Second Leg Down Phenomenon

An observable pattern featuring in many deep corrections and bear markets is the second-leg-down phenomenon. Currently, we can see the S&P 500 attempting to break out of a steep downward channel, which can be categorized as the first move down when viewed through the lenses of sentiment and volatility. Importantly, we have not yet seen a bear-market rally that managed to reset the prevalent extremely pessimistic sentiment to average levels.

Sentiment re-setting bear-market rally in progress?

Sentiment and Positioning

After a long, resilient period of exuberant sentiment with few and minor market setbacks, a prolonged stock market downturn will need several weeks or months to trigger a rise of extreme pessimism in traders and investors. Initially, they tend to remain anchored to the previous market regime, which handsomely rewarded a Buy the Dip mentality.

But over time mounting losses will cause this attitude to change, and inevitably filter through into actual investor positioning. They will decrease exposure to stocks as sentiment deteriorates, until there are fewer and fewer marginal sellers left. Despite a flurry of negative news and bad fundamental data stocks will stop going down — they simply can’t anymore, because everyone currently willing to sell their stocks or to bet on a falling market has already done so! This is the exact inverse of the mechanism that often causes a market top to occur at peak optimism.

So this is where we are now: Equities hover above their lows and finally stage a recovery rally.

Goldman Sachs

A long bear-market rally becomes a necessity, simply because deeply negative sentiment (and with it positioning) needs to reset for potential sellers to re-appear in the market. Once sentiment has normalized, and more and more investors are becoming convinced that the bottom is in, the stage is set for the next leg of the journey. Now the reality of the core macro environment becomes the decisive factor: Either the economy powers through a temporary slowdown (often aided by a dovish pivot in FED policy), or the fundamental deterioration continues, which, in the worst case, leads to a deep recession. 

Today, I fear, lasting hawkish FED policy (caused by the toxic combination of resilient unemployment numbers in concert with steeply rising inflation) will cause a prolonged deterioration. For this reason, my main expectation (but not the only scenario I prepare for) is that we will see a strong second leg down — counter-intuitively it is likely to be worse the more enthusiastically investors are embracing the current rally as a potential turnaround.

The behavioral interplay of hedging and volatility can have the effect that this final stage of a bear market is often the most violent.

Volatility and Hedging

More off the beaten path is a look at the second leg down phenomenon through the lens of volatility, and with it the entire complex of portfolio hedging, consequences for market maker positioning and the resulting reflexive flows that have a large impact on stock prices.

The current decline, while steep, has been largely orderly in a stair-step-down pattern, with the riskiest stocks selling off first and hardest. This is a sign of a well-hedged market, where popular put strikes (e.g. 10%, 15% and 20% below the S&P 500 high) repeatedly serve as a temporary floor, and there is no sense of wide-spread panic yet. (Nasty events are contained to the most speculative areas of financial markets, e.g. crypto or high-growth tech stocks.)

Practical Trading Ideas
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A deep dive into liquidity flows influenced by the options market starts here and goes into practical ideas here.

VIX and Fixed-Strike Vol
Ironically the ample presence of hedges is the very reason that their performance disappoints in such a decline. Specifically their long-volatility component underperforms and even causes losses despite a large market drop! This seems at odds with the VIX, which did rise during the downturn just as expected, yet long-volatility exposure did not profit. 

Here the important idea of looking at fixed-strike volatility (the implied volatility of specific options) rather than the VIX, which reflects a wide range of SPX 30-day option’s implied volatility, comes into play: Out-of-the-money (OTM) options have a higher implied volatility then ATM options. The prevalent skew shows that index OTM put options are being priced relatively highest, because investors have strong demand to guard against the crash risk inherent in the stock market.

As the market moves down towards those OTM put strikes, VIX naturally rises reflecting the higher implied volatility at lower strikes. But, at the same time, a specific, deep OTM put’s implied volatility may stay constant or fall as it moves into the money — its performance as a hedge is much worse than expected. Many sophisticated investors use option structures concentrating on long volatility exposure rather than market direction, because a simple long-put hedge becomes very expensive to maintain over time, and most of these cheaper, more complex hedges lost money over recent months.

So, what are investors likely to do now? They tend to ditch their hedges in frustration as sentiment improves, because they didn’t work properly in a falling market. This sets up the potential for a second-leg-down event, as the market is now under-hedged. During the next sell-off, panic put-buying can cause a much more violent downward spiral, because options dealers are forced to sell increasing amount of S&P futures into an accelerating down move — a negative gamma squeeze ensues. This creates a feedback loop of even more put buying causing massive S&P 500 selling pressure, and an outperformance of long volatility strategies.

When can we expect such an event to occur? Volatility wizard Cem Karsan says within 3 to 9 months, and he has been correctly anticipating many of the twist and turns we experienced since 2020.

My thinking here is inspired by volatility specialist Cem Karsan, who has been very prescient in describing current dynamics in the earliest stages of their development. (If the subject has you hooked, I would recommend listening to one of the many podcasts and other interviews he has recently been on. His twitter feed is an excellent learning tool once you have deciphered his unique writing style.)

A broader well of information and ideas I found in the aptly named book The Second Leg Down by Hari P. Krishnan.


Such a strong sell-off will exacerbate a feeling of doom, which has the potential to infect a large group of people that so far have stuck to their guns and played no role in the proceedings: the passive buy-and-hold investors. Should they join the active crowd and start to panic out of their never-sell investments a huge new group of sellers is unlocked, which puts additional pressure on the entire market. Even the highest quality stocks will then suffer equally in a rush for the exit.

The chart below visualizes this process well: Cash levels have currently risen to around 23% as tactical investors have reduced risk, but an all-out panic, as in 2003 or 2009, can cause passive investors to liquidate their holdings to the tune of 40% or higher.

As this is all part of a never-ending cycle, panic selling finally sets the scene for a lasting bottom in stocks — just when pessimism reaches a the-end-is-nigh crescendo and the economic outlook is at its bleakest.

Good luck with your trading, and thank you for reading!


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