I want to flash you traders back to the flash crash. The fund I work with was trading had entered a May OEX butterfly that had been doing reasonably well, until the first week of May. The Market began to fall away from my short strikes. At one point the trade was down almost 10% on the butterfly, even after all of the hedging and adjusting we had made. Then on May 6th, the flash crash happened, and we made a bloody killing. Why? Because I was long what most market makers call ‘units.’ These units caused my butterfly position, which by itself got killed by the crash was more than protected by these options.
A Unit is an extremely inexpensive option that has, unpredictable Greeks to say the least. I break them down relative to product, the more expensive the underlying the more expensive the unit. For instance, in SPY, an option becomes a unit around 20 cents, in the SPX; an option is a unit closer to 2.00. All units will have deltas below 5 and little to no gamma, or vega. So how do these units work?
I like to compare option trading models to Jay Cutler, great between the 20’s but not so great beyond that. No where does this rear its ugly head than in super cheap options. Inexpensive options, especially, puts tend to gain far more value than the model predicts. What is the cause of this, volatility?
One of the major issues with most models, especially, those used by the retail world, is that they predict uniform increases in volatility. This simply is not the case. When the market makes a violent move downward, two things happen:
Think of the volatility curve in a strong down move like a thin piece of wood evenly balanced over a fulcrum. If a fat guy jumps on one side of the wood, what will happen? Like a seesaw the more one move down the board away from the fulcrum, the more, in distance, the wood will have moved. There is another factor though, since the fat guy jumped on the piece of wood, the wood will have moved violently, this causes the wood furthest from the fulcrum to temporarily bend upward.
This is the way cheap puts act in a major down move. In the panic, the world is buying ATM puts, downside puts, you name it. Every trader that is selling or short these puts races to buy something that will protect his or her position in case the market absolutely tanks.
These shorts buy ‘units’ all of this buying causes the unit to gain a little price, which increases vega, which increases the delta which increases the value of the unit as the market tanks, which in turn causes the unit to gain more value as traders race to buy these to protect sales, which raises the vega…..you get the point, there is a snowball effect.
Here is an example of exactly what we saw at the fund in the OEX, on April 20th, we bought the OEX May 505 puts as a hedge against a short iron butterfly. When the market fell on May 6th, these options were worth almost 10 dollars, on May 7th, they closed at 14.50, a return of over 1200%. Not bad for an option that cost us 1.20.
So how can the average trader use units to increase the returns of his or her portfolio, easy. Buy units, not a huge amount, At OptionPit.com we teach that about 5 to 10% of allocated trading money (not the total account value) should go into puts. Against a standard set of spread trades (condors, fly’s, and time spreads). This amount should be enough so that, adjusted for any increase in volatility if the market drops 10%, your position is no longer losing money, or possibly gaining value. If the market drops 20%, the trader should be making money at this point.
Obviously, the math is not that simple. Understanding how units work comes with understanding volatility. When I am teaching at OptionPit.com this is only one of the steps we take to ensure our traders are safe. After all, trading is not easy and nothing is for certain, but by properly implementing units I am willing to bet that a trader will never have to sell his or her house because the market dropped 25%
I want to give a special thank you to all who attened my event at the Option Club this morning, expect another good one in two weeks!
Register here: TheOptionClub
