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Turmoil Lurks Around The Corner
On October 12, 1987, a week before Black Monday, the Wall Street Journal warned of the potential for significant market turmoil. Per the article: The use…
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On October 12, 1987, a week before Black Monday, the Wall Street Journal warned of the potential for significant market turmoil. Per the article: The use of portfolio insurance “could snowball into a stunning rout for stocks.” Today, we are increasingly alarmed that another trading tool similar to portfolio insurance could set markets up for a bout of turmoil.
The quote above and a detailed analysis of Black Monday can be found in a Federal Reserve white paper entitled A Brief history of the 1987 Stock Market Crash.
Despite the growing risk to foster market turmoil, 0DTE is a term few investors have heard of.
0DTE stands for zero days to options expiration. These are put-and-call options on individual stocks and indexes that expire within 24 hours. 0DTE options may seem like speculative YOLO (you only live once) bets at first glance. However, when one appreciates how brokers hedge options, they then grasp the potential for these options to generate significant volatility in individual stocks and the market.
Before exploring 0DTE options, it’s worth briefly discussing portfolio insurance’s role in Black Monday 1987.
1987 Portfolio Insurance
One of our first reactions to hearing of the recent popularity of 0DTE trades was to recall Black Monday and the 22.6% crash of the Dow Jones Industrial Average on October 19, 1987. There are several causes for the turmoil, but the factor that significantly amplified the decline was portfolio insurance.
At the time, institutional investors were buying portfolio insurance from Wall Street brokers to help protect against losses. During market declines, the brokers’ computer algorithms would automatically sell S&P 500 futures contracts short. As the market sold off further, the algorithms would sell more contracts.
As the programs sold, they pushed markets lower, necessitating more portfolio insurance-related selling. Selling begat selling, and a correction turned into an avalanche of panic.
The following quote is from a Wall Street Journal article rehashing the turmoil:
The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time. They pushed stock prices into free fall and individual investors under the bus.
0DTE Options
The popularity of 0DTE options is rising precipitously. As the graph below shows, half of the volume of options on S&P 500 futures are 0DTE. That dwarfs the 5-10% share existing before the pandemic.
Individual and institutional investors are using options that have a very short time until expiry for speculative and hedging purposes. It is also likely investors may be using 0DTE options to manipulate markets. Regardless of the objectives, 0DTE options have a similar feature as portfolio insurance; they can significantly intensify market moves.
To reiterate the WSJ quote: “The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time.” Sound familiar?
How Manipulation Creates Signifcant Instability
To help better appreciate the risk of 0DTE options, we walk through a hypothetical example using Tesla stock. This case uses data from the early afternoon on January 25, 2023. After the close that day, Tesla reported its quarterly earnings.
Hypothetical hedge Fund ABC owns 100,000 shares of Tesla stock (TSLA). TSLA was trading for $144, which meant ABC had a $14,400,000 investment in TSLA. With earnings due shortly, ABC wanted a low-cost trade to juice their returns if earnings were better than expected.
One such way is 0DTE options. To do so, they could buy calls with a $160 strike that expired in a day. At the time, the price per 0DTE call was $1.36. Each call option controls 100 shares. If they chose, buying 1,000 calls would give them the right to purchase 100,000 shares at $160. The options cost was $136,000 or about 1% of their total Tesla investment. If TSLA shares flopped on earnings, they would lose 1% on the options. If the stock rose, they would likely sell the options and could easily double or triple their return. More importantly, their calls could force significantly more buying if the stock rose.
Delta Hedging Begets Delta Hedging
As frequently occurs, ABC indirectly buys calls from a Wall Street dealer. Most dealers run managed books meaning they have limited risk-taking tolerance. Accordingly, they often hedge their risks. In this case, the dealer’s risk is an increase in the price of Tesla.
Dealers use a hedging method called delta hedging. An option’s delta estimates how much an option’s value may change for a $1 move up or down in the underlying security. The delta at the time of the trade was .15. For each $1 that TSLA shares rose, the options would increase by 15 cents. The delta increases toward 1.0 as the price approaches the strike price and falls toward zero as the price declines.
