Follow Us: TwitterFacebookRSS feed

Option Trading Gurus Created A Big Market Decline!

Posted by Pete Stolcers on March 1, 2007

Many of you are asking for my perspective on this drop. Earnings are good, the economy is strong, employment is full, the P/E ratios are in-line… The stocks that looked good a week ago still look good and they are cheaper. What could possibly cause the market to go down? In a word – fear.

Margin debit as a percentage of account balances is as high as it was in 2000. When traders are over-extended, they can’t take the heat when the market starts to fall. That is a classic shakeout. Most people think… well I’m in it for the long haul and I’ll just ride it out. That mentality works for the first 10% move. By the next 10%, they are nervous and they are out. A big decline with a “V” bottom becomes a mere blip on the radar screen of a 10-year chart. However, seasoned traders look at those blips and remember the blood that was spilled.

Such was the case in 1998. I had grown one of the largest option order desks in the country and I had thousands of option traders using our services. The economy was strong, the earnings were good, interest rates were in line and the internet was creating a buzz. Out of nowhere, we had a big rally to new highs and a sharp reversal. Sound familiar? Everyone looked at the fundamentals and took comfort knowing that everything was still intact. It seemed that a hedge fund had lost some money.

Initially everyone thought… so what, it’s a hedge fund. The stock I liked yesterday is the same today, except it is 3% cheaper. The hedge fund was created by two of the founders of modern day option pricing models (Robert Merton and Myron Scholes). It was called Long-Term Capital Management. They had a very “conservative” arbitrage model. It was so conservative that brokerage firms felt very comfortable letting them leverage the positions. The fund collapsed in 1998 when Russia defaulted on their debt and the whole house of cards came crashing down. Here is a link that describes the event in greater detail. Long Term Capital Management The ensuing sell off in 1998 was huge and the SPY fell 25% in a month.
.
.

image
.
.

The market was up big going into the hedge fund collapse and the drop it created was nasty. Mind you, the SPY was still 50% below the 2000 high and it had a long way to go.

The Yen-Carry Trade is in trouble if: the Yen rises, Japanese interest rates continue to move up or traders using the strategy get nervous. There is still room in the spread, but as it narrows, the pressure will increase and traders will start to unwind it. Borrow cheap, leverage big. This trade has been leveraged 15:1 and there are more hedge funds than ever.

Retail margin debit as a percentage of the account balance is at 2000 levels and I sense a shakeout. Novice option traders like to pound their chest and brag about all of the money they’ve made during a bull market run. They only see one side of the market and I’m sure they will be buying into this dip. The last 3 years have been in a nice uptrend, just like they were in 1998. Seasoned option traders have been humbled and they always keep their emotions and positions in check. This is a time to be balanced and to keep a portfolio of longs and shorts. The implied volatilities are still inexpensive relative to their 10-year average. Being long puts and calls can be a winning combination even with the recent spike in premiums.

After the dust settled in 1998, there was a great buying opportunity and the SPY went from 95 to 140 in less than a year. The take away is that the market was a good buy in 1998 at 125. However, if you were an option trader, you blew through your capital and you never got a chance to participate.

Is the market a good value? Yes, I think the fundamentals are very sound. Is the Yen-Carry trade a LTCM situation? Perhaps, there are more hedge funds than ever and if they are leveraged, a small move in the wrong direction could cause a massive liquidation. Over confidence leads to over-exposure. One series of sharp drops creates fear, margin calls and losses. If you’re really, really sure that this is a buying opportunity, be careful. A warning shot has been fired.

Get Today's Options Trades Here
OneOption conducts extensive option trading research and it provides specific options trading entry and exit instructions. Select from a spectrum of options trading strategies and find a service that is just right for you. Hedge funds, professional traders and active investors count on OneOption for solid research.

Posted in Analysis - Technical, Fundamental, Market

Option Trading Comments

  • On 03/01, ODA 125 said:

    Pete,

    Spot on!!!  I have so many charts to prove the market maker shakeout.  If people really thing anything other than the “need” to bring the market down to an acceptable level then they need to go back to studying charts.  The price actions does not lie.  A really good article.  Thanks for taking the time to write it.

