Eugene Linden
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THE PROBLEM WITH MUSK'S BID FOR TWITTER IS NOT THAT HE'S A BILLIONAIRE

Matt Taibbi, a journalist whose writing I admire, has joined the throng decrying the hypocrisy of pundits who write on the pages of the Washington Post (owned by a billionaire) that if billionaire Elon Musk buys Twitter it will be a threat to democracy. This is too glib. The problem isn’t b...

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CanWeReallyUnderstandMatter

BY EUGENE LINDEN


Monday, Apr. 16, 1990
Few tasks are more daunting than standing in the path of a charging theoretical physicist who is hell-bent on getting funding for the next particle accelerator. As practitioners of the hardest of the hard sciences, physicists do little to discourage their aura of intellectual supremacy, particularly when suggesting to Congress that a grand synthesis of all the forces of nature is at hand if the Government will only cough up a few billion dollars more. But what if this confidence is misplaced? What if the barriers to knowledge are higher than many physicists like to admit?

For much of this century, scientists have known that the comfortable solidity of things begins to break down at the subatomic level. Like the Hindu veil of Maya, the palette from which nature paints atoms proves illusory when approached. From afar, this world appears neatly separated into waves and particles, but close scrutiny reveals indescribable objects that have characteristics of both.

Physicists have prospered in this quirky realm, but neither physics nor the rest of science has fully digested its implications. Inside the atom is a world of perpetual uncertainty in which particle behavior can be expressed only as a set of probabilities, and reality exists only in the eyes of the observer. Though the recognition of this uncertainty grew in part out of Albert Einstein's work, the idea bothered him immensely. "God does not play dice with the universe," he remarked.

The set of mathematical tools developed to explore the subatomic world is called quantum mechanics. The theory works amazingly well in predicting the behavior of quarks, leptons and the like, but it defies common sense, and its equations imply the existence of phenomena that seem impossible. For instance, under special circumstances, quantum theory predicts that a change in an object in one place can instantly produce a change in a related object somewhere else -- even on the other side of the universe.

Over the years, this seeming paradox has been stated in various ways, but its most familiar form involves the behavior of photons, the basic units of light. When two photons are emitted by a particular light source and given a certain polarization (which can be thought of as a type of orientation), quantum theory holds that the two photons will always share that orientation. But what if an observer altered the polarization of one photon once it was in flight? In theory, that event would also instantaneously change the polarization of the other photon, even if it was light-years away. The very idea violates ordinary logic and strains the traditional laws of physics.

The two-photon puzzle was nothing more than a matter of speculation until 1964, when an Irish theoretical physicist named John Stewart Bell restated the problem as a simple mathematical proposition. A young physicist named John Clauser came upon Bell's theorem and realized that it opened the door to testing the two-photon problem in an experiment. Like Einstein, Clauser was bothered by the seemingly absurd implications of quantum mechanics. Says Clauser, now a research physicist at the University of California, Berkeley: "I had an opportunity to devise a test and see whether nature would choose quantum mechanics or reality as we know it." In his experiment, Clauser, assisted by Stuart Freedman, found a way of firing photons in opposite directions and selectively changing their polarization.

The outcome was clear: a change in one photon did alter the polarization of the other. In other words, nature chose quantum mechanics, showing that the two related photons could not be considered separate objects, but rather remained connected in some mysterious way. This experiment, argues physicist Henry Stapp of Lawrence Berkeley Laboratories, imposes new limits on what can be established about the nature of matter by proving that experiments can be influenced by events elsewhere in the universe.

Clauser's work pointed out once again that the rules of quantum mechanics do not mesh well with the laws of Newton and Einstein. But most physicists do not see the apparent disparity to be a major practical problem. Classical laws work perfectly well in explaining phenomena in the visible world -- the motion of a planet or the trajectory of a curveball -- and quantum theory does just as well when restricted to describing subatomic events like the flight of an electron.

Yet a small band of physicists, including Clauser and Stapp, are disturbed by their profession's priorities, believing that the anomalies of quantum theory deserve much more investigation. Instead of chasing ever smaller particles with ever larger accelerators, some of these critics assert, physics should be moving in the opposite direction. Specifically, science needs to find out whether the elusiveness of the quantum world applies to objects larger than subatomic particles.

No one worries about the relevance of quantum mechanics to the momentum of a charging elephant. But there are events on the border between the visible and the invisible in which quantum effects could conceivably come into play. Possible examples: biochemical reactions and the firing of neurons in the brain. Stapp, Clauser and others believe that a better understanding of how quantum theory applies to atoms and molecules might help in everything from artificial-intelligence research to building improved gyroscopes. For now, though, this boundary area is a theoretical no-man's-land. Certainly physicists are a lot further from understanding how the world works than some would have Congress believe.

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Short Take

HOW THE OPTIONS TAIL HAS COME TO WAG THE MARKET DOG: A Simple English Language Explanation of How Structural Changes in the Stock Markets Contribute to Whipsaw Movements in Prices.

Lately a string of violent price movements and reversals in the equity markets make it look like the markets are having a nervous breakdown. The last day of trading in April 2022 saw a 939 point drop in the Dow. The day before that, the Dow rose about 625 points, and two days before that it fell over 800 points. The very next week, after two quiet days, the Dow rose over 900 points after the Fed announced its biggest rate hike in 22 years (ordinarily a big negative for the markets), and then, the next day, fell over 1000 points (more on this later).  There have been plenty of headlines – about the Ukraine Invasion, inflation, the threat of a Fed caused recession, supply chain disruptions – to justify increased uncertainty, but the amplitude of the moves (and the sudden reversals) suggest something more may be at work. Here follows an effort to explain in simple language the significant changes in the market that have contributed to this volatility.

