A Minyanville friend, “Mr. Practical”, pinged me with his thoughts on leverage derivative-fueled market crashes.

Image from the Guardian article: Mathematical Equation that Caused the Banks to Crash.

Leverage, Options, and Derivative-Fueled Crashes by Mr. Practical

Option contracts have been around since antiquity, ever since someone said, “if you do this, then I will do that”. Clever people who knew how to intuitively price options (agreements/bets/contracts), making the “this” worth more than the “that”, got ahead, accumulated wealth. With the advent of liquid markets came the ability to “hedge” options, and with that, the Black-Scholes model. Pricing options, even after the BS model was derived, is obtuse and so they are consistently misvalued.

Options began trading as securities in the late 1970’s and became part of a group of securities called derivatives: securities or contracts that derive their value from an underlying asset. All derivatives connote leverage in varying degrees with options being the most levered. But unlike most other more vanilla derivatives, options, when employed properly, serve a real purpose for investors/traders other than leverage: they segment risk into upside and downside and facilitate delineation of return profiles.

But the derivatives market has grown immensely and now dwarfs the cash markets which it overlays. Depending on how you measure it, the notional value represented by the derivative markets globally is around a quadrillion dollars, a thousand trillions. Now the tail wags the dog.

What do I mean by that? First, leverage introduces extra risk in the market because asset prices are effectively purchased with debt (i.e., for an up-front payment less than the full value of the underlying, with the remainder to be paid later), driving up prices higher than they normally would be. However, the real problem is that the asset prices act as collateral for the debt that bought them, so when those asset prices fall, the collateral might have to be sold by the lender, driving prices down even further. Second, options introduce a special form of leverage called gamma, and it helped exacerbate the 1987 crash, the early 2000 crashes, and especially the crash of 2008.