How I Survived (Even Profited) in the Flash Crash

07/23/2010 12:01 am EST


Juan Sarmiento

Independent Trader,

Flash crash or not, there is a way to survive and thrive, yet profit if the crash does not materialize. If you have been dismayed by the sudden volatility injected into the markets by the events of May 6, 2010, you might think that there is no point in trading, let alone investing in these unpredictable markets. If you think that this is not for you, that the time spent is not worth the meager rewards or risky losses, you are among the majority of traders. I, for one, went through a period of fear between September 2000 and March 2003, but I eventually jumped back in the saddle again. The reason I am telling you about it now is because I persevered through very insecure times in my life. The end result is that I learned and implemented approaches that allow me now to trade, profit, and sleep well at night with the certainty that at the end of the year, my accounts will be higher than they are today. I don’t need to sit by my computer all day, every day, as daytraders do. In fact, I hate that approach. I can run my pathology consulting business and take two or three vacations a year confident that I will be OK. I want to teach you my strategy for surviving and thriving in events such as the flash crash of May 6, 2010, but also in events such as the crash of October 2008, with profits rather than losses. Moreover, with my favorite single strategy, you can do all that and still profit if the markets go into a raging bull market.

Back in the early 2000’s, I had been successfully trading the biggest bull market the world had ever seen by simply buying calls in the most popular technology stocks. But I also had a core portfolio of stocks that included 600 shares of AAPL. After all, I thought, the real way of investing is to hold stock for the long term. I bought those shares when Steve Jobs returned to AAPL in 1997, a time when AAPL shares were $4.75 (split corrected). History has shown what a powerful CEO Jobs has turned out to be. At the time, I relied solely on the Elliott Wave analysis, and according to that, AAPL would rally to new highs by the end of that year.

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As the chart above (figure 1) shows, my wave count showed a rather tame pullback to the low $20’s from a high of $32.50, but still within my expectations for a wave four. That did not matter to me, because AAPL was still going to make a new high for wave five, and that would surely take AAPL to $40, and I could then lighten the load. Confident in my approach as a trader, I held on, as some of you may have done at some point in your life. Apple had introduced a new computer (“The Cube”) early that year, which was surprisingly quiet, with a small footprint and quite elegant. I bought one myself, but by the end of September, Apple warned of poor sales and a huge loss that drove the price of AAPL to $14 overnight. AAPL continued to go down in the months ahead, reaching a low of $6.50 by April 2003. As painful as this was, there were stocks such as Enron and WorldCom, which had been leaders in their fields, and were now bankrupt. So I considered myself lucky that I had shares of AAPL because I went from the buy-and-hold crowd to the never-own-stock crowd when I was hit with AAPL’s debacle. You might say that I would be ecstatic today if I only had held onto those shares of AAPL, but who was to say that AAPL wouldn’t be the next Enron? No matter, I consider the lessons learned with AAPL to be invaluable, and closing my entire stock portfolio soon thereafter was a blessing, as other stocks were soon to follow AAPL with strong declines of their own.

At the peak of the market, when my success with options was great, I had thought about finding a way to take advantage of the main features of options, i.e. limited risk and leverage, to devise a strategy for stock substitution that would allow me to hold my positions for extended periods of time without need for constant attention, which is what I had been doing by simple short-term call buying during the 1990’s. With the events of 2000-2001, I discovered that bear markets have a completely different character than bull markets in that buying puts in periods of high volatility requires even more focus, faster decisions, and that the setups and Elliott Wave counts were not going to be much help. I lost confidence in my abilities to recognize Elliott Wave patterns, so I stopped trading. I was just thankful that I could still claim a good profit from the entire decade. I entered a period that I call “the black hole.” That is how bad I felt about myself. All my ideas about trading had to be revised, tested, and proven to be profitable again, and I thought that this was the end of the line for my trading career.

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It was in August 2002 that I saw an infomercial about options trading. My juices got flowing again. I thought I was missing out on great opportunities. I thought again about my low-risk, high-reward stock substitution goal. I needed guidance beyond the many books I had read until then. I needed a breakthrough. The infomercial was from Optionetics with George Fontanills talking about low-risk strategies. Knowing what I knew about options until then, Fontanills made sense. So I attended courses, both basics (not much help there) and advanced. I began to think about trading again in a big way, but was not willing to risk one penny.