  • On 03/03, Bill aka NO DooDahs! said:

    A “Fear Enema.” Nothing fundamental has changed, but unlike the permabears, I actually like the fundamentals.  More downside in the short term, but I believe it EVENTUALLY will be a buying opportunity.

  • On 03/04, Pete said:

    Exactly, fear and greed drive the market. Right now, fear has the ball. Some traders have started adding the word hope to their vocabulary. They are taking heat on their longs and it is just a matter of time until they bail. When the permabulls are shaken out and the bears have had a chance to get short, there is a chance for a big bounce. It is still too early. We may see a few bounces, but they will be shorting opportunities.

  • On 03/04, Allocator said:

    Great commentary, Pete.

    I remember the Asian crisis and LTCM very well.

    Besides investing in the stock market, I play the Motley Fool’s CAPs game http://caps.fool.com/, where you pick stocks to outperform or underperform, and it tracks your performance relative to the S&P500;.

    My position there right now is 80% underperform (short). Before last week if the S&P500;went up 1% my CAPs score would go down 30-50 points as you might expect. Last Wednesday however, on the morning rally after Non-Phat Tuesday, when the S&P500;was up 1% my CAPs score was UP 100 points! While the big-cap stocks were being bought, the junk around them was still being sold.

    This big up-tick in fear immediately prompted me to sell 65% of my portfolio into the strength the market was offering, and I sold another 10% on Friday.

    I’ve been in the markets since 1978, and I’ve seen this movie before. It’s a great time to keep your powder dry.  I feel sorry for the poor bastards heading into Monday morning long and fully margined.

    Besides retail margin, who knows if there’s isn’t another LTCM lurking just beneath the surface right now.  SOMEBODY with big index-future positions got blind-sided last week.  It will be interesting to see what floats to the surface as things develop (unravel?).

    I’ve got a blog as well at http://stockadventures.wordpress.com/ if you’re interested.

    Cheers,
    Allocator

  • On 03/07, OptionPundit said:

    Great article Pete. Sometimes, technicals, fundamentals doesn’t drive the market crazy...it’s the “other side”. Thanks for sharing your knowledge and experience, it helps develop a wider perspective.

    Profitable trading,
    OptionPundit

  • On 03/17, jasonnoguchi said:

    Frankly, I do not see things you do. You might see that market fundamentals are strong but in fact, market fundamentals are very shaky now and has never been so shaky before. I quote many reasons and put in focus all the fundamental reasons why the market is weak on a daily basis and you ight wish to check it out and give me your comments at http://sharemarketcomments.blogspot.com .

    Hope we can learn more from each other.

  • On 04/01, Tom Fenlon said:

    help requested...please
    three trading days ago, i bought DIA options assuming they would expire on the third friday of april.  instead, they expired at the end of the quarter. On my trading platform, I clicked on April expirations to look at options prices and clicked on the strike and I bought.

    Whereas I should be way ahead, my options expired worthless and i lost several thousand dollars.  do i have recourse???

  • On 04/01, Pete Stolcers said:

    Hello,

    If you bought options on the DIA, they do expire the third Friday of the month. This was taken right from the CBOE’s website:

    Symbol:
    DJX

    Index Description:
    The Dow Jones Industrial Average is a price-weighted index composed of 30 of the largest, most liquid NYSE and NASDAQ listed stocks.

    Underlying:
    Options are based on 1/100th of the DJIASM level.

    Index Components

    Multiplier:
    $100.

    Premium Quote:
    Stated in decimals. One point equals $100. Minimum tick for options trading below 3.00 is 0.01 ($1.00) and for all other series, 0.05 ($5.00).

    Strike Prices:
    Strike prices for options are set to bracket the index level in minimum increments of 1 point.

    Expiration Cycle:
    Generally, up to three near-term months plus up to 3 months on the March quarterly cycle.

    Expiration Date:
    Saturday following the third Friday of the expiration month.

    If by chance you bought March options, you have no recourse. When you have an online brokerage account, you are expected to know the contract specifications and risks. If you buy the wrong option, they are not resonsible. They have order confirmation screens to help you can double check the order.

    I hope that you are long April DIA options and someone was just playing an April Fools joke on you by giving you bad information.

Stock Option Trading Education