During the onset of the Russian Crisis of 1998, while a floor
trader on the Philadelphia Stock Exchange, I had an experience that
forever impacted my views on risk and disciplined trading.
I bring this up because, as I was discussing a straddle position during a recent Price Shock Trader webinar, the episode came to mind. Even nearly 13 years later, it still enters my thoughts from time to time.
The Ruble Becomes Rubble
It was August of 1998, and trouble was brewing in Russia. Earlier that July, the IMF had approved a $22 billion package to stabilize the Ruble, but the market wasn't buying it. The VIX began a spike that would peak above 45 in October, after the S&P 500 had fallen well in excess of 20%. (In fact, that peak in VIX held through the 2000-2003 bear market and was not eclipsed until the market meltdown in the fall of 2008.)
At the time, I was trading Service Corp International, Abbot Labs, State Street Bank, and JP Morgan. I had been on the PHLX floor for more than 5 years, had traded my way through the 1997 Asian Currency Crisis (making a few dollars in the process), and generally felt that I was pretty good at the game. I had an excellent mentor and boss who advocated a disciplined approach to position management.
Position management is a form of risk management that is unfamiliar to most people who haven't traded on an option exchange. As a market maker, in a stock like JP Morgan, I would have thousands of options, spread across nearly every strike and month offered, and up to a few hundred thousand shares in my position. So there were a number of things that could impact my position -- changes in implied volatility, interest rates, time passing, and of course changes in the price of JP Morgan.
Price changes could affect whether you were long or short Deltas (think of that like long or short stock) and by how much you are long or short (e.g. long 500 deltas at one price, long 1000 deltas at another price). That change -- how much you are long or short -- is called Gamma. For non-option traders who don't know what Gamma is: if you are Long Gamma you want the stock to move around a lot, if you are Short Gamma you want the stock to stay in one place for the duration of your position.
Trading Gamma, while not effective for most individual investors, is essential for market makers. We would manage our changing Delta risk by buying or selling the underlying stock to eliminate most or all of our price risk. For example, if at some price my net option position made me short 500 Deltas in JP Morgan, I would buy 500 shares of stock and end up what is called Delta Neutral. Normally I would start a day Delta Neutral, make adjustments throughout the day as the stock moved and new option trades were incorporated into my calculations, and end the day Delta Neutral.
It was a good business, and not nearly as complicated as you might think, but I digress.
Volatility Was Not My Friend
On the fateful day in early August, JP Morgan was trading down sharply in premarket action and I was Short Gamma, meaning I wanted the stock to stay put. Without getting into the mechanics, I was Delta Neutral the night before but, with the stock down, I had to sell stock to get back to delta neutral, which I did. I knew that I was probably headed for an ugly day, but I felt, as my boss and I had discussed, that if I stayed disciplined in my hedging I could probably mitigate some of the damage.
When the stock opened at 9:30 for trading, it actually opened up a little! Now I was annoyed that I had sold stock so much lower and, because the stock had bounced back, I was short more deltas than was prudent. I should have bought some stock back right then, took the loss, and gotten myself back to Delta Neutral. It's what my boss would have done.
At this point the stock was down a few dollars, so my losses were getting a little smaller, but I was still short more Deltas than I should have been and I was feeling more confident as the stock dipped below $129. If the stock continued its decline, I would probably make out with only small net losses on the day.
However, not long after lunch and for no apparent reason, the stock started moving higher. But not just moving higher in an orderly fashion -- gapping higher: a few hundred trade at $129, the next trade at $129.50, the next trade at $130.25, and so on.
Things were going horribly wrong, and as the stock reached $133, I knew that if I bought the 5,000 shares I needed to get back to Delta Neutral, I would be locking in a loss of $10,000 - $15,000. My head was starting to spin, when my boss came over. Other bank stocks were going crazy as well, and he was checking in.
There was no way I could BS my way out of this one, so I told him where I was. His face said it all -- it was somewhere between stunned at my stupidity and outright anger -- but he only spoke six words, "Buy it now, at the market."
When it Rains it Pours
It should have been done earlier, but I had to do it now, and I was going to hear a lot more than six words after the market closed. I was just hoping that they weren't going to include, "You're fired."
I looked at the market in JP Morgan and, amazingly, my day just got worse. The market in the stock was $133 bid, offered at $138 with only a couple of hundred showing on the offer. That meant sending a 5,000 share market order in this abyss of a market could end up pushing the stock up over $140 if there were really no sellers out there -- and then I would probably have to buy another 5,000.