Fortunately, Optionetics offered their Web-based software, Platinum, which allowed me to backtest my ideas. It took me until 2005 before I had summoned enough self-belief to begin trading significant amounts of capital. It is not a bad idea to start small…very small. I tested over two dozen approaches, I bought licenses for Advanced Get and the Refined Elliott Trader, which are two Elliott Wave software packs. But until I could trust Elliott Wave again, I needed a system that was independent of my ability to forecast the market direction. I knew the S&P 500 was close to a low in early 2003, but I also knew that corrections come in three waves at least. Eventually a “C” wave would come, so I needed a system that would allow me to trade the bull market fully expecting “the second shoe to drop,” as they say.

Meanwhile, I read a book by Glenn Neely entitled Mastering the Elliott Wave with the most complicated methodology for Elliott counting (or any other analysis for that matter) that I had ever seen. However, Neely did provide a comprehensive compilation of possible patterns. There had to be an easier way. So keeping the Elliott Wave discovery as a pet project, I began to trade a system that had little to do with any technical analysis at all. The system was based on a complex spread I found in Larry McMillan’s book, Options as a Strategic Investment, which I dubbed “PCCRC” (Put Call Calendar Ratio Combination), a variation of that trade described in that book.

Earl Nightingale says that, “There isn’t such a thing as luck. Luck is preparation meeting opportunity.” In 2005 I was ready. I began my blog, talking about the Elliott Wave at first, the software I was testing, and soon thereafter, I began to describe my breakthrough options trading strategy, the PCCRC. Since 2000, I had committed myself to finding a low-risk, high-reward form of trading, and it took me three years to get enough courage to put my “bad luck” behind me and another two years to trade this approach with confidence. After many articles describing my approach and the great returns in the first two years, I decided it was time to make my findings available to anyone who would like to give it a shot. You see, I like to say that my strongest instinct is the pursuit of mastery, and my biggest joy is in sharing what I have learned. I believe that I could profitably trade the PCCRC in the most difficult of markets and produce returns well above 30% a year. I realized that I could persuade the readers of my blog to participate, so I told them I would gladly share my strategy, provided that they would “pay it forward.” I felt that I could make good money on my own, but I felt that there was more to life than making money, and that my goal had to go beyond just personal gain. I have found the trade that allows me plenty of time to run my business, travel the world, and sleep well at night regardless of what the market will do.

In the middle of 2007, I realized that my words would be meaningless to others unless I could show them the results of my trading in “real time.” There would be little use in showing my trades retrospectively. Others needed to see my work as it happened, not from old successful trades that I could easily cherry pick. So I opened a paper trading account, proceeded to trade live, and recorded my trades in video tutorials so that the participants of my group could see that it really did work. By the end of that year, after six months of trading, the account had increased by 45.7%. From the original $100,000 fictitious dollars, I closed that year with $145,730.80 (see profit/loss report for 2007, figure 2 below).

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I know that paper trading is not the same as real money. But I wrote and followed a very specific set of rules (available for group members) without deviations, which I also followed in my own real trading account so that I could say with integrity that the results were reproducible in real life. Although I was not willing to show my real accounts due to privacy concerns, I figured that the paper trading account was the next best thing. Given the great results in the first year, I understood that the profits could not be explained by advantageous executions (mid-price executions). Knowing that this was, in fact, what I had in my own accounts, I felt at peace with the results obtained in the paper trading account. I decided to keep doing this for the second year. Only once a week of trading would do nicely. Furthermore, I was going to do all trading in this account in a one-hour trading session a week and no more. If I could show great results with just over 52 hours of trading a year, my case would be made. After all, if you have to spend two, three, or even more hours per day trading, then you have to subtract what you would make if you had a day job. Trading would not come out very favorably in terms of man hours.

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So I traded the PCCRC in 2008, one of the worst years in US market history. By the end of 2008, my paper trading account had grown from $145,730 to $197,316, a great return by anyone’s standards (see Profit/Loss report, figure 3 below).

