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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America's Game


Monday February 03, 2014

Note: I published the following some years back, but every Super Bowl I can't help but wonder what a Martian anthropologist might make of our annual ritual of ceremonial warfare.

   As we make fateful decisions during the coming weeks (no, I'm not talking about the Democratic Primaries, but whether to mute the ads or the game during the Super Bowl), we might take a moment to ponder the ways in which football really is America's game. With apologies to Bronislaw Malinowski --whose pioneering treatise on the Trobriand Islands off New Guinea led to studies of the ways in which the islanders appropriated cricket and turned it into a native ritual -- let's explore how we Americans took over the primitive sports of soccer and rugby and adapted them to our belief system.     

Where both antecedent sports offer nearly continuous action, American football amounts to brief periods of furious motion squeezed in between meetings (or huddles as they are called by initiates). This innovation is both comforting and familiar for legions of middle managers across this great land for whom meetings have ritual significance (in the sense that they represent something you have to do that produces no discernible results). During these meetings the CEO -- the coach -- delivers his instructions to his chief operating officer -- the quarterback -- who is expected to deliver quarterly results. A football quarter is calculated in minutes rather than days, or course; it only seems as though each period takes months. As in the markets that are the soul of this nation, analysts pour over the team's performance in real time, comparing the results to the "whisper number" that represents a consensus of some of the best minds in the country. While company earnings may be scrutinized in financial centers, the best analysts in this business are in Las Vegas. It's a safe bet that the expected numbers produced by bookies are far more reliable as a guide to future performance than the estimates that come from Wall Street.     

Football also reflects our American fondness for litigation. Teams of referees roam the field, sometimes interfering with the play in progress. When eight or ten official eyes are not enough to rule beyond a reasonable doubt, a plaintiff can appeal a decision. In such cases, the officials turn to another American icon -- technology.     

When reviewing plays, the technology is the television camera, but the average pro football team uses more computing power than the Apollo rockets that put a man on the moon. Apart from simulations and other analytical tools, players wear padding that is the result of thousands of man-years of ergonomic studies, while field generals communicate with their coaches through helmets with telecommunications links that have fidelity and security better than that used by Iraqi commanders during their recent loss to team America. The way things are going, future quarterbacks will have heads-up, intelligent displays that give them real-time interpretation of defensive sets, much like fighter pilots have today.     

While the naïve fans of soccer and rugby expect players to be generalists who can play both offense and defense, we Americans have done what we've always done when we want results: we turn to specialists. Zoologists who argue that dogs have the greatest variation in size of any species have obviously never seen a pro football team where you can fit three placekickers into the pants of one defensive tackle.  Fortunately, territorial boundaries on the playing field are so rigorously enforced that the two almost never encounter each other.     

If we Americans have "optimized" rugby according to our notions of progress, there are still things many team owners might like to import from Trobriand cricket. While in football, the home team wins most of the time, in the Trobriand Island sport the home team always wins. There is still consolation for the visitors though, since the home team throws a feast in their honor. Huge differences remain, however. While football, with its fighter plane flyovers and other militaristic trappings often seems to celebrate war, cricket was introduced to the Trobriands in 1903 to replace war. How primitive!

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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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