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...