My broker looked at me in disbelief when I gave him the order. I just said, "Send it," as I felt the blood draining from my head. There was no limit on my order, so it just hung there, the market didn't move and I was getting a fill ... 15 seconds, nothing ... 30 seconds, nothing and there were no other trades going up in the stock ... 45 seconds, bought 5,000 at $135. The next trade was $135.15 ... $134.80 ... $134.25 ... $133.50 ... it was falling apart.
It was falling faster than I could think, mostly because I don't believe there was any blood flowing into my brain. In the next half hour or so, the stock dropped $7 while I sat in disbelief. I had to leave the floor before I passed out. Again I had to flatten out, and told my broker to sell 5,000 at the market and call me in my office with a report.
$128 was the price I got on the sale. In the space of 45 minutes, $35,000 went down the drain. The total for the day was about $45,000. Over the next several days, as the stock whipped around and I tried to get my Gamma under control, I lost another $30,000.
Just to torture myself, I went back a few days later and figured out what I might have lost if I had been disciplined that day. At around $12,000, it still wouldn't have been pretty, but it would have been a heck of a lot better than $45,000.
Living to Trade Another Day
My boss did not fire me, but we reevaluated exactly how much risk I should have in JP Morgan, and I learned two very important lessons.
First, I had been a little too comfortable with the risk in JP Morgan, taking the position too lightly and just expecting it to continue to work in my favor.
Today, if I feel too comfortable with a position, then I know I am not thinking about it correctly. In other words, when I get complacent in the success of a trade or a position, then I haven't thought it through and need to reexamine the risks, because ending up with a loss frequently results from not fully understanding what can go wrong. It doesn't mean that something will go wrong, but getting into an "I can't lose" mind set can lead to getting blindsided.
Second, situations can quickly get out of control when you lose your discipline. By simply hedging in a consistent, predetermined fashion, I would have saved myself more than $30,000. In fact, up until that day I had been disciplined and it had consistently made me money over time. In the heat of the action, emotion in the form of annoyance and anger overrode both logic and intuition.
Don't make excuses for why you are abandoning your disciple "just this once". Chances are you are going to make things worse.
1998 ended up being a pretty good year, but it could have been better simply by staying on top of my risk levels and remaining disciplined.
I bring this up because, as I was discussing a straddle position during a recent Price Shock Trader webinar, the episode came to mind. Even nearly 13 years later, it still enters my thoughts from time to time.
The Ruble Becomes Rubble
It was August of 1998, and trouble was brewing in Russia. Earlier that July, the IMF had approved a $22 billion package to stabilize the Ruble, but the market wasn't buying it. The VIX began a spike that would peak above 45 in October, after the S&P 500 had fallen well in excess of 20%. (In fact, that peak in VIX held through the 2000-2003 bear market and was not eclipsed until the market meltdown in the fall of 2008.)
At the time, I was trading Service Corp International, Abbot Labs, State Street Bank, and JP Morgan. I had been on the PHLX floor for more than 5 years, had traded my way through the 1997 Asian Currency Crisis (making a few dollars in the process), and generally felt that I was pretty good at the game. I had an excellent mentor and boss who advocated a disciplined approach to position management.
Position management is a form of risk management that is unfamiliar to most people who haven't traded on an option exchange. As a market maker, in a stock like JP Morgan, I would have thousands of options, spread across nearly every strike and month offered, and up to a few hundred thousand shares in my position. So there were a number of things that could impact my position -- changes in implied volatility, interest rates, time passing, and of course changes in the price of JP Morgan.
Price changes could affect whether you were long or short Deltas (think of that like long or short stock) and by how much you are long or short (e.g. long 500 deltas at one price, long 1000 deltas at another price). That change -- how much you are long or short -- is called Gamma. For non-option traders who don't know what Gamma is: if you are Long Gamma you want the stock to move around a lot, if you are Short Gamma you want the stock to stay in one place for the duration of your position.
Trading Gamma, while not effective for most individual investors, is essential for market makers. We would manage our changing Delta risk by buying or selling the underlying stock to eliminate most or all of our price risk. For example, if at some price my net option position made me short 500 Deltas in JP Morgan, I would buy 500 shares of stock and end up what is called Delta Neutral. Normally I would start a day Delta Neutral, make adjustments throughout the day as the stock moved and new option trades were incorporated into my calculations, and end the day Delta Neutral.
