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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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SANDY AND THE WINDS OF CHANGE: You don't need a climate scientist to see which way the wind blows


Friday November 30, 2012

 

by EUGENE LINDEN

 

Even as Sandy underwent its bizarre metamorphosis from hurricane to winter storm, the question arose in many inquiring minds (at least those not beholden to a solemn oath of climate-change denial): Was this historic storm a symptom of global warming? Climate science has two ready answers: Absolutely! And, of course not!

On the one hand, a warming globe makes megastorms more probable, while on the other, it is impossible to pin a global warming sticker on Sandy because the circumstances that turned it into a monster could have been mere coincidence.

There is, however, another way of looking at Sandy that might resolve this debate, and also help frame what we really should be worried about when it comes to global warming: An infrastructure created to defend against historical measures of worst-case natural threats was completely overpowered by this storm.

THEN AND NOW: Devastation from super storm Sandy

New York City's defenses were inadequate, and coastal defenses failed over a swath of hundreds of miles. Around the nation, such mismatches have been repeated ever more frequently in recent years.

This summer, barge owners discovered that dredging in the Mississippi River, predicated on the history of the river's ups and downs, left it too shallow for commercial traffic because of the intense Midwestern drought. And, famously, levees in New Orleans that were largely through the process of being improved even as Hurricane Katrina struck in 2005 were still breached in 50 places. Then, seven years to the day after Katrina struck, Plaquemines Parish was drowned by Hurricane Isaac in flooding residents described as worse than Katrina's.

It's true that factors other than megastorms — loss of flood plains, subsidence and neglect — can exacerbate a failure, but the number of failures of all types of defenses has been stunning.

Such failures are telling us that something new is afoot. Our levees, dredging protocols and, in New York City, subway tunnel designs and improvements incorporate society's best guess of what it takes to protect against the worst nature might throw at us. Such defenses are expensive, so a city or agency won't spend more than it deems necessary. But the consequences of underestimating are also so enormous — consider the billions that will be spent restoring Manhattan's infrastructure and ruined neighborhoods alone — that we routinely construct them to withstand 100- or even 500-year events, estimates based on probability calculations and history of rare, extreme disasters. Yet these days such events seem to occur annually.

This is borne out by statistics. Among the many records set by Sandy, one was for the highest wave ever recorded in New York Harbor: 32.5 feet. That eclipsed the previous record wave of 26 feet. When was the earlier record set? Just last year, courtesy of Hurricane Irene.

Another message from Sandy is the reminder that climate change is camouflaged. It arrives as familiar weather events and after slowly accumulating changes.

Sandy was unusual in many ways, but it is also easy to dismiss its significance because it started out as a hurricane and hurricanes have always marched up the Atlantic coast, even as late as November. As for the surge that inundated beach towns and city streets, it came on top of a sea level that has been rising slowly, on average less than one-tenth of an inch per year, though the pace has been accelerating in recent decades. The oceans are now roughly 9 inches higher than they were 140 years ago, and, for the most part, our sea defenses have not kept pace.

Perhaps the most important message from Sandy is that it underscores the enormous price of underestimating the threat of climate change. Damage increases exponentially even if preparations are only slightly wrong. In trying to protect Grand Forks, N.D., from a spring flood in 1997, the city used sandbags to defend against a high-water mark of 52 feet, comfortably above the 49-foot crest predicted by the National Weather Service but, unfortunately, below the 54-foot crest that occurred on April 21. It was only 10% higher than what was expected, but the damage was many hundred times greater than if the protections had not been breached; 50,000 homes suffered damage.

At some point the consensus among climate scientists might convince even those now in denial that they ignore the role of global warming in extreme weather events at the nation's peril. In the meantime, Sandy's trampling of the Northeast's defenses against the weather, as well as scores of other major infrastructure failures in the face of extreme floods, heat, drought and winds in the United States and around the world, tell us that climate change is already here.

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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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