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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Fire & Flood
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Deep Past
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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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Global Warming Slips on Its Ski Mask


Wednesday August 09, 2006

Climate change is going to creep up on us. The assault might have started already. By Eugene Linden (7/30/06) I've written a good deal about global warming over the years, but like most people, I still have a hard time envisioning how we will know when the apocalypse arrives. Nobody will ring a bell to announce that a climate-change event has begun, and it's easy to ignore the signals that climate is changing. After all, we've always had extreme weather, and it's possible that what signifies the point of no return will not be in the realm of weather anyway but rather a derivative effect such as a financial crisis or crop failure. That's not to say that some future dramatic event such as the Greenland ice sheet sliding into the ocean won't happen, but it's more likely that global warming will creep up on us as the weather gradually unmoors from its normal patterns. Single events will be explained away. But at some point, the frequency, severity and ubiquity of the unusual weather will produce a sense of foreboding, a sense that something is happening beyond our control. What with killer heat waves, killer hurricanes and killer droughts, it's arguable that we've already passed that point. Indeed, I had that feeling of foreboding in the last week of June, as Washington gradually surrendered ground and the routines of daily life to incessant rain: Cars floated down ordinarily meek Rock Creek, government buildings flooded, the Metro was disrupted and roads were closed. You may have had the same feeling last week as the power dimmed and temperatures surged in Southern California and beyond. That said, the real, more insidious scenario might be that climate change will intrude on our lives like an omnipresent and ever more confiscatory taxman. Where they can, insurers and banks will pass weather risks to individuals and the government, making the costs of daily life more expensive. In some areas, housing might become uninsurable and unsalable, which in turn could cause a financial crisis. Municipal budgets and government safety nets will gradually succumb to the ever-increasing burden imposed by windstorms, floods, droughts and other weather extremes. Infectious diseases will thrive. The middle class will slowly find its savings and creature comforts stripped away, and the ordinary details of living, such as eating fresh vegetables and traveling to see family and friends, will become more expensive and uncertain. At some point it will dawn on us that the weather is making us poorer and sicker. Whether we are in Act 2 or Act 4 of a five-act climate drama, we are not the first to live out this play. At some point, for instance, the Moche elders, who lived in Peru 1,400 years ago, must have begun to wonder whether torrential El Niño-related rains were going to spell the doom of their civilization. Sometime during a 10-year stretch of intensely cold winters and short, cool summers, the Norse living in Greenland in AD 1350 must have begun to feel a sense of dread. In fact, that period was one harbinger of the Little Ice Age, which persisted for several hundred years. NOW IT'S our turn. Like fugitives who must worry about every knock on the door, we can no longer dismiss events such as the late June rains and the July heat wave as just another instance of wacky weather. There's a distinct difference, though, between us and the Moche and the Norse, not to mention the Mayans, the Anasazi, the Akkadians and other players in previous episodes of climate chaos. All of them were victims of natural cycles; the evidence suggests that we wrote the script for this latest episode of climate roulette. It's easy to be condescending about past civilizations. They didn't have the science and technology that have enabled us to understand how climate works or to determine the role of climate in the collapse of their cultures in South America, the American Southwest and the Middle East. If only they knew what we now know about climate, maybe they would have adapted and survived. Then again, maybe not. We do know what we know, and still we do nothing. That's going to have future historians scratching their heads.

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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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