It was a good business, and not nearly as complicated as you might think, but I digress.
Volatility Was Not My Friend
On the fateful day in early August, JP Morgan was trading down sharply in premarket action and I was Short Gamma, meaning I wanted the stock to stay put. Without getting into the mechanics, I was Delta Neutral the night before but, with the stock down, I had to sell stock to get back to delta neutral, which I did. I knew that I was probably headed for an ugly day, but I felt, as my boss and I had discussed, that if I stayed disciplined in my hedging I could probably mitigate some of the damage.
When the stock opened at 9:30 for trading, it actually opened up a little! Now I was annoyed that I had sold stock so much lower and, because the stock had bounced back, I was short more deltas than was prudent. I should have bought some stock back right then, took the loss, and gotten myself back to Delta Neutral. It's what my boss would have done.
At this point the stock was down a few dollars, so my losses were getting a little smaller, but I was still short more Deltas than I should have been and I was feeling more confident as the stock dipped below $129. If the stock continued its decline, I would probably make out with only small net losses on the day.
However, not long after lunch and for no apparent reason, the stock started moving higher. But not just moving higher in an orderly fashion -- gapping higher: a few hundred trade at $129, the next trade at $129.50, the next trade at $130.25, and so on.
Things were going horribly wrong, and as the stock reached $133, I knew that if I bought the 5,000 shares I needed to get back to Delta Neutral, I would be locking in a loss of $10,000 - $15,000. My head was starting to spin, when my boss came over. Other bank stocks were going crazy as well, and he was checking in.
There was no way I could BS my way out of this one, so I told him where I was. His face said it all -- it was somewhere between stunned at my stupidity and outright anger -- but he only spoke six words, "Buy it now, at the market."
When it Rains it Pours
It should have been done earlier, but I had to do it now, and I was going to hear a lot more than six words after the market closed. I was just hoping that they weren't going to include, "You're fired."
I looked at the market in JP Morgan and, amazingly, my day just got worse. The market in the stock was $133 bid, offered at $138 with only a couple of hundred showing on the offer. That meant sending a 5,000 share market order in this abyss of a market could end up pushing the stock up over $140 if there were really no sellers out there -- and then I would probably have to buy another 5,000.
My broker looked at me in disbelief when I gave him the order. I just said, "Send it," as I felt the blood draining from my head. There was no limit on my order, so it just hung there, the market didn't move and I was getting a fill ... 15 seconds, nothing ... 30 seconds, nothing and there were no other trades going up in the stock ... 45 seconds, bought 5,000 at $135. The next trade was $135.15 ... $134.80 ... $134.25 ... $133.50 ... it was falling apart.
It was falling faster than I could think, mostly because I don't believe there was any blood flowing into my brain. In the next half hour or so, the stock dropped $7 while I sat in disbelief. I had to leave the floor before I passed out. Again I had to flatten out, and told my broker to sell 5,000 at the market and call me in my office with a report.
$128 was the price I got on the sale. In the space of 45 minutes, $35,000 went down the drain. The total for the day was about $45,000. Over the next several days, as the stock whipped around and I tried to get my Gamma under control, I lost another $30,000.
Just to torture myself, I went back a few days later and figured out what I might have lost if I had been disciplined that day. At around $12,000, it still wouldn't have been pretty, but it would have been a heck of a lot better than $45,000.
Living to Trade Another Day
My boss did not fire me, but we reevaluated exactly how much risk I should have in JP Morgan, and I learned two very important lessons.
First, I had been a little too comfortable with the risk in JP Morgan, taking the position too lightly and just expecting it to continue to work in my favor.
Today, if I feel too comfortable with a position, then I know I am not thinking about it correctly. In other words, when I get complacent in the success of a trade or a position, then I haven't thought it through and need to reexamine the risks, because ending up with a loss frequently results from not fully understanding what can go wrong. It doesn't mean that something will go wrong, but getting into an "I can't lose" mind set can lead to getting blindsided.
Second, situations can quickly get out of control when you lose your discipline. By simply hedging in a consistent, predetermined fashion, I would have saved myself more than $30,000. In fact, up until that day I had been disciplined and it had consistently made me money over time. In the heat of the action, emotion in the form of annoyance and anger overrode both logic and intuition.
Don't make excuses for why you are abandoning your disciple "just this once". Chances are you are going to make things worse.
1998 ended up being a pretty good year, but it could have been better simply by staying on top of my risk levels and remaining disciplined.
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