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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A REPUBLIC OF BIRDS: THOUGHTS FROM MIDWAY ATOLL


Thursday January 24, 2008

EUGENE LINDEN
Iíve been to a number of places where wild animals are trusting of humans, but perhaps none so unlikely as Midway Atoll, smack in the middle of the Pacific Ocean. After more than a century of abuse at the hands of man -- first being slaughtered for their feathers by hunters, then being paved over by Seabees, then shelled by the Japanese during World War II, and finally Osterized by the engines of the planes of the U.S. Strategic Air Command during the Cold War -- the albatross and other birds donít seem to bear a grudge. Maybe thatís because theyíve won. Albatross have succeeded where the Japanese military failed and have successfully taken over the island. And, they did it in a way that Mahatma Ghandi would applaud Ė through passive resistance. Itís only fair since theyíve have ancestral rights to Midway (or whatever itís called in Albatross-speak), but itís still both eerie and wonderful to see how the birds been able to enforce an avian eminent domain and build their nests on every available open space, including the middle of the islandís paths. Even more moving is the gracious way in which we humans have surrendered control and allowed the establishment of a republic of birds. For the most part itís a peaceable nation, and the citizens are irresistible, albeit short. Iíve discovered that itís impossible not to talk to them as I make my way around the island on foot or on bike. For their part, the albatross make we humans feel like superstars as we pick our way among them. The combined effect of tens of thousands of birds clacking in the background makes it seem as though our every move is accompanied by polite applause from a very large crowd. Their curiosity and clumsiness on land make them endearing. Every day, our group trades stories of heart-stopping take-offs as birds flap their wings and run wildly down impromptu runways that open in the middle of the nesting area. More often than not they inadvertently step on a nesting bird at some point during take off, eliciting an indignant squawk. The concept of zoning doesnít seem to have taken hold in bird land, although there are a couple of paths to the beaches that the albatross use for a more official runway, and the albatross using these runways even line up and (mostly) take turns. Landings are even more dramatic. If youíre an albatross, every landing seems to be an emergency landing. Unless thereís a stiff wind to land into, they have to put on the brakes immediately on touch-down, and quite often this ends up in a face plant, if not a collision with another hapless bird. In the air, though, they are magnificent, even heroic, and their life style would appeal to both feminists and the most fire-breathing moralists. Feminists would have a hard time finding fault with males who pitch in and take over care of the baby immediately after hatching while the mom gets a chance to rest up. Albatross may be one of the few species where spouses are actually an asset, rather than a clumsy menace, around newborns. On the other hand the ďvaluesĒ crowd might find inspiration in their commitment to monogamy since the birds mate for life. All in all Midway today is a happy place. The few humans working here or visiting here all care deeply about restoring the atoll as the haven for wildlife. God knows the albatross need it. Between the plastics that get into their digestive systems when they feed, to the impacts of global warming, the albatross run a gauntlet of threats during their life on the high seas. Once back on the atoll, however, at least for the moment, they find a haven where humans have turned the infrastructure of war and conflict towards their betterment. Theyíve managed to get a superpower as a protector and they donít control a drop of oil -- no mean trick for a birdbrain. Thatís an auspicious augury at the dawn of the 21st century.

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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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