I'd already roughed out an article for this weekend's edition before Thursday afternoon's events. After that action, I put that article aside. I didn't want to disregard what subscribers might have experienced on Thursday. Instead, let's do a follow-up of a "Lessons from the Trenches" article I wrote several months ago.
Many retail traders found themselves in the trenches Thursday afternoon, fighting a grim war with an enemy that we didn't even recognize. I've heard from people who were in the position to know that even floor traders weren't sure what was happening. We retail traders heard rumors of a fat-finger trade or a big carry trade unwinding. The two have different implications, one more dire than the other. With so little information available, floor traders weren't quite sure how to react, and we retail traders had even less information upon which to make our decisions.
It's my great hope that no readers suffered great losses, but I understand that's probably an empty hope. Stops were surely triggered and filled at terrible levels. Some traders probably didn't have stops and now have large losses. Some of us rushed in to cover positions, knowing as we did so that the action might be reversed at any moment, but that we had to get some risk off the table.
Even those in pure bearish trades may not have been able to lock in gains if they'd wanted to do so. The difficulties many experienced getting accurate quotes or placing trades may have prevented locking in those profits. Some who did lock in gains might be wondering if their trades will be unwound. Many exchanges were sending releases by late Thursday evening saying that certain trades executed between 2:40 and 3:00 pm ET for prices 60 percent above or below the 2:40 price would be busted. Some brokerages were alerting their customers, but I did not receive any emails from either of the two brokerages at which I trade. If you executed trades during that time period, I suggest checking with your brokerage.
As this article is edited on Friday afternoon, we still don't know what happened on Thursday, May 6. The SEC, FINRA and every other regulatory entity will likely be sorting that out for some time to come. The event was called unprecedented, and headlines touted the biggest drop ever in prices in some securities. People who had been trading decades mentioned in forum posts that they had never seen a market event like this.
Perhaps they hadn't been trading quite enough decades. A Wikipedia article notes that on Black Monday in 1987, the Dow dropped 22.61 percent in a single day. Since the Dow was trading at a lower level back then than it is now, that 22.61 percent drop wasn't as big a point drop as we had Thursday, but it was a much bigger percentage drop.
For years, a legend had circulated that on that Black Monday, calls actually gained in value as stock market prices plummeted. This was supposedly due to the rise in volatility. I'd always wondered if that was an urban legend. However, on Thursday I watched the prices of the calls that were part of my iron condor escalate in price above their values the previous day. It's difficult to trust the quotes we were getting, but at one point when the SPX was down near its low of the day, at almost 100 points below the previous day's close, those calls were quoted at prices about double what they had been the previous day. Oh, if I'd only bought a whole bunch of long straddles the day before, I remember thinking! It had been my intention to use the decline to close out my bear call spreads for a profit, but instead the spreads had widened. No profit was available.
If such days as Thursday are unlikely but not completely unprecedented, we again have to take some lessons from the trenches. I'm privy to hearing the stories of lots of traders, both experienced and inexperienced. I wanted to talk to you about some of the stories I'm hearing from those traders, since I know some of you are more isolated.
First, I'm hearing reports that some trading platforms completely fell apart. Brokers are noting that the information coming from the exchanges was faulty, and it was, so that quotes were untrustworthy. However, some traders reported being "locked out" of some platforms, not able to trade at all. I heard that about more than one brokerage platform, so it wasn't an isolated case.
The lessons from the trenches here are two-fold. Both are lessons I have mentioned in previous articles through the years. Always have the telephone number of your broker available, if you have one, or the trading desk at your brokerage, if you don't have one. You don't want to be scrambling for those numbers when you need them. This isn't a time to be digging through a file, looking up a contact list, or searching on the brokerage's site for the number you need. Have it written down and posted near your trading desk or stored in your cell phone.
The second lesson from the trenches is that having more than one brokerage may be imperative once trades get large enough that there must be a backup plan. If your trading account is a $5,000 one, you probably don't want to split the account up into two accounts on different brokerages. If you're trading $100,000, you probably do want to have some money split off into an account at a second brokerage. You can at least buy a long put or call if markets start cascading lower or soaring up, and you don't have access to your primary brokerage for some reason. Some traders recommend having futures capability at both places, so futures can be bought at either to hedge positions in the other. I'm not a futures trader myself, and I certainly don't want my first futures trade to be under adverse market conditions in which risk may quickly escalate. I use back-month long options to hedge increasing risk.
In my case, I had completely different experiences with the two brokerages I use. On one, a sold MNX put that was $10.00 in the money, part of a double diagonal trade, was supposedly $99,999.99 in the hole at one point. Umm, that's a small account in a second platform that I use to test small trades. It's not my primary brokerage, and I certainly didn't have that kind of money in that tiny test account to close that trade! Smile.
I heard from traders whose overview pages were showing them that were instant paper millionaires or instantly in the hole by millions, at least on paper. I heard figures of being paper millionaires to the tune of $80, $67, and $49 million, for example. I heard stories from traders who believed that their accounts had been shut down when their screens just went blank and they were refused access to their accounts.
