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U.S. stock prices near level for 'mechanical selling' - Nomura's McElligott

By Saqib Iqbal Ahmed

NEW YORK (Reuters) - The latest leg lower in U.S. stock prices has put them in a danger zone that could trigger so-called "mechanical selling" pressure and accelerate a downside move, according to Nomura strategist Charlie McElligott.

U.S. equities tumbled on Thursday, as surging Treasury yields pressured growth stocks a day after the Federal Reserve signaled another rate hike coming this year and stiffened its hawkish stance.

On Wednesday, the S&P 500 dropped to 4,401.38, near a a four-week low, putting the index on the verge of setting off a deluge of "mechanical selling", or stock selling by options dealers and certain trend-following investors, including commodity trading advisors (CTAs), Nomura’s McElligott said.

"Expensive" U.S. equities have bled to a location within the ballpark of triggering potential downside "accelerant" flows," McElligott said in a note on Thursday.

The drop in the stock index means options dealers, typically large banks or financial institutions that buy and sell options contracts to satisfy demand from investors, could add to any market weakness by selling stock futures as the market declines.

Dealers typically strive to stay market neutral. When they are net sellers of options - "short gamma" in industry parlance - they tend to sell stock futures as the market falls, thereby aggravating weakness.

The S&P 500 below 4,400 would place dealers in "short gamma" territory, McElligott estimated.

The selloff also pushed the Cboe Volatility Index - an options-based gauge of expected stock market gyrations - to its highest in nearly four weeks. That means dealers who may have sold VIX call options - contracts investors use to insure against a selloff - may be squeezed as the VIX shoots higher, particularly above the 17 and 20 levels, McElligott said.

On Thursday, the VIX was up 1.04 points at 16.18.

Market weakness could also be aggravated by selling from CTAs, that often rely on technical signals and rules to dictate their buying and selling.

A drop below the 4,409 level for the S&P 500 triggers selling by CTAs with an estimated $12.3 billion of stock futures up for sale in aggregate, McElligott estimates.

One key factor that has countered "mechanical selling" in the recent past has been the willingness of some investors to sell volatility, essentially betting that market gyrations will soon subside, McElligott said.

If investors react to the latest drop in the market by selling volatility or by taking profits on existing hedges it could help stifle the selling pressure on the market, he said.

(Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili and David Gregorio)