This Book Is Out Today and I Ordered It

This excerpt in the WSJ and this appearance on NPRs Fresh Air( transcript here)convinced me this will be a great read. The book focuses on the growth of "quants' on wall street  and how their activities in quantitative trading and derivatives contributed much to the market meltdown. And it wasn't the first time. As the author pointed out the first time this happened was in the 1987 market crash when portfolio insurance (essentially a short options position) played a crucial role in the meltdown. Add in LTCM and some other smaller blowups (many disastrous to individual funds or trading desks but not big enough to make the headlines) and the impact of the quants on markets is undeniable.

Another book written by a practitioner and a PhD quant Richard Bookstaber entitled Demons of Our Own Design makes similar points. Bookstaber had been in charge of risk management at several big Wall Street firms. He blogs here. In this recent post(below) he points out the crucial role of liquidity (everyone running to the exits at the same time) is responsible for much of the disastrous impacts of the quants models.

Essentially many of these products have option like characteristics and for many trading desks their positions are essentially short options. For those option geeks that means the trading desks are "short gamma" and as the market moves against them they need to sell increasingly larger positions to stay hedged. But the hedging required is not fixed it is a dynamic number and if there is large scale selling it will create a feedback loop with lower markets generating another round of selling. Hence: "demons of our own design" market demons created by the derivative products. Bookstaber makes these points well in his book.

He makes the same point in this entry on his blog where he argues it wasn't a lack of awareness of the existence of  fat tails

...So, to recap, we all know that there are fat tails; it doesn’t do any good to state the mantra over and over again that securities do not follow a Normal distribution. Really, we all get it. We should be constructive in trying to move risk management beyond the point of simply noting that there are fat tails, beyond admonitions like “hey, you know, shit happens, so be careful.” And that means understanding the dynamics that create the fat tails, in particular, that lead to market crisis and unexpected linkages between markets.

What are these dynamics?

One of them, which I have written about repeatedly, is the liquidity crisis cycle. An exogenous shock occurs in a highly leveraged market, and the resulting forced selling leads to a cascading cycle downward in prices. This then propagates to other markets as those who need to liquidate find the market that is under pressure no longer can support their liquidity needs. Thus there is contagion based not on economic linkages, but based on who is under pressure and what else they are holding. This cycle evolves unrelated to historical relationships, out of the reach of VaR-types of models, but that does not mean it is beyond analysis

I think this dynamic is part of the market puzzle that needs to be considered in addition to behavioral finance. I call it the institutional factor, the existence of large positions in the markets with option like characteristics, hedge funds with similar models of pairing long and short postions (like ltcm) done with leverage all create "demons" that can cause large spikes in volatility and market meltdowns (and meltups). it also happens in all sorts of smaller ways for instance unusual price movements when a particular security trades near a an option strike price where there are large positions, moves on dates of option expiry, unwinding of carry trades and more.

Much of this is well known in the micro world of specific markets but missed by the general public and most financial journalists and academics. I was amused by the excerpt from the Quants in the WSJ where hedge fund players ferverishly  unwinding their paired positions where they were long some stocks and short others in a "market neutral" strategies. As previously weak stocks rose and strong stocks fell the journalists struggled to provide a specious rationale.

Investors on Main Street had little idea that a historic blowup was occurring on Wall Street. AQR risk-management guru Aaron Brown had to laugh watching commentators on CNBC discuss in bewilderment the strange moves stocks were making, with no idea about what was behind the volatility. Truth was, Mr. Brown realized, the quants themselves were still trying to figure it out....

Everyday investors had no insight into the carnage taking place beneath the surface, the billions in hedge fund money evaporating. Of course, there was plenty of evidence that something was seriously amiss. Heavily shorted stocks were zooming higher for no logical reason. Vonage Holdings, a telecom stock that had dropped 85% in the previous year, shot up 10% in a single day on zero news. Online retailer Overstock.com; Taser International, maker of stun guns; the home building giant Beazer Homes USA; and Krispy Kreme Doughnuts—all favorites among short sellers—rose sharply even as the rest of the market tanked.
From a fundamentals perspective, it made no sense. In an economic downturn, risky stocks such as Taser and Krispy Kreme would surely suffer. Beazer was obviously on the ropes due to the housing downturn. But a vicious market-wide short squeeze was causing the stocks to surge.
The huge gains in those shorted stocks created an optical illusion: the market seemed to be rising, even as its pillars were crumbling beneath it.

Both Patterson's journalistic account and Bookstaber's view as a market professional both convince me to have that black swan hedge through a long volatility position as a permanent part of my portfolios.