a drop in rates, initiated a positive feedback loop that resulted in the SPX to close with a gain of +1.45% and NASDAQ +2.2%.

Identifying a squeeze can be tricky, especially when market internals start off neutral. A sudden shift to strongly bullish readings often indicates a squeeze might be underway. Usually, a catalyst like economic data or statements from the Fed triggers this. For instance, even though the squeeze wasn't immediately clear on this particular day due to neutral market internals, things changed after the release of JOLTS Job Openings. The internals surged and maintained an upward trend throughout the session.

A steady rising VOLD curve, ADD +1800, Growth outperformance in addition to a contraction in volatility, VIX closing lower -4.5%.

The first move higher is usually the most significant, and is often followed by a grinding dipless rally with sustained overbought conditions. Typically, we have a setup to enter the initial move since squeezes often start from oversold conditions. However, there are times when we might not have a setup or miss the opportunity.

One approach is to wait for a reliable setup of a 5-minute (5M) cycle low, but there's only a 50% chance of this occurring. This means waiting might result in missing out on the trend. To increase our chances of getting into the trend, we can switch to the 1-minute (1M) cycle and apply the same method by going long at the 1M cycle low.

On this day, the 1M cycle presented four opportunities to enter the trend, all of which worked out successfully.

It's generally wise to avoid counter-trend strategies on days with extreme market conditions. If you do choose this approach, we recommend being cautious by taking smaller positions and managing them defensively.

Occasionally, a good counter-trend opportunity arises on a squeeze day when there's a Call Wall present. The optimal entry point for this is typically between 1:00 pm to 2:00 pm ET, as the market often experiences a sell-off driven by profit-taking around this time. However, this dip is usually short-lived, and the market tends to rebound, setting the stage for another leg higher into the market close.

On days marked by a squeeze, the market usually closes near the highs or retraces to the previous consolidation zone after the last leg higher. As you can observe, in this instance, the market closed at 4497, high of day just below the Call Wall level.


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