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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Time Warp on Climate Change


Thursday August 28, 2014

 

In yesterday's New York Times, there were two articles on climate change. The first was a front page piece about how President Obama will try to end-run Congressional paralysis on dealing with climate change by seeking to update the existing Kyoto treaty in ways that commit nation's to targets to reduce green house gas emissions. Then there was an article by Justin Gillis discussing a new UN report that outlines dire predictions for climate change, which is being circulated a month before the organization meets to forge an agreement on climate change. This triggered a distant memory: seventeen years ago, the UN was also about to convene to try to agree to a climate treaty, and seventeen years ago I published an op-ed in the New York Times that offered a simple idea to break the impasse. Think about that: seventeen years ago, people were frustrated by the global community's inability to deal witht the threat. And what has happened since? The rate at which greenhouse gasses are accumulating in the atmosphere has nearly doubled. Oh, and Obama's outline for an agreement repicates some elements of the approach I proposed back then.

Here's the op-ed:

 

Here's the text of that op-ed. It's astonishing how little the basic debate has changed even as the threat has become so much more dire and imminent:

 

 If global warming were a Communist plot, there would be a treaty to combat the peril by now. Instead, only two months before representatives from industrial and developing nations are scheduled to meet in Kyoto, Japan, to agree on steps to counter the threat of climate change, it is becoming ever more clear that five years of negotiations have produced little that is meaningful.

 In a last-ditch attempt to develop an American consensus on action, President Clinton plans to hold a White House conference on Oct. 6. Given the prospects of the Kyoto treaty, it is time to consider creative alternatives for reducing the so-called greenhouse gases – byproducts of combustion – that are linked to climate change. A solution outside the framework of the negotiations for the Kyoto agreement may be the only way to resolve the impasse between economically advanced nations and those that are trying to catch up.

The industrial nations that account for most emissions cannot agree among themselves on a way to address global warming. They are reluctant to commit to freezing or reducing emissions, mainly because of concern about the possible economic costs of such actions. Meanwhile, countries with emerging economies worry that curbs on emissions will imperil economic development.

Yet nobody wants to admit total failure, particularly since with every passing year, new information emerges about climate changes, underlining the risks of human tampering with the atmosphere. The latest surprise is new evidence that climate changes may not be gradual, but more rapid and extreme. The reason for such flips isn’t clear, but most scientists recognize that the more carbon dioxide dumped into the atmosphere, the more likely that the climate will change.

What to do? Earlier this year, a delegation from the European Union may have inadvertently offered the kernel of a solution. The delegates proposed that the world’s nations commit to a 15% reduction from 1990 levels of greenhouse gases by 2010. It was a cynical suggestion because the Europeans knew the United States would never accept those terms. It was also hypocritical because Europe has an easy way of achieving greenhouse reductions: inviting the former Communist states into the European Union.

 As they modernize their antiquated, coal-fired industries, Eastern European nations like Poland and Hungary will be making significant reductions in the emissions that cause global warming. By bringing these nations into the European Union, the economically mature countries of Europe could more than offset their own increases in greenhouse gas emissions.

But the idea of linking industrial and emerging economies offers a way out of the impasse that has paralyzed the talks on global warming. Why not divide the world into three giant regions and hold each to an agreed-upon target for reducing greenhouse gases that the regions could achieve any way they want?

 North and South America could be one region, the slice of the globe from Northern Europe (including Russia) through Africa could be another, and Asia and Oceana could make up the third. With industrial powers and emerging economies in each region, countries could trade emission rights and share new technologies.

This plan could also help solve a knotty political problem. By shifting responsibility for reducing greenhouse gases from individual nations to a larger unit, no country would need to fear being placed at an economic disadvantage by a climate treaty. The goals for each region should be different since the biggest reductions in greenhouse gases will come in the modernizing economies of the former Communist states, while developing nations, especially in Asia and Latin America, will have more difficulty limiting emissions.

  Rewards for success and penalties for failure could be based on regional tariffs. That’s a tricky concept in an era of free trade, but no one has proposed a better enforcement alternative for the treaty being negotiated now.After years of talk about a solution, the problem of global warming looms every more ominously. It’s time for a new approach.

That last sentence was true seventeen years ago. That it's still true today is pathetic -- and tragic.

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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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