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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Forget SARS. What About the Weather?


Global climate change could have a far greater impact than worries about terrorism or disease Friday, May. 02, 2003 When it comes to evaluating risks, both ordinary people and policymakers tend to be wildly inefficient. Remember that in the 1970s, intelligence officials, preoccupied with communism, discounted the threat posed by Islamic fundamentalism. The lesson: Ignored threats often pose more serious threats to global stability than the fears du jour. So with SARS and terrorism now dominating headlines and our worry space, it's worth pondering what threats have been squeezed out. The recent bad winter suggests one strong candidate for consideration: the threat of rapid climate change. An important consideration in evaluating a threat is whether it is more likely to do its damage through uncertainty or by bringing about instability. Uncertainty is bad for an economy, but instability is a killer. In uncertain times people worry about whether to postpone a vacation, while businesses put off hiring decisions and reduce spending. In unstable times, people stockpile food or hit the road as refugees, while businesses shutter. Uncertainty focuses on worries about what the future might bring, while instability has to do with upheavals in the here and now. Fears of terrorism and disease have already pummeled world economies, but, at least for the moment, the damage wrought by these threats comes more from their attendant uncertainties than their direct affects. So what might bring about actual instability? The endless winter in the northeast, for instance, may be a signal that an abrupt change in climate lies right around the corner. If so, large parts of the world might face ice age ? that's right, ice age ? conditions with virtually incalculable consequences for agriculture and travel, much less ordinary commerce. The key to this threat is a recently discovered vulnerability of the Gulf Stream. The current, dubbed the Blue God by author William MacLeisch, warms much of Europe and eastern North America by bringing enormous amounts of tropical water northward as part of the "great ocean conveyor" that distributes heat around the world. As this warm water moves north, evaporation makes it saltier and heavier. By the time the stream has reached the far northern waters between Norway and Greenland it has given up most of its heat, and this salty, heavy water plunges into the abyss, pulling more water behind it. This is where our warming globe can screw things up, according to scientists such as Robert Gagosian, president and director of the Woods Hole Oceanographic Institution in Massachusetts. The melting of glaciers and increased precipitation in the north has poured fresh water into the Atlantic, in some places leaving a ten foot thick layer on the ocean surface, according to Terence Joyce, also of Woods Hole. As the lighter fresh water slows the sinking of the Gulf Stream as it hits these northern latitudes it reduces the pull that brings warm water northward. Scientists estimate that the speed of the conveyor in the far north has diminished by 20% since the 1970s. Coincidence? Perhaps, but the synchronous freshening of the North Atlantic, a less vigorous Gulf Stream, and a cold snowy Northeast when the rest of the world is baking (last year was the second warmest year on record), may be conveying an urgent message. Something like this happened 12,700 years ago when a post-ice age warming suddenly reversed and in just a few years plunged much of the North Atlantic region into a 1,300 year deep freeze. If this signals the beginning of an abrupt change in climate, instabilities that dwarf the threat of terrorism lie in our future. If these great ocean currents are interrupted, temperatures in the Northeast might drop 10 degrees F (this winter represented a drop of about 2.5 degrees F) in less than a decade. Naturally, one winter does not an ice age make, and maybe our cold winter represents nothing more than a byproduct of regularly recurring cycles such as the North Atlantic Oscillation and El Nino. At the moment we don't know. But maybe we should try to find out. As recently as the 1980s, a cold winter was a curiosity, an outbreak of a new disease, a problem for the third world, and, while the Soviets had many nuclear weapons, they knew better than to use them. Today's tightly connected globe means that uncertain times create a petri dish in which destabilizing fears multiply. Worse, if climate change does come about and those fears become real, the damage will be far greater if we're not prepared. Such uncertainties will be with us for the foreseeable future, dampening spending and investment, and leaving regions prone to sporadic panics. The last thing the public needs right now is another threat on people's minds, but a little more attention to rapid climate change is in order. In an uncertain world, the first order of business is to know what to worry about.

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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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