 

“This time it’s different” is perhaps the most dangerous phrase in finance as usually it’s uttered by market cheerleaders just before a bubble bursts. That said, markets do change, and those changes have their impacts. One change in the markets has been the shift from intermediaries (such as brokers) to direct electronic trading, a shift that has made the markets somewhat frictionless, and allowed computer driven funds to do high speed trading. This shift began a couple of decades ago. Today’s markets can move faster than a human can react.

 

Another shift has been the degree to which passive investing through index funds and algorithmic trading through various quant funds have come to eclipse retail investing and dominate trading. A consequence of this is that to some degree it has mooted individual stock picking because when investors move in or out of index funds, the managers have to buy or sell the stocks held on a pro rata basis and not on individual merit. This change too has been developing over recent decades.

 

A more recent and consequential shift, however, has been the explosion in the sale of derivatives, particularly options (the right to buy or sell a stock or index at a specified price on or before a specific date). Between 2019 and the end of 2021, the volume of call options (the right to buy a stock at a specified price on or before a particular date) has roughly doubled. During times of volatility, more and more retail and institutional investors now buy calls or puts rather than the stocks. 

 

Today, trading in options has reached a scale that it affects market moves. A critical factor is the role of the dealers who write options and account for a significant percentage of the options issued. Dealers have been happy to accommodate the growth in option trading by selling calls or puts. This however, makes them essentially short what they have just sold. Normally, this doesn't matter as most options expire out of the money and worthless, leaving the happy dealer to book the premium. Being short options, however, does begin to matter more and more as an option both moves closer to being in the money and closer to expiration. 

 

This situation is more likely to occur when markets make large and fast moves, situations such as we have today given the pile of major uncertainties. Such moves force dealers to hedge their exposure. 

 

Here’s how it works. If, for instance, a dealer has sold puts on an index or a stock, as a put comes closer to being in the money (and closer to expiration), the dealer will hedge his short (writing the put) by selling the underlying stock. This has the combined effect of protecting the dealer -- he's hedged his potential losses – while accelerating the downward pressure on the price. In other words, this hedging is pro-cyclical, meaning that the hedging will accelerate a price move in a particular direction.

 

Traders look at crucial second derivatives of stock prices, referred to by the Greek letters delta and gamma to determine exposure to such squeezes. As an option moves closer to in the money it's delta -- it's price movement relative to the price movement of the underlying, and its gamma -- the rate of change of the delta relative to a one point move in the underlying, both rise. The closer to both the strike price and expiration date, the more the dealer is forced to hedge. The result is what’s called a gamma squeeze. Once the overhang of gamma exposure has been cleared, however, the selling or buying pressure abates, and gamma may flip, with new positioning and hedging done in the opposite direction. The result can be a whipsaw in the larger markets. This same phenomenon can happen with indexes and futures.

 

How do we know that the hedging of option positioning are contributing to violent price changes and reversals in the market? While not conclusive, perhaps the strongest evidence is that large lopsided agglomerations of options at or near the money have been coincident with surprising market moves as expiration dates approach. In fact, some market players use this data to reposition investments, in effect shifting investment strategy from individual companies to the technical structure of the markets. This is what Warren Buffett was referring to when, at his recent annual meeting, he decried the explosion of options and other Wall Street fads as reducing companies to “poker chips” in a casino.

 

The week of the May Fed meeting gave us a real-time example of how a market move that looks insane on the surface reflects the underlying positioning in various derivatives. To set the stage: ordinarily, given debt burdens and the threat of recession, the markets would be expected to react badly to a Fed tightening cycle that is accelerated by the biggest rate hike in 22 years. On Wednesday, however, market indices began to soar on Wednesday when Fed Chairman Powell, one half hour after the Fed announced it 50 basis point raise, suggested that the Fed was not considering larger 75 basis point hikes during this tightening cycle. Traders interpreted this as taking the most hawkish scenario off the table. Up to that point, institutions were extremely bearish in their positioning, heavily weighted to puts on indexes and stocks, and also positioned for future rises in volatility in the markets. Right after Powell made his comments, investors started hedging and unwinding this positioning, and all the pro-cyclical elements entailed in this repositioning kicked in. By the end of the day, the technical pressures producing the squeeze had largely abated, setting the stage for a renewed, procyclical push downward the next day, as the negative aspects of the tightening cycle (and other economic headwinds) came to the fore. 

 

What these violent moves in the market are telling us is that while in the broader sense, this time is not different --the overall sine wave of the market is still that bubbles build and burst -- how the present bubble is bursting may be following a different dynamic than previous episodes. The changes since the great financial crisis-- the rise to dominance of passive trading through indexes and algorithmic trading through various quant strategies – reduced the friction in the markets as well as the value of picking individual companies. Now, the more recent explosion of option issuance, further accelerates market moves, and leads to unpredictable reversals that have to do with option positioning rather than fundamentals such as earnings, politics, or the state of the economy. 

 

The tail (the options and other derivatives markets) now wags the dog (the equities markets).

 

 



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