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
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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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Why Corporations Will Soon Embrace Kyoto


This ran in TIME.com a while back under the headline, "Who's Going to Pay for Climate Change." The essay has renewed salience as concerns about changing climate surface once again. By EUGENE LINDEN The Bush administration, so warlike in response to terrorism, has revealed a pacifist streak in its approach to the threat of climate change. At meetings on the Kyoto Treaty last fall in New Delhi, U.S. delegates argued that we ought to be thinking about adapting to changing climate. The administration's position seems to have gone from doubt about the science of climate change to suggesting it is inevitable without ever acknowledging that the nation might take steps to avert the threat. The new position is a clever one: By leaving moot the question of cause, and by implying that no one could have done anything about it, the administration also implies that no one is responsible. The administration underscored its genial "no fault" approach when it recently asked industry to voluntarily reduce emissions. Nice try, but don't be surprised if there are few takers for this line of reasoning. As the costs of climate change become more obvious in everything from lost crops to wrecked real estate, victims will begin pointing fingers and businesses will begin diving for cover. John Dutton, dean emeritus of the Penn State's College of Earth and Mineral Sciences, estimates that $2.7 trillion of the $10 trillion U.S. economy is susceptible to weather-related loss of revenue, meaning that an enormous number of companies have "off balance sheet" risks related to climate. This could wound corporate America in a lot of ways, particularly as insurance companies discover this new area of risk. Most policies covering natural disasters are renewable on a yearly basis. When risks become too expensive, insurers can simply walk away. Something like this happened after the Sept. 11 attacks. Insurers suddenly realized that they had vastly underpriced the risk of terrorist attacks and stopped writing new policies. This brought many big construction projects to a standstill until President Bush signed a bill in Nov. that shifted responsibility for $100 billion of future terrorism-related losses from insurers to the taxpayers. If climate change starts inflicting losses, insurers will again head for the exits. Just such insurer flight has already caused problems in North Carolina's Outer Banks and in parts of New York's fabled Hamptons, where coastal storms are eating up homes and businesses. When insurance companies quit these high-risk places, the burden shifts to banks. But they don't have the same freedom simply to cancel mortgages and loans. What will happen to the markets if banks start demanding insurance for weather-related events that is either prohibitively expensive or completely unavailable? The climate change threat that will really get the attention of executives and boardmembers, however, is the possibility that they might be liable for damages. This could happen if insurers like financial giant SwissRe start changing the insurance policies that insulate directors and officers (called D&O insurance) from the costs of lawsuits resulting from the actions of their corporations. Businesses open themselves to lawsuits when they take a position contrary to others in their industry, and in recent cases such as asbestos litigation, courts have assessed damages proportionate to a company's contribution to a problem. Chris Walker of Swiss Re describes how this might come about with regard to climate change. He notes that energy giant Exxon/Mobil accounts for roughly 1% of global emissions, and has aggressively lobbied against any efforts to reduce greenhouse gasses. "So," says Walker, "we might then go to them and say, 'Since you don't think climate change is a problem, we're sure you won't mind if we exclude climate related lawsuits and penalties from your D&O insurance.'" Swiss Re recently set the stage for such action by sending a questionnaire to its D&O customers inquiring about their company's strategy to deal with climate change regulations. Some climate change regulation seems to be coming, whether the federal government acts or not. States such as New Jersey, Massachusetts and New York are following the lead of California, imposing their own limits on greenhouse gases and presenting businesses with the prospect of a crazy quilt of regulations. Various state attorneys general are going further, exploring ways they might sue companies for climate change-related damages. And if the Kyoto Treaty comes into force, as now seems likely this spring, countries might similarly seek trade sanctions against the U.S. for its unwillingness to abide by its terms. Faced with the prospect of class-action lawsuits, states that take a "roll your own" approach, and trade sanctions, many of those executives who are opposed to the Kyoto Treaty might begin to rethink their position, and the Bush administration might find itself abandoned by its ostensible allies. For corporate executives pondering climate change, threats to the wallet may prove far more persuasive than science. -----------------------------------------------------------------------

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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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