The dealer might initially delta-hedge the calls in our scenario by buying 15,000 shares (.15*100,000). As the price rises or falls, the number of shares they own will change according to the delta. The table below approximates the delta for Tesla shares on that day for a range of prices.
If the hedge fund is right and Tesla has excellent earnings, the stock will jump and force the dealer to buy more Tesla. The further it rises, the more shares they must buy. As the dealer and other dealers increase their hedges, the buying pressure on Tesla shares increases and pushes the delta higher. Buying begets buying.
Options on The Market
The Tesla 0DTE example pertains to the movement of one stock. While Tesla’s price may be more volatile than it would have been without 0DTE options, its effect on the broad market is limited.
More concerning, investors are buying 0DTE calls and puts on the S&P 500 and other indexes. Often such options are purchased in advance of potentially market-moving events. Recently, CPI, Fed meetings, and employment reports have drawn sizeable interest from 0DTE traders.
Suppose 0DTE volume is large enough, and options buyers are betting on the same directional market move. In that case, the environment becomes ripe for significant market instability if dealers are forced to aggressively delta hedge. Adding strength to such an event, investors become irrational when markets fall precipitously. A considerable downward move could trigger other investors to panic sell. Selling could beget selling, and a few percent loss could quickly turn into a severe decline.
Summary
If you take one thing away from this article, it is that for every option, there is likely a bank/dealer on the other side of the trade. Risk management protocols force dealers to buy or sell up to 100 shares of the stock or index for each option. It takes little money for a hedge fund to manipulate stock or index prices and, therefore, little money to create market turmoil.
Unlike portfolio insurance, delta hedging is limited as the delta can only go to one or zero. However, a heavy dose of delta hedging could cause panic selling among other market players. Fear can beget fear!
Closing Note
When we calculated the TSLA 0DTE example, Tesla closed the day at 144.43 minutes before the company reported its Q4 earnings. Its shares shot 10% higher the next day on the most volume in six months. 0DTE certainly helped TSLA shareholders!
The post Turmoil Lurks Around The Corner appeared first on RIA.
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How much more financial pressure can Australian mortgagees take?
Talk to anyone on the street these days and the conversation will inevitably turn to how inflation is increasing their cost of living in some form or another….
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Talk to anyone on the street these days and the conversation will inevitably turn to how inflation is increasing their cost of living in some form or another. Inflation has risen steadily since the beginning of 2022 despite the determined efforts of Reserve Bank of Australia (RBA) to bring it back towards its target range of 2-3 per cent.
In less than 1 year and 11 interest rate rises later, official interest rates have risen from 0.10 per cent to 3.85 per cent but inflation remains stubbornly high at 7 per cent. Interest rates have never risen this fast before nor from such a historically low level either.
As previously outlined in an earlier blog entry on Commonwealth Bank (ASX:CBA), the big four banks of Australia have just under 80 per cent of the residential property mortgage loan market. In “normal” economic times of rising interest rates, banks should be natural beneficiaries of these conditions. However, these are not normal times.
The business model of banks has generally stayed the same for centuries, i.e. borrow money from one source at a low interest rate and lend it to a customer at a higher rate. Today, the Australian banks generally get their funding from wholesale and retail sources. However, the banks were offered a one-off funding source from the RBA called the Term Funding Facility (TFF) during the COVID-19 period to support the economy. This started in April 2020, priced at an unprecedented low fixed rate of 0.10 per cent for 3 years with the last drawdown accepted in June 2021 for a total of $188 billion. Fast forward to today and the first drawdowns from this temporary facility have already started to roll-off which means that these fund sources need to be replaced with one of considerably more expensive sources, namely wholesale funding or retail deposits. As a result of this change in funding, bank CEOs have unanimously declared that net interest margins, and hence its effect on bank earnings, have peaked for this cycle despite speculation that interest rates may still rise later in the year.
Prior to the start of the roll-off of TFF drawdowns, the entire Australian banking industry engaged in cutthroat competition for new and refinancing mortgage loans in a bid to maintain or grow market share. In the aftermath of the bank reporting season, two of the big four banks have stated they are no longer pursuing market share at any price, with CBA and National Australia Bank (ASX:NAB) announcing they will scrap their refinancing cashback offers after 1 June and 30 June respectively.
