Before the indices and many individual equities started their drop off the January highs, it had been a long time since markets had produced the percentage drops that occurred during that decline. What's different about trading when markets are dropping sharply, other than the obvious difference in the direction?

Last week's article on the effects of expanding implied volatilities pointed to one difference. If you didn't read that article, I urge you to read it now.

On Monday, February 3, major differences showed up in the way trades unfolded. Those differences were due to problems that traders blamed on their brokerages and that, sometimes, brokerages blamed on exchanges. Not long after the markets opened, traders began reporting that one brokerage was having temporary "system-wide order routing problems." Another trader reported trying to cancel an order that wasn't filling while markets dived. The original order "hung up," the trader said. That trader had to call into the trading desk and was told the problem was the fault of the exchanges, not the online brokerage. The trading desk had to contact all exchanges and get live updates for orders.

Perhaps the exchanges were having difficulties, although I certainly couldn’t confirm that. I didn't check all the exchanges, but the "NYSE Market Status" page did not report any routing issues. They had last reported routing issues on December 16, for example, when they reported "sporadic routing issues in a subset of symbols."

I was exiting my FEB butterfly trade that Monday for a loss, but less than the planned maximum loss, and I experienced problems. Those problems included slow or no fills and also bounced orders. I was exiting my complex trade in alternating batches of positive-delta and negative-delta bits, keeping my deltas as flat as possible to avoid more harm if there was a big price movement either direction. It was important to know when one batch filled so I could place an order to fill the opposite-delta side and not leave the trade unprotected. I got a message that my order to sell four of my flies was "not delivered," but that same message warned that I should contact the trading desk to "confirm the status." Yikes. Was it delivered after all? Had it filled? A call to the trading desk cleared up problem, and I was told it was a "hiccup in internet feed" that had likely caused the problem. It could have been more than a hiccup from my perspective.

One trader reported an SPX order that wasn't filling for hours, even though the listed mid-price for his order swung $2.00 either side of the trader's order amount. Although the price was swinging through levels that would have almost guaranteed a fill any other day, the swings were sometimes so rapid that the price just didn't sit anywhere long enough to trigger a fill. The unfilled order could also have been due to the uncertainty in the markets, among other causes.

All the difficulties that day could probably be tied to that uncertainty, rapid price movement, and high volume. With prices dropping rapidly, those who aren't required to make a market were likely stepping away from filling orders. Those who were required to make a market were likely wanting a hefty fee (indicated by the high implied volatilities and widening bid/ask spreads) for filling orders. In some cases, it just is not easy to get a fill on a trade, especially a trade with many legs.

What is a trader to do? First, especially once the VIX approaches that 12-ish level that is so often support and then starts heading higher, traders might consider how much risk they have and whether they're comfortable with that risk. They might consider buying an Armageddon put, a cheap put that helps ameliorate risk. My Armageddon put was not cheap at $833.00 because it was helping protect a trade with a maximum margin of well over $46,000, but when I had closed everything else that Monday, I sold the Armageddon put for $2,350. It clearly had helped ameliorate my loss.

However, even with that Armageddon put, I elected to exit that day and take my lumps. I, like so many others, was having so much trouble with complex orders that I had to consider whether I wanted to leg out of positions. For example, the first thing I was doing that morning was selling call debit spreads. No one much wants to buy call debit spreads in a sharply declining market, for any price! What could I have done if those orders had never filled? What did I consider?

If I desperately needed to stability the trade by lowering deltas and couldn't exit the call debit spreads, I could have bought a put with the same negative deltas as the amount of positive deltas in the call debit spreads. Of course, that would be only a temporary measure and wouldn't help beyond stabilizing the trade. If my intention was to exit, I'd have an extra piece to exit, but I would have time to work the call debit trade if the RUT continued lower. However, if the RUT had turned around and zoomed up, as it has so many times in the past, that put would have rapidly lost value.

I could have legged out of my call debit spread, but there is of course danger in that tactic, too. I would have had to have first bought back the sold calls and then, as the market was still dropping hard, sold my long calls for less than they would have been valued a few minutes earlier. In that case, I would have longed for a sudden turnaround as I bought back the sold calls and before I could place the order to sell the long calls.

Neither of those two choices or the other choices I might have employed would have been ideal, but they might have been necessary if I just couldn't get anything filled. Fortunately, the order to sell the call debit spreads filled before the markets got too bad, and my lower breakeven on the butterflies was at about 1097. I had time that day to get rid of the higher and lower butterflies in alternating batches, keeping delta flat so that the position wouldn't be hurt by a big drop or rally.

Think ahead of time about what you would do in such a situation, with volumes high, problems placing orders and problems getting fills. You're going to find it easier to deal with these problems on days like that Monday if you have kept your risk level a comfortable one for you. You don't want to be panicking. If you've experimented with various adjustments before the problem ever occurs, and if you have the telephone number of the trading desk at your brokerage written down or keyed into your phone, you're less likely to panic. What might you do if you panic? I can't tell you how many traders I know who have sold spreads they intended to buy or bought ones they intended to sell, for example. Being told your trade has been bounced back but you should call the trading desk to determine its status while the markets are running away is not a time to be scrambling for the trading desk's number.

Rallies can be just as sharp and fast as the declines, and they can wreak havoc on nicely positioned bearish trades, just as sharp declines can wreak havoc on bullish ones. When markets are rallying, however, pullbacks tend to be shallow. When markets are rapidly declining, relief rallies do not always tend to be small in dimension, as we have seen this last week. When there's been a sharp decline, it's sometimes more difficult to guard against a move in the opposite direction.

Linda Piazza

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