Markets can go wild
Do you have two minutes? I would like to tell you about one of the craziest days in the history of the US Stock market and the amazing power of tail options.
Two and a half weeks before the infamous flash crash of May 10, 2010, I opened my first options trading account with Think or Swim. My knowledge of options was limited, but I had years of experience trading futures as a member of the Chicago Board of Trade, now known as the CME group.
I only put a small amount of money in the new options account. I was a beginner, and I knew I needed to go slow. It turned out that I probably should have gone even slower because I ended up purchasing options that had a very low likelihood of paying off. The options were inexpensive, far out of the money put options. They are designed to pay off if the market goes down by a large amount.
Unfortunately, markets rarely have large declines and that is why the far out of the money options cost very small amounts.
The day before the Flash Crash, I purchased 1200 puts for .02 cents. I had no idea what I was doing. I only had a vague understanding that if the market went down, it would produce profits from the puts.
The next day, around 2pm Chicago time, the US stock market began to drift steadily low. But this was far from unusual until all of a sudden, the market broke down completely.
I was sitting in a small office in the building that used to house the Chicago Board of Trade. I watched the market drift lower until suddenly all of the bids and offers on the screen disappeared. There was no market! Prices were plummeting so quickly that no one would post a bid.
I looked at my new Think or Swim account. The profit and loss (PNL) was showing my gain for the day at $3,400,000.00! The tiny .02 puts had gone up several thousand times their original value.
The market was near to closing and I was convinced it would close on the lows. Turns out, this was the most expensive mistake of my entire career. Suddenly, the market found buyers and staged a furious comeback. It was down over 10% at the peak.
I watched most of the 3,400,000 million disappear, but I did sell for close to $50,000.
It was a painful lesson, and it is hard to avoid the “if I had only” trap when I think about that day. However, I did learn a powerful lesson. Options can deliver rare, but fantastic gains. Mathematically, this is called convexity. Out of the money options have extreme convexity.
Thanks for taking the time to read my story.