Turning our attention back to the average Australian, the big bank mortgage customers have been remarkably resilient. The Australian dream of owning the house you live in is still alive for now, with owners willing to endure significant lifestyle changes in a bid to keep up with mortgage payments. The big banks have reflected this phenomenon with a reduction in individual loan provisions and only a modest increase in collective loan provisions.
Time will tell how much more financial pressure Australian mortgagees can take, especially with the RBA still undecided on the future trajectory of interest rates. What has been agreed on by the big banks, is that things are not going to get easier. At least not in the short-term.
The Montgomery Funds own shares in the Commonwealth Bank of Australia and National Australia Bank. This article was prepared 29 May 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.
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U.S. Breakeven Inflation Comments
I just refreshed my favourite U.S. breakeven inflation chart (above), and I was surprised by how placid pricing has been. This article gives a few observations regarding the implications of TIPS pricing.Background note: the breakeven inflation rate is …
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Background note: the breakeven inflation rate is the inflation rate that results in an inflation-linked bond — TIPS in the U.S. market — having the same total return as a conventional bond. If we assume that there are no risk premia, then it can be interpreted as “what the market is pricing in for inflation.” I have a free online primer here, as well as a book on the subject.
(As an aside, I often run into people who argue that “breakeven inflation has nothing to do with inflation/inflation forecasts.” I discuss this topic in greater depth in my book, but the premise that inflation breakevens have nothing to do with inflation only makes sense from a very short term trading perspective — long-term valuation is based on the breakeven rate versus realised inflation.)
The top panel shows the 10-year breakeven inflation rate. Although it scooted upwards after the pandemic, it is below where is was pre-Financial Crisis, and roughly in line with the immediate post-crisis period. (Breakevens fell at the end of the 2010s due to persistent misses of the inflation target to the downside.) Despite all the barrels of virtual ink being dumped on the topic of inflation, there is pretty much no inflation risk premium in pricing.
The bottom panel shows forward breakeven inflation: the 5-year rate starting 5 years in the future. (The 10-year breakeven inflation rate is (roughly) the average of the 5-year spot rate — not shown — and that forward rate.) It is actually lower than its “usual” level pre-2014, and did not really budge after recovering from its post-recession dip. (My uninformed guess is that the forward rate was depressed because inflation bulls bid up the front breakevens — because they were the most affected by an inflation shock — while inflation bears would have focussed more on long-dated breakevens, with the forward being mechanically depressed as a result.)
Since I am not offering investment advice, all I can observe is the following.
Since it looks like one would need a magnifying glass to find an inflation risk premium, TIPS do seem like a “non-expensive” inflation hedge. (I use “non-expensive” since they do not look cheap.) Might be less painful than short duration positions (if one were inclined to do that).
Breakeven volatility is way more boring than I would have expected based on the recent movements in inflation. The undershoot during the recession was not too surprising given negative oil prices and expectations of another lost decade, but the response to the inflation spike was restrained.
The “message for the economy” is that market pricing suggests that either inflation reverts on its own, or the Fed is expected to break something bigger than a few hapless regional banks if inflation does not in fact revert.
Otherwise, I am preparing for a video panel on MMT at the Canadian Economics Association 2023 Conference on Tuesday. (One needs to pay the conference fee to see the panel.) I have also been puttering around with my inflation book. I have a couple draft sections that I might put up in the coming days/weeks.
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“What’s More Tragic Is Capitalism”: BLM Faces Bankruptcy As Founder Cullors Is Cut By Warner Bros
"What’s More Tragic Is Capitalism": BLM Faces Bankruptcy As Founder Cullors Is Cut By Warner Bros
Authored by Jonathan Turley,
Two years…
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Two years ago, I wrote columns about companies pouring money into Black Lives Matter to establish their bona fides as “antiracist” corporations. The money continued to flow despite serious questions raised about BLM’s management and accounting. Democratic prosecutors like New York Attorney General Letitia James showed little interest in these allegations even as James sought to disband the National Rifle Association (NRA) over similar allegations. At the same time, Black Lives Matter co-founder Patrisse Cullors cashed in with companies like Warner Bros. eager to give her massive contracts to signal their own reformed status. It now appears that BLM is facing bankruptcy after burning through tens of millions and Warner Bros. cut ties with Cullors after the contract produced no — zero — new programming.
