I spent the better part of this past weekend coming up with "bullet proof" strategies, and then I read this. Back to the drawing board I go.
Quote from Maverick74:
OK, so here is my story. There is a thread here buried deep in the archives, but it's here, about a poster who had this unique strategy of selling DOTM puts in SPX options. Now, I know what you guys are thinking. Hey Maver, that ain't original, I've been doin that fur years. Not like this you have. This guy had the idea to sell shit so deep out of the money, there really wasn't even a market on these strikes. You see, he did very extensive research and back testing going back oh I don't know, years he says, that shows the market never made such a large move over the time to expiration he would be exposed to. As an example, say SPX was trading at 1600, he might sell the Oct 900 puts. But Maver you say, there ain't no market down there. How he gonna do it? Well, he would put offers out up and down the strikes at .05 offer waiting to get lifted. Then once filled, he would wait till expiration and deposit profits in the bank.
Well this guy walked into my prop firm. Now I debated this guy, on this very message board, in this very forum, just like I am now. I explained to this guy why he was wrong and told him he was going to blow out. I walked him through step by step EXACTLY how it was going to happen. It's in the archives!
But he insisted on doing this. I let him come into our firm with 50k. I told him day one, EXACTLY what we were going to do to his positions should his haircut get out of control. I walked him through it a dozen times. That's just how I roll. He understood. So the trading begins. He did exactly what he said he would do, he put out offers up and down the SPX chain for a .05 so so so so so far out of the money. It would take Elon Musk years to reach these strikes using his new hyperloop travel. That's how far away they were.
So sure enough, this guy starts getting filled on these orders and after a few months, the guy is banking some coin. He sells the puts, waits, collects the money and repeats month after month. Keep in mind during this whole process I reiterate just how badly we are going to lube him up and pluck his rear when the time comes. He understood.
Well one day, an event happens. You can call it, a rare event, an unexpected event, a fat tail, black swan, whatever you like. But it happened. History gave it the name of the flash crash. After some riots broke out in Greece on a down day in the market, something random happened. A fat finger error triggered some sell orders in an already weak tape coupled with some serious technology issues. The market went into free fall. Not even the hyper loop could move this fast. Well, what this guy was not anticipating, despite the fact I laid out in detail, on this very message board (it's in the archives) exactly what would happen IF there was such an event. Those nickel puts went 20.00 offered. Yes, as in 20 pts. And yes, the ones that were a million points out of the money. These options actually had real bids on them as well. Well, this guy with a 50k account was showing an unrealized loss of close to 10 million dollars. And no I'm not making that number up. I had the risk desk in my ear the whole time speaking some language I was not familiar with. Now, we all knew that the prices in the market were not indicative of any real value, but as the old saying goes, price is truth. We had to buy these puts back. This trader did not like that idea. It wasn't his choice though. I explained that to him before he sold his first contract. Now, we weren't about to lift the 20.00 offers. But we were bidding for him. Some at 5.00, 7.00, 10.00. It actually took several days to even get filled at these outrageous prices. I explained to him we had no choice, as no broker does because had we not bought them back as a firm, our clearing firm would have paid 20.00 and closed our shop.
You see, I tried to explain to him, that in the market, what you think does not matter, nor what your spreadsheet or your backtest told you. What matters are the rules you have to play by. When you are short options with any kind of leverage, there is not a broker in the world that will not hesitate to blow you out, even if there is next to zero chance that these options would ever get remotely close to your short strike. That's just how margin works. Believe it or not, we were actually able to work the orders so the guy only lost 100% of his account. That was an act of God. We sent the trader his U-5, and this guy probably never traded another option again ever.
Of course afterwards he was still angry why we would buy back his options at such inflated prices. And my response to that is, what inflated prices. We actually paid far less then what the market was offering. We got them cheap. Let me repeat this one more time, this guy laid out this entire strategy on ET. I responded on that thread in detail exactly what would happen if he did that strategy. This trader did it anyway. And what I said would happen DID happen and exactly in the fashion in which I described it.
Moral of the story...listen to those with more experience. And remember, whatever you think you know is not even close to what you probably should know. So account for that error in your future decision making process.
