Eugene Linden
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Latest Musing

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
rapid climate change
global deforestation
fragging

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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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Don't Bother Me Honey, I'm Working!


Don't Bother Me Honey, I'm Working! by Eugene Linden It used to be so easy for a husband to justify his working life. He went off in the morning and then returned that evening. What he did during the day constituted "work." While wives, who took care of the house and family, might fairly ask who had the harder job, most arguments remained low in intensity so long as "work" paid the bills. The potential for conflict has risen in recent decades since many wives now work at jobs during the week and still do most of the housework. When the working wife is a lawyer, however, and the husband is a writer, the potential for conflict rises to infinity. To begin with lawyers are not known for shying from an argument, and then with a New York lawyer for a wife there is always the issue of how much money a writer's "work" brings in. As for the balance of power? In an argument about what constitutes a hard days work, a lawyer wife is the U.S. nuclear arsenal, and the writer is Costa Rica, which gave up its armed forces decades ago. Or so it would appear. May I humbly submit, however, that perception is not always reality. An outsider (or wife) observes a writer at work and sees a guy slumped in front of a screen for a few hours a day between long breaks for lunch, golf/tennis/windsurfing, and other activities more suited to the leisure class. This is an understandable misunderstanding, but the great preponderance of those activities that the lawyer wife sees as procrastination or outright laziness are actually vital parts of the writer's work. For instance: Lying in bed in the morning. To the lawyer wife the snoozing writer-husband appears to be nothing more than the embodiment of sloth, but for the writer this period between sleep and waking is the most precious part of the day and should be prolonged as much as possible. The virtues of the so-called "alpha state" between waking and consciousness have been well documented. During this period the barriers between the unconscious and conscious mind are porous, and the brain, which has been working throughout the writer's vital nine hours of sleep, presents metaphors, solutions to writing problems and other ideas as a gift to the new day. Try and use this valuable work time, however, when you have two babies and three cats marauding on the bed and the only other creature in the room who speaks English is your wife exhorting you to get up! The two hour lunch. Writing is a solitary profession, but it is critically dependent that the writer be in touch with mercurial shifts in the zeitgeist as well as be aware of the constant reshuffling of editors at publishing houses and magazines. The lawyer, grabbing a sandwich at her desk, might dismiss a writer's lunch as little more than gossip, griping, backbiting, and complaints about money, but initiates to the ritualized dialogue of publishing, recognize a rich tapestry of New Business Development, Forward Planning, Strategic Positioning, Marketing, and a host of other productive activities. No wonder the lunch takes a chunk out of the day! In a corporation, any one of these functions would require an entire department to fulfill, but the writer can adeptly dispense with all of them during the course of one meal. The break for tennis. Just because lawyers cannot bill time spent on the courts, they tend to look down upon those who take a couple of hours in the afternoon to clear their heads and restore their hearts. The British, a group who understand the vital importance of non-traditional work activities, have long recognized that the Battle of Waterloo was won on the playing fields of Eton. Exercise stimulates blood flow to the brain, invigorating renewed creative activity, and, it bears mentioning, it also helps reduce the lingering effects of drinks imbibed during the earlier sessions of New Business Development, Forward Planning, and Marketing. The weekly poker game. Admittedly, the work aspects of poker are not intuitively obvious, but keep in mind that poker is as much as about wit and badinage as it is about winning (or perhaps losing) money. Poker thus serves to condition the writer's most important "muscle." I could go on but let me instead confront head-on the billable hours mentality that has so stigmatized writers and others who opt off the treadmill. Leisure, not necessity, is the mother of invention. Christophe Boesch, a Swiss field biologist who has studied chimpanzees in the Tai forest in the Ivory Coast, has argued that the most innovative groups of chimpanzees are the ones with the richest diet, and hence, the most free time. Freed from the constant search for food, they have the leisure to test new ape ideas, and the well-nourished Tai chimps have shown ingenuity in developing nut cracking and monkey hunting techniques. Applied to humans, this suggests a solution to the impasse over what constitutes work: lawyers should keep writers well-nourished so they can explore new directions, an arrangement that in essence leverages the optimum skills of both writer/husband and lawyer/wife.

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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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