A review of May 6, 2010 flash crash and the far OTM put options

As part of my project of the study of Super Trader Karen, I worked on the analysis of surviving the flash crash using Karen's trade style in the last couple of week and would like to share the initial part of this analysis here. Any comments are welcome.

 On Thursday May 6 of 2010, the US stock market had a famous flash crash when Dow Jones Industrial Average crashed 1,000 points (9%) and S&P 500 Index crashed 100 points (9%). The VIX shot up 18 points (74%) on the day as market volatility exploded. However, the US stock market recovered most of the losses within a couple of days. The 5 minute chart is shown below as a reference to the flash crash market action.

Looking at the big picture, the US market was in a big and long bull market since the historical bear market bottom at March 2009. The flash crash occurred in the beginning of a market correction. The correction lasted for about 4 months ending in late August of 2010 and the fall from top to bottom was about 17%. Although the market crashed about 30 minutes only, the volatility remained extremely high for over one day, as the fear of continuing market crash stayed rampant in those two days.

From this experience of a 100 point crash of SPX, it should be easier for us to understand why Karen chooses a crash point of 100 or 200 SPX fall in her money management rules. In the following sub-sections, we’ll examine the available option chains first. It should help us to understand the possible trade adjustment options. Then, we’ll try to make up a hypothetical trade that is opened before the crash and required for trade adjustment.  It should help us to gain some insights on how our trade position reacts to market crashes and what kind of impacts the position will experience after the trade adjustments.

The Option Chains at the End of Flash Crash Day

As the market started to fall significantly on this day, the put contracts with the original 5% ITM probability would have its probability increased to over 30% rather quickly. A Karen style option trader would be likely to begin the normal trade adjustment strategy by rolling down or rolling out the part of the put options in the portfolio. Considering the trader would not know how deep the drop would be for the day when the probability reached 30% initially, it would be logical for the trader to roll down or roll out to the next month at first.

After reviewing the put option trading volumes and open interests of June, June Quarterly and July cycles, it looked like Karen’s team might have rolled down the June puts to a strike of $800. As shown in Figure 9 SPX June Option Chain on May 6, 2010, the strike had an ITM probability of 4.2% and trading volume of 53K on the day. The trading volume of put strikes of about 5% ITM probability for June Quarterly and July had so much less contracts that they did not appear to be traded by professional traders. For example, the June Quarterly puts at $800 with 4.79% ITM probability had 55 days to expiration which was close to the 56 day norm as Karen specified. But it had only 7 contracts traded for the day.

Note Karen stated she had rolled out to October time frame. But there were no October and November options available on the day of May 6, 2010 according to TOS. I assume Karen did not remember the exact months for her trade adjustments during the flash crash a couple of years ago before the interview.

As the market continued to fall deeper in the afternoon, the Karen style option trader would be likely to see more and more put option strikes in existing portfolio reaching the points of 30% ITM probability. At this time, it would be logic to assume that the trader would like to further roll out the rest of the put options in the portfolio. A review of the option chains of July (70 DTE), August (105 DTE), September (133 DTE), September Quarterly (147 DTE) could give us some clues as well. The September put options of around 5% ITM probability were heavily traded as shown in Figure 10: SPX September Option Chain on May 6, 2010. The September Quarterly puts were thinly traded with the open interests under 100. So it did not look like Karen used this option cycle on that day.

Therefore, let’s take a deeper look at the September option chain to understand what kinds of trade adjustments could be done in this type market crashes...