'Higher Oil Screams Higher Vol': Sticky Correlation Is Holding Back S&P 500

After showing some solid resilience (at the index levels) amid a week of chaotic headlines, this morning's ugly payrolls report pushed the S&P to the low-end of its months-long trading range...

The options positioning backdrop looks largely unchanged.

SpotGamma highlights that Positive gamma starts to build above 6,900, acting as increasing resistance, while the broader negative gamma backdrop below that level makes for wide intraday swings, as seen in Thursday’s price action.

The gamma picture is the same as always: Negative gamma from ~6,875 down through 6,600s.

This signals that the soft underbelly of this market remains in place, despite its repeated bounces from 6,800-6,700.

At the risk of sounding like overbearing parents ("Drink your milk!", "Put on a sweater!") we again warn you: this market is about managing risk to growing capital.

Vols are only "warmed up" (not rich enough given the war), and there is a real lack of stability in the positioning.

We'd argue that oil making fresh highs is a signal of increasing conflict.

Additionally, as Bloomberg macro strategist, Michael Ball points out, a restart of the grind higher would need dispersion and a rotation back into a low-correlation regime to re-emerge -- a dynamic that has yet to show up.

The spike in equity correlation this week looks like a classic macro shock response to Iran headlines, which prompted everything to trade in tandem as risk-off swept markets.

That forced index-level selling halted the stock pickers’ environment that had been supporting the SPX for months.

If the risk-off macro impulse fades and a low-correlation regime returns, index vol would face heavier headwinds and the gauge can grind higher even without an all-clear macro signal.

Yet the dispersion trade, where investors short the index or a specific sector vol while going long vol in other sectors or single-name stocks, has yet to resume. Tuesday was telling -- crowded longs in sectors like materials, industrials and energy all lagged; the latter was particularly jarring, given higher crude should have been a tailwind for that sector. The outperformance of software, one of the most shorted sectors, since then indicates some caution to pile back into the broader trade.

If investors are reluctant to re-enter this trade due to macro shock worries, the SPX will be missing a vol selling supply and the gamma backdrop will evolve.

The current higher-vol regime only reinforces the upside resistance while making the downside more fluid.

Technically, SPX participation looks mixed near-term and there’s yet to be a broader expansion in breadth, according to MenthorQ’s MACD breadth gauge. They highlight that while the index is still range-bound, single-name momentum is falling and the spread of buy signals is only moderate versus prior periods.

All this drives uncertainty for the dispersion trade.

Higher index vol could entice some to sell vol, but higher correlation means there are fewer long-vol single names that can outperform index moves.

The trade ultimately becomes a call on the duration of the Iran conflict, which is the primary reason for the higher correlation.

If markets move on due to positive developments, the re-engagement of this trade will support the SPX stabilizing back into a tighter trading range that bodes well for a move higher, while markets could again see more rotation under the surface.

Circling back, SpotGamma's lack of bullishness is due to the ongoing geopolitical conflict, and the likelihood that traders will want to watch their risk into the weekend.

They continue to hold the core view that equity volatility is unlikely to come down until there is some cooling of the Iran situation.

For now, higher oil, in the short term, screams higher vol.