Eugene Linden
home   |   contact info   |   biography   |   publications   |   radio/tv   |   musings   |   short takes   

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...

continue

Books


Fire & Flood
Buy from Amazon


Deep Past
Buy from Amazon

more info

Articles by Category
endangered animals
rapid climate change
global deforestation
fragging

Books
The Ragged Edge of the World



Winds of Change
Buy from Amazon

more info
Afterword to the softbound edition.


The Octopus and the Orangutan
more info


The Future In Plain Sight
more info


The Parrot's Lament
more info


Silent Partners
more info


Affluence and Discontent
more info


The Alms Race
more info


Apes, Men, & Language
more info

Climate Change is Here, Ready or Not. So What Now? Part 2


Friday April 12, 2013

 So how should we respond? Most obviously, we should stop making things worse. Tax penalties, tax credits, and import tariffs can nudge consumers, producers, and exporters towards reducing emissions without wasting more years on fruitless international negotiations or creating cumbersome new bureaucracies.

Second, we need to start adapting to the changes that are inevitable. Emergency loans and other financial aid to redress the billions in damage from extreme weather of the past couple of years already pressure budgets from the federal government on down. Hurricane Sandy showed the Northeast, for instance, where the vulnerable spots were. If someone wants to rebuild in one of those areas, so be it, but there is no reason that taxpayers should subsidize individual folly. The rates a private insurer would extract to enable a person, corporation or farmer to rebuild or replant in vulnerable areas would largely accomplish the necessary relocations—again with no bureaucracy.

Most importantly, we need leaders with the courage to steamroll the deniers and the vested interests. After a very short respite greenhouse gas emissions are getting worse. The Great Recession largely stalled U.S. greenhouse gas emissions for several years (though globally CO2 increased thanks largely to China). The respite ended in 2012, which saw the biggest jump in CO2 in the atmosphere in this millennium. The journal Science just published a reconstruction of past climate that showed that current temperatures are the highest in 4,000 years. Still, this won’t convince the deniers – nothing will – and the U.S. and the rest of the world are going to have to act over the loud objections of vested interests just as the government took action on smoking over the objections of the tobacco lobby.


A resident walks through flood water and past a stalled ambulance in the aftermath of superstorm Sandy on Tuesday, Oct. 30, 2012 in Hoboken, NJ. (Charles Sykes/AP)

This brings us to a roadblock as formidable as the great ice wall in Game of Thrones—we haven’t had those leaders. Since it’s open to question whether the present Congress would have the courage to take on the tobacco lobby if the link between smoking and cancer first arose today, how can we expect them to act against the vastly richer fossil fuel lobby? How can a political system that could not institute real reform in the financial system even after near collapse in 2008 be expected to act rapidly to impose new taxes—the most polarizing word in the political lexicon—and do that during a time of weak economic growth? The answer is obvious: it can’t—at least not without overwhelming pressure from powerful groups that can’t be bought off or befuddled.

Therein lies the faintest glimmer of hope. With $5 trillion of invested capital, the American insurance industry has as much economic clout as the fossil fuel industry. Insurers lose money if they under-price the myriad risks of climate change. If they can’t raise prices to match the estimated risk, they simply pull out of the market. This happened in Florida where a series of governors stymied insurers’ requests for rate increases to adjust for increased risks of hurricane damage. The insurers said sayonara leaving the state to backstop homeowners who insisted on living in harm’s way. Thus we have the delicious irony of Florida having a free-market champion and climate change denier governor, Rick Scott, presiding over the socialization of climate change risk. A study by the non-profit CERES estimates that government—meaning us the taxpayers’—exposure to climate-related risk has increased fifteen fold since 1990 as private insurers have pulled back and extreme events increased. If government stopped smothering the market signals coming from the insurance market, both adaptation and calls for action on dealing with global warming would accelerate enormously.

Outside the U.S., developed nations take climate change seriously, and if the international community started imposing tariffs on goods coming from nations that fail to address emissions, that would get the attention of Congress. It’s sad, but at a time of imminent peril, we are stuck with a political system that will not act without adult supervision.

President Obama made strong statements about the importance of climate change when he first ran for president. Then, in his first term, he abandoned the issue, just as every other American leader has done since global warming first entered the national conversation. Now he is promising to do what every previous administration could have done by using executive powers to actually lead on the issue. Presidents are said to care about their legacy. Climate change is a civilization killer, and if we continue down the climate rapids, future generations probably will not be thinking about any presidential legacy of our era—except to assign blame.

contact Eugene Linden

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).

 

 



read more
  designed and maintained by g r a v i t y s w i t c h , i n c .
Eugene Linden. all rights reserved.