I also heard stories of traders whose purchase of long puts saved their accounts, usually of puts purchased before the debacle. In this kind of market environment, with markets having spiraled to the heavens and volatilities dropped to the ground, buying some out of the money puts a while ago to have in the portfolio was a good thing to do, and that may be another lesson from the trenches for the future for many traders. I always spend about 10 to 15 percent of the credit I've taken on an iron condor on some extra long puts, for example, but I also typically look around whenever there's been a big rally for some cheap puts that I can buy to have, just in case. They're not meant to make money. They're too far out of the money with very little chance of ever being profitable. They're doomsday protection only. I'm typically going to lose money on those puts, but they're there. I'm hearing stories from the trenches that buying puts either previous to the downdraft or as it started helped save some traders from big losses. In a fast market, it's often easier to buy a single long call or put than it is to unwind a more complex trade.
Other stories concerned the inability to get accurate quotes, with some platforms or some securities apparently experiencing worse problems with this than others. The lesson from the trenches here is again two-fold. Profit-loss charts and portfolio Greeks as listed by one's brokerage or a charting platform can't be accurate if the information that they're getting from the exchanges isn't accurate. I wouldn't trade any longer without the ability to look at such charts but understand that they depend on accurate quotes or implied volatilities upon which to base theoretical values.
Under certain conditions such as those experienced Thursday, quotes and profit-loss charts may not be accurate and there's nothing a particular brokerage or software program can do about that. At one point on Thursday, those profit-loss charts were telling me that my newly established 60-contract iron condor position was down more than $30,000, although my sold put was still way below at 1010. I knew from experience that the position shouldn't be down that much, even with exploding volatilities. I'd traded iron condors through the worst 2008 had to deliver, for example.
What I knew or, rather, suspected didn't help me, however, in determining how best to hedge my position. I had a fairly hefty price hedge in the form of two long JUN 1040 puts and I had plenty of money in the account to buy more in steps as the SPX barreled down, but I had no way of knowing how many I should buy to hedge the price risk as I couldn't trust the portfolio Greeks I was seeing or the profit-loss chart I was studying.
My experience also told me that the best idea was to close out the positions, take the profit in the long puts I had, and remove all risk until I could assess what was happening. The next lesson from the trenches relates to my efforts to close my trades under conditions in which I couldn't entirely trust the quotes I was getting. It helps in such conditions to have some experience with the strategies and underlyings that you're employing. I knew about what price I should be paying to exit those spreads at that level, and I was able to get fills fairly quickly. This speaks to the benefit of getting to know your strategy or underlying well rather than jumping from one type of trade to another.
In contrast to my experience closing out my iron condor's bull put spreads, I was trying out a two-contract MNX double diagonal on the little account that I use to test small trades. It's part of my efforts to diversify my trades into two or three types of trades that vary volatility and other risks. My primary brokerage actually has lower prices for big trades but charges a minimum ticket, so it's prohibitive to learn these new trades with small lots. I'm not as familiar with pricing on MNX options, and so experienced some difficulty exiting that trade when it became necessary. My loss was far heavier than it should have been because I had to rely on the quotes I was receiving to get fast fills rather than draw from my own experience to probe prices where I thought I should get fills.
Another lesson is that contingent and conditional orders may not have worked as expected. As Tom Sosnoff of think-or-swim said when speaking to the Sheridan Mentoring community, once those orders are in their system, TOS is at the mercy of the quotes they're receiving, and quotes are coming from the exchanges. I heard a broker from one platform defending the problems another platform was having because the information they were receiving was just impossible. I heard of quotes for options that were bid at $0.00 and ask at $2,000.00. That's a wide bid/ask spread!
I've mentioned in recent articles that I set alerts and then get to the computer to put in the orders manually, but I was considering a more active use of conditional or contingency orders. The original article intended for this Trader's Corner in fact concerned contingent or conditional orders, and it will appear within the next two weeks.
I still believe in having catastrophe orders beneath the markets if you don't feel that you can get to the computer after an alert sounds. I haven't heard from many traders about their experiences with contingency or conditional orders during Thursday's debacle. From your position in the trenches, you need to evaluate these choices. Would it be better to just set catastrophe orders at levels that shouldn't be hit, just in case you don't get to the computer to respond to the alerts that have sounded? In some cases, most definitely. Yesterday? I'm not sure. Unfortunately, there are pros and cons to each decision we make as options traders.
We're not through learning lessons from these trenches. We don't know what's going to happen concerning busted trades, and some of those lessons may be painful. So far, I've heard only about the possibility of stock trades being busted and not options trades, but what if you'd bought a stock near Thursday's low, between 2:40 and 3:00 pm ET, and then sold it for a profit after the 3:00 pm ET deadline for busting trades? If that stock was included in those with erroneous trades and if the price at which you bought it was within the parameters for busting the purchase, you will now be short that underlying. As a result of the busted purchase, you sold something you didn't own. Margin calls will result for those traders without enough margin to cover the short position, according to Jon Najarian, speaking to the Sheridan Mentoring community on Friday afternoon.
I don't know what trades might be busted. If you did happen to buy a stock at the low, during that time period that's been bandied about, and sell it later, after that time period had closed, you might talk to your broker or brokerage to clarify whether that stock is included in those whose trades are being examined. You could then determine how the brokerage intends to proceed with helping clients who might suddenly find themselves short a stock they'd thought they owned long enough to sell.