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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Betting the farm against climate change


Friday September 09, 2011

Global warming is extracting real costs, even in states where the governors are in denial.

Footprints mark the bank of a partially dried-up pond near downtown Dallas, Texas August 1. Scorching heat and lingering drought across Texas have pushed electric use to a new all-time peak according to the state grid operator. (Tim Sharp / Reuters)

Footprints mark the bank of a partially dried-up pond near downtown Dallas, Texas August 1. Scorching heat and lingering drought across Texas have pushed electric use to a new all-time peak according to the state grid operator. (Tim Sharp / Reuters)


 

Leon Trotsky is reputed to have quipped, "You may not be interested in war, but war is interested in you." Substitute the words "climate change" for "war" and the quote is perfectly suited for the governors of Texas, Oklahoma and New Mexico, all of whom have ridiculed or dismissed the threat of climate change even as their states suffer record-breaking heat and drought.

In his book, "Fed Up!," Texas governor and presidential aspirant Rick Perry derided global warming as a "phony mess," a sentiment he has expanded on in recent campaign appearances. Susana Martinez, the governor of New Mexico, has gone on record as doubting that humans influence climate, and Mary Fallin of Oklahoma dismissed research on climate change as a waste of time. Her solution to the extraordinary drought: Pray for rain (an approach also endorsed by Perry).

Although they may dismiss climate change, a changing climate imposes costs on their states and the rest of us as well.

In Texas, the unremitting heat has been straining the capacity of the electric grid, killing crops and livestock, and threatening water supplies. As reported in the Wall Street Journal, the grid's governing body, the Electric Reliability Council of Texas, bases its forecasts on the average demand over the previous 10 years. In a world without the threat of global warming, this is an entirely reasonable approach. But what if climate change makes the past an unreliable guide to the future? Then Texas is left with the present situation, in which the grid operator is forced to procure power in a tight market where wholesale prices have skyrocketed to 60 times normal.

Grid problems in Texas are but one pixel in a vast panorama of weather-related costs. In 2010, extreme drought in Russia and floods in Australia contributed to a doubling of grain prices. This year, floods from the Dakotas to Louisiana, and drought in the American Southwest and parts of Europe, have kept grain prices high.

The floods in Australia also contributed to a rise in steel prices in 2010 by closing Brisbane's port and interrupting the shipment of iron ore. The Mississippi floods this spring affected the delivery by barge of materials ranging from grain to such basic manufacturing chemicals as caustic soda and cumene. This year may surpass the 2008 record of $9-billion-plus weather-related disasters, and it probably will be the costliest in U.S. history in terms of tornado damage. Add it all up — well, you can't because, as in the case of the Mississippi floods, it's hard to pry apart weather-related damage from the compounding effect of dunderheaded human actions such as walling off the river from its natural flood plain.

Politicians who dismiss the risk of climate change like to talk about the uncertainties of the science. And, at least in one sense, they're right. It's impossible to assert that global warming contributed X amount of damage to this year's floods, much less finger climate change as a precise component of the extraordinary violence of this spring's tornadoes. The best climate science can say is that a warming globe provides a nurturing context for more intense storms and weather extremes. Scientists can offer only scenarios, rather than a script, as to how that will play out.

Richard Seager of Columbia University's Lamont-Doherty Earth Observatory labs offered one such scenario in a much-discussed paper in the journal Science. It postulated that a warming globe would shift upper-atmosphere circulatory patterns and lead to "perpetual drought" in the American Southwest and other subtropical regions around the world.

Given that events on the ground have been playing out in a way that supports Seager's hypothesis, one would think, for instance, that planners for electrical grids and other sectors likely to be affected would stress-test their models for situations in which prolonged heat and drought became more frequent events. Via email, Seager told me that, indeed, the study had prompted concerned government officials to contact him. But how likely is any follow-up action if the very highest elected officials in the affected states dismiss the threat with scorn?

Though there have yet to be political costs to adopting an anti-scientific posture on the threat of climate change, the real economic costs of mispricing this risk have caught the attention of a good segment of the business community, from commodity traders to insurers. Reinsurers in particular (companies that insure the insurers against catastrophe) see risks on a global scale and have the data that allow them to sort out local effects from global trends. Insurers also are the best equipped to price those risks — when politicians let them.

For instance, increased hurricane risk in Florida caught the attention of insurers and reinsurers in the 1990s, even as people flocked to the coast to live. Responding to the perceived threat, insurers tried to raise rates, but a succession of Florida governors stymied these increases, causing many insurers to abandon the market and the state to form an insurance pool to provide protection for homeowners.Rick Scott, the new governor, remarked on the record that he does not believe in climate change, which means Florida's taxpayers — and the rest of us, if a major disaster strikes — have joined him in making a bet that global warming is a myth.

In the states governed by climate-change deniers — and in the nation as a whole, where we are doing too little to address the threat of a warming globe — nature seems to be calling that bet.

Eugene Linden is the author of "The Winds of Change: Climate, Weather, and the Destruction of Civilizations," among other books. In 2005, he helped edit "Climate Change Futures: Health, Ecological and Economic Dimensions," a project undertaken by Harvard Medical School and sponsored by the United Nations Development Program and Swiss Re, a worldwide reinsurer.
 
 

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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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