Some states belatedly investigated BLM as founders like Cullors seemed to scatter to the winds.
Gone are tens of millions of dollars, including millions spent on luxury mansions and windfalls for close associates of BLM leaders.
The usual suspects gathered around the activists like former Clinton campaign general counsel Marc Elias, who later removed himself from his “key role” as the scandals grew.
When questions were raised about the lack of accounting and questionable spending, BLM attacked critics as “white supremacists.”
Warner Bros. was one of the companies eager to grab its own piece of Cullors to signal its own anti-racist virtues. It gave Cullors a lucrative contract to guide the company in the creation of both scripted and non-scripted content, focusing on reparations and other forms of social justice. It launched a publicity campaign for everyone to know that it established a “wide-ranging content partnership” with Cullors who would now help guide the massive corporation’s new programming. Calling Cullors “one of the most influential thought leaders in American public life,” Warner Bros. announced that she was going to create a wide array of new programming, including “but not limited to live-action scripted drama and comedy series; longform/event series; unscripted docuseries; animated programming for co-viewing among kids, young adults and families; and original digital content.”
Some are now wondering if Warner Bros. ever intended for this contract to produce anything other than a public relations pitch or whether Cullors took the money and ran without producing even a trailer for an actual product. Indeed, both explanations may be true.
Paying money to Cullors was likely viewed as a type of insurance to protect the company from accusations of racial insensitive. After all, the company was giving creative powers to a person who had no prior experience or demonstrated talent in the area. Yet, Cullors would be developing programming for one of the largest media and entertainment companies in the world.
One can hardly blame Cullors despite criticizism by some on the left for going on a buying spree of luxury properties.
After all, Cullors was previously open about her lack of interest in working with “capitalist” elements. Nevertheless, BLM was run like a Trotskyite study group as the media and corporations poured in support and revenue.
It was glaringly ironic to see companies like Warner Bros. falling over each other to grab their own front person as the group continued boycotts of white-owned businesses. Indeed, if you did not want to be on the wrong end of one of those boycotts, you needed to get Cullors on your payroll.
Much has now changed as companies like Bud Light have been rocked by boycotts over what some view as heavy handed virtue signaling campaigns.
It was quite a change for Cullors and her BLM co-founder, who previously proclaimed “[we] are trained Marxists. We are super versed on, sort of, ideological theories.” She denounced capitalism as worse than COVID-19. Yet, companies like Lululemon rushed to find their own “social justice warrior” while selling leggings for $120 apiece.
When some began to raise questions about Cullors buying luxury homes, Facebook and Twitter censored them.
With increasing concerns over the loss of millions, Cullors eventually stepped down as executive director of the Black Lives Matter Global Network Foundation, as others resigned. At the same time, the New York Post was revealing that BLM Global Network transferred $6.3 million to Cullors’ spouse, Janaya Khan, and other Canadian activists to purchase a mansion in Toronto in 2021.
According to The Washington Examiner, BLM PAC and a Los Angeles-based jail reform group paid Cullors $20,000 a month. It also spent nearly $26,000 on meetings at a luxury Malibu beach resort in 2019. Reform LA Jails, chaired by Cullors, received $1.4 million, of which $205,000 went to the consulting firm owned by Cullors and her spouse, according to New York magazine.
Once again, while figures like James have spent huge amounts of money and effort to disband the NRA over such accounting and spending controversies, there has been only limited efforts directed against BLM in New York and most states.
Cullors once declared that “while the COVID-19 illness is tragic, what’s more tragic is capitalism.” These companies seem to be trying to prove her point. Yet, at least for Cullors, Warner Bros. fulfilled its slogan that this is all “The stuff that dreams are made of.”
U.S. Breakeven Inflation Comments
Biden reaches ‘tentative’ US debt ceiling deal: Report
Biden reaches ‘tentative’ US debt ceiling deal: Report
“What’s More Tragic Is Capitalism”: BLM Faces Bankruptcy As Founder Cullors Is Cut By Warner Bros
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