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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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Thursday February 03, 2011

Eugene Linden


A well-trodden meme of TV and cinema has been the plot in which someone or something uses tantalizing illusions to sap humans of their will to resist while simultaneously pursing hostile ends. In The Martian Chronicles, the subtle race of Martians distracted the invading Americans with irresistible life-like illusions that spoke to their most intimate yearnings; in one episode of the X-Files, a fungus slowly digested an unlucky couple who lay in a field and were rendered completely passive by the fungus’ hallucinogenic properties. And then, most famously, the machines of the movie The Matrix ruled over a ruined wasteland and seduced people with a beguiling virtual reality in order to maintain their passivity while they tapped humanity’s body heat as an energy source.

Now, a lot of investors believe that life is imitating art in an alliance of the Federal Reserve and the big banks to create the illusion of healthy equity markets despite massive retail equity withdrawals in the years following the financial crisis. In this broadly-believed scenario the Fed’s motives are comparatively benign – to foster asset inflation that improves animal spirits, fosters a wealth effect, and restores access to the equity markets for financial institutions and other companies in need of capital.

The idea is that through its program of quantitative easing the Fed is buying treasuries from its primary dealers who then turn around some portion of the proceeds in the equity market. Data miners have discovered strong correlations between the Fed’s permanent open market operations (POMOs) and up days in the equity markets, with a statistically significant spike on such days during the final 45 minutes of trading. So strong is the perception that these operations pump the market that Bernanke’s announcement of a new quantitative easing program last August set off a rally that moved the market up over 14% before the program was scheduled to begin in November.

Whether or not there is a direct connection between QE and a bid for stocks, the mere fact that the link is so widely believed has played a non-trivial role in the equity markets. Which begs the question: if the markets have risen on this scenario, does it matter whether or not this connection exists? After all, millions of investors have been benefitting from the ride. The cynical answer is that it probably does not matter -- if such manipulations could continue in perpetuity.

There’s the rub: nothing continues in perpetuity. In fact, QE2 is scheduled to end around mid-year and if it is not extended, the markets will face a crunch whether or not there is a real connection between QE and the market. Thus, if the Fed will not (or cannot) extend QE past June, it behooves its officials to convince investors well beforehand that it has not provided the invisible hand supporting stocks. Regardless of the Fed’s role, there have been other, more disturbing bits of evidence that we are in a Matrix Market.

Exhibit One is the so-called “flash crash of May 2010 during which stocks fell by 600 points in five minutes before staging and equally vertiginous recovery. The crash offered evidence that something truly scary lay behind the reassuring façade of buoyant markets. Subsequent investigation revealed that High Frequency Trading, which relies on algorithms to execute superfast trades, exacerbated the collapse. Revelations about the extraordinary percentage (sometimes over 80%) of trading attributable to HFT programs in stocks such as Citi and AIG suggest that the metaphor of a Matrix Market may be literally as well as figuratively true, and also helped explain how a market suffering continuing retail withdrawals could still rise to a multi-year high during a very weak economic recovery.

Economist Michael Hudson of the University of Missouri calculated that the average time a stock was held during 2010 was 22 seconds, not exactly buy and hold. Of course it’s entirely possible that both HFT and the impact of the Fed’s easing program are overblown; that the market’s rise can be simply explained by solid corporate earnings and the perception of a real recovery. If that’s the case, the market will continue to plug higher so long as the recovery story remains credible to investors and earnings hold up. If, however, the rally is largely an artifact of the jet fuel supplied by the Fed and amplified by algorithmic trading, then watch out.

The recent example of the auction-rate securities market shows that fake markets can seduce and then trap the most sophisticated investors. Adapted for municipal finance in 1988 by Goldman Sachs, the market grew to about $300 bn before it collapsed amid a series of failed auctions when the main players – Citi, UBS, AG, MS, and ML – pulled back from their practice of being the bidders of last resort. What was revealed subsequently was that for several months before that, auctions had basically been a sham with the big underwriter banks supplying the majority of bids for the securities they helped issue. Given that the investors were institutions and high net worth individuals, it’s remarkable that this could carry on so long without being uncovered. The ARS market was doomed in March, 2007 when FASB announced that ARS should not be counted as cash on balance sheets and liquidity began to dry up. From that point on the auction rate securities market was a ghost.

Those who paid attention (which did not include me) saved themselves much grief. Others remained oblivious for eleven months before the axe fell, and when it fell, it fell suddenly – one week after the first cracks appeared in the market 80% of the auctions that priced the securities failed. In hindsight it’s obvious that during that “dead man walking” period it was in not in any underwriter or broker’s interest to say that the ground had fatally shifted under what had been a highly profitable market. This was not a grand conspiracy or racket, but, more likely, a series of individual crimes as like-minded players continued a game because they could see no alternative. I’m sure that many of the players were amazed that it continued as long as it did.

Something similar happened in the mortgage-backed securities market as firms such as Bear Stearns continued to package and push them on investors long after it became obvious that the underlying mortgages were going sour in unprecedented numbers (when the MBS market finally did collapse new issuance went from hundreds of billions annually to zero). Something very similar is going on right now in the commercial real estate market where lenders are extending maturities because no-one wants to face the consequences of setting off a cascade of defaults and subsequent massive write-downs in a weak market. Is something similar going on in the equity markets?

For sure, we’re gonna find out, probably by mid-year.

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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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