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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Fire & Flood
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Deep Past
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endangered animals
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The Ragged Edge of the World



Winds of Change
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Afterword to the softbound edition.


The Octopus and the Orangutan
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The Future In Plain Sight
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The Parrot's Lament
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Silent Partners
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Affluence and Discontent
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The Alms Race
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Apes, Men, & Language
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WHAT IF THE CLIMATE SKEPTICS ARE RIGHT? THEN WE ARE REALLY IN TROUBLE!


Thursday November 23, 2006

Faced with overwhelming evidence that climate is changing at an accelerating rate, the naysayers seem to be regrouping around a new meme: yes earth is warming, but humanity is not the cause. One champion of this position is Senator James Inhofe of Oklahoma, current chair of the Committee on Environment and Public Works. The logic of this strategic retrenchment seems to be that if changing climate is not our fault, then we needn’t worry about it. Whew! Hmm, on second thought, just one question: if we are already seeing alarming changes in climate, wouldn’t it be better if we knew that human-sourced emissions were the cause? If we started this round of climate change, then presumably we can stop it. If Inhofe is correct, however, we can’t do anything about it because we don’t know what is causing the changes. Either the effects greenhouse gas emissions have yet to be felt (a terrifying prospect given the startling shifts we are already seeing) or that the entire scientific community has been wrong about the role of carbon dioxide emissions. Imagine six billion people on a raft entering rapids without paddles or a rudder and with no knowledge of what waterfalls might lie ahead. This is supposed to be a comforting thought? Fortunately, (if that’s the word), there is almost no doubt that Inhofe is wrong. There is plenty to debate about climate change, both in policy and the science, but the consensus among scientists is that humans have contributed to the current warming. I suspect that the right loses all perspective on the issue in part because the proposed solutions involve a house of horrors of libertarian nightmares, including international treaties, regulations, new taxes, and, worst of all, admitting that those insufferable environmentalists are right. If that’s the case, fine, let’s talk about alternative approaches and likely impacts. That conversation, however, hasn’t gotten off the ground. Instead, Inhofe, who for the past six years has had the most important position in the Senate with regard to climate, calls the threat of global warming the “greatest hoax ever perpetrated on the American people.” Those in Congress have the flimsy but credible excuse of scientific stupidity (credible since they are members of one of the few remaining forums where evolution remains a subject of debate), but the few scientists in the skeptic camp have no cover for debating in bad faith. Bad faith? Yes, serious climate scientists have become so frustrated by the misinterpretation of their data that they have taken to tacking on public disclaimers that their findings should not be used to contradict the consensus on global warming. Peter Doran, a scientist whose study about cooling in the interior of Antarctica, was cited by so many naysayers as evidence that the world isn’t warming that he wrote an op-ed for the New York Times publicly aligning himself with the global warming consensus. Climate skeptics also trumpet that Mount Kilimanjaro’s glaciers started shrinking before industrial era greenhouse gas emissions really began in earnest. Here again, Douglas Hardy, one of the authors of the cited paper complained that “Using these preliminary findings to refute or even question global warming borders on the absurd”. What frustrates Doran, Hardy and many others is the skeptics’ tendency to cherry-pick data, and take findings out of context. To win, the skeptics don’t have to disprove global warming, they just have to convey the notion that it’s still under debate so that the public says, “I’ll wait until the scientists sort it out before I start worrying.” But the scientists have sorted it out, and they’ve done so despite being natural contrarians. That’s why the consensus that humans are affecting climate is so extraordinary. If the public realized the breadth and depth of this consensus, climate change would get the consideration it deserves. The naysayers know this, and they jump on any report that underscores the rare scientific unanimity on the issue. Naomi Oreskes of the University of San Diego felt this heat when she published a study in Science. Her simple thought was that if rank and file scientists did not share the consensus of the leaders of major scientific organizations, dissents would have shown up in the peer-reviewed literature. Critics castigated her on the internet, on television and on the op-ed page of the Wall Street Journal, but there has been no credible challenge to what she actually said in her article. Just recently, the sports psychologist who’s unpublished study was the basis for the naysayer attack on Oreskes, backed off from his assertions. There has always been an easy way to get past the naysayers disinformation campaign because their arguments always fall apart upon close examination. The climate skeptics’ strategy rests on the assumption that most Americans are too lazy or too ignorant to look past the headline. So far they have been right, but ultimately spin collides with reality. Just such a collision seems to have taken place in the case of American attitudes towards the war in Iraq, and it cost the GOP control of Congress. Among those swept out of power will be Inhofe, and the incoming chair, Barbara Boxer of California, has stated that she will make global warming a priority. That alone gives cause for hope that a real discussion of the threat of climate change can get started. Let’s hope that it’s not too late.

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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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