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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Articles by Category
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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PLEASE TREAD ON ME (Updated)


A few weeks back, President Bush signed a budget measure that would effectively cut environmental protection spending by the EPA over the next year by about six percent. Score another win for the corporate Browns in their long-standing rivalry with the Greens in this latest game in the World Environmental Football League. Recurrent lopsided scores should not be a surprise in this league since the Browns are pros playing for money, while the Greens are amateurs playing for effete liberal ideas like the viability of the planet. The league itself has unusual rules and traditions. The Greens play touch, while the Browns play tackle. Moreover, leaving nothing to chance, the Browns buy the ref. Strangest of all; the Greens would not have it any other way. I was prompted to look into the rules of this bizarre set-up a few years ago. I attended a meeting of an international environmental group and listened as a highly motivated group of greens discussed plans to fund a pilot project on ecotourism in Quintana Roo, Mexico. The idea was to point the way towards nature-friendly projects in this beautiful but vulnerable stretch of Caribbean coast. I should have been swept up by their idealism, but I wanted to tear my hair. Fourteen years earlier, I had visited this very area and heard highly motivated greens discuss similar plans to raise money to fund pilot projects in ecotourism. In the interim, highly motivated developers have built real hotels, destroying mangroves, killing reefs, and fouling once-clear sinotes in the process. There are no pilot hotels. This was but one episode of a pas de deux of destruction now playing in the U.S. and around the world (the WEF is the world’s one true global league). While greens concoct pilot projects and scrupulously honor "process," developers develop, loggers log, and poachers poach. When a builder in Quintana Roo or a timber interest in the Tongass covets a piece of real estate, he does whatever necessary to get the necessary approvals, produces an environmental impact study that suggests that sewage is good for coral reefs, or cutting is good for forests, and then builds. When environmentalists find some natural treasure, they hold conferences, fund surveys and censuses, seek consensus with locals, and say things like, “after doing x,y and z we can begin to…” Greens are always beginning to do something or other. A green-run airline would have pilots perpetually training for flights that were forever delayed. When they need it, exploiters have an ace in the hole: corruption. Pay offs and muscle, ubiquitous in decisions affecting natural areas in the developing world, and more subtly used in the U.S., utterly trump the law-abiding, bureaucratic approach of greens. Mario Villanueva, the governor of Quintana Roo, accused of taking mordida to approve hotels, eventually went on the lam, but the damage was already done. When, during the ’97 Asian financial crisis, greens asked Treasury Secretary Robert Rubin to support making new loans to Indonesia contingent on environmental reform, he replied that the time to talk about environment was when the country was back on the path to prosperity. Wrong: it was when Indonesia was richest that its corrupt politicians and generals were the most destructive. Since Rubin’s remarks, Indonesia has become the most critical environmental catastrophe on earth as free-lance loggers, squatters, and poachers take advantage of the country's instability to invade the nation's protected areas and remaining forests. On some islands, even the legal amounts of timber allocated for cutting vastly exceed the remaining stands of trees, parks included. The mismatch between the Browns and the Greens offers one reason that decades of mounting environmental awareness have produced so little in the way of facts on the ground. The decline of earth's ecosystems has only accelerated despite a geometric growth in the number of environmental groups around the world. Perhaps the most aggravating aspect of this danse macabre is that even its victims accept it as the way it should be. As one environmentalist told me, "of course we have to do an assessment; how else can we make the case for what to save and where to put boundaries." He's right. But, doesn't it seem strange that even as we watch forests disappear, fisheries die, and creatures go extinct, we continue to agree that the burden of proof lies with those who would protect nature rather than those would exploit her? Greens do their studies before entering an area, while if a company is building a pipeline in Kamchatka or a road in the Amazon, they make their plans first and let others worry about environmental impact. The practical reality is that once a development project is announced, with all its promise of jobs and profits, it is very difficult to halt. Still, what seems like common sense today may go down in history as collective madness as the bills start coming due for the destruction of earth's life support systems. Greens need to toss their playbook, and find a legitimate way to level the playing field. The huge reservoir of environmental awareness in the rich consuming nations offers enviros a powerful weapon to bring to bear on corporations, financial institutions, and international lending agencies that control the flow of money to the developing world -- a point made by activists at every international globalization forum. This is a useful step. And please, no more pilot projects!

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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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