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But considering that, in that year, the average account fell by 50% or more, I felt I had proven my point in as honest and clear a way as I could. I feel rich when I share what I know with others. I feel rich when I travel around the world visiting exotic places and watching animals thriving in their ecosystems. I feel rich when I generously give my knowledge in the hope that you would pay it forward, doing something generous for others. So if you are not feeling good about your trading, rest assured that there is a way out, provided you have a vision of how much better you can be at it, and that financial independence is possible, provided that you have the “burning desire” to prosper in your trading. My vision is that if I strive for mastery of my craft, the financial rewards will follow. All I need is to have what Napoleon Hill calls “active faith.” This is the faith that will keep you on the road to success by backing it up with action.

There is no question in my mind that one continues to grow intellectually through life, and that is particularly true for trading. Remember my trade on AAPL? After these many years, I have come to understand Elliott Wave even better, although I am not sure that I should call my analysis “Elliott Wave” analysis other than to acknowledge the great contributions of that wise man. Glenn Neely should also be acknowledged here for the great contributions he made and how it influenced me. However, my methodology is more complex than Elliott’s and far simpler than Neely’s, but I can confidently say that I now understand what went wrong with my counts on AAPL back in September 2000. Napoleon Hill was right when he said, “Our prevailing thoughts determine what we become.”

I never stopped thinking about that AAPL chart for ten years. I tried various software for Elliott Wave analysis and approaches to trading, but it was only recently, starting in August 2008, that I discovered what I needed to discover to once again trust my abilities as an Elliottician. It was while learning about daytrading with Tom Busby that I discovered that one can easily learn and test the Elliott Wave theory by studying short-term charts of the /ES (S&P 500 e-mini). I found that the patterns are clear and obvious, perhaps because the /ES is widely traded and never sleeps. I tested the channeling methodology and the Ichimoku Kinko Hyo system to generate my Elliott Wave counts. At long last, I could understand that chart of AAPL back in 2000 (figure 4 below), and I can confidently say that I can use my variation of Elliott Wave theory to forecast the markets long as well as short term.

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And I have finally solved the AAPL puzzle that plagued me for ten years.

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The 1997-2000 wave pattern for AAPL was a double zigzag, a trending pattern quite distinct from the impulse series described by Elliott, but just as powerful nonetheless. I should have known better and exited my AAPL shares near the top of the market. So you see, your trading goal should not be about how much money you can make, but it should be about the mastery of a discipline.

As good as my PCCRC strategy has been to me, 2009 was not a great year for it (see Profit/Loss report for 2009, figure 5 below).

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I am including the profit/loss report for the paper trading account for 2009-2010. As it turns out, 2009 was a period of ever-declining volatility, and that made trading the PCCRC quite difficult. I told my people that bullish butterflies were better for this period, but nevertheless, I continued to trade the PCCRC. The good news is that I had no big losses. I added the iron condor as a hedge for periods of declining volatility in the PCCRC account. It is noteworthy that the transition from low to high volatility that occurred in May this year was great for the PCCRC strategy (see Profit/Loss report for 2010, figure 6 below).

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So the PCCRC is not without flaws, but it can be quite profitable in uncertain markets, and it will protect you against unforeseen events, such as the now famous flash crash. Year to date, the account shows a $44,160 profit despite the flash crash! In fact, the flash crash was great for the PCCRC trades because a spike in volatility can produce great results in this form of trading. The point of the PCCRC is to invest large amounts of capital, say 10% of your account, yet placing only a small portion of it at risk (2% of your account, on average). You have a perfectly manageable ten-trade portfolio, and any surprise will be a positive surprise.

Note at the end of the profit/loss report that the most profitable trade so far has been an AAPL trade, which I placed just before the flash crash. Only a few days after earnings, I entered the trade (April 23, 2010). This was a synthetic, three-leg variant of the PCCRC, which is commonly called a “call seagull,” but the results are the same. The seagull might be slightly cheaper at the time of entry, so I use these trades interchangeably. Both are affected by implied volatility (IV) of the options. Here is the trade, as executed in the TOS platform and entered in the Optionetics Platinum platform (figure 7 below).

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I am including the risk graph with price as the independent variable and profit/loss as the dependent variable (figure 8 below).

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It may appear to you that the only way to make money here is if AAPL goes up or down strongly, but you are not considering the effect of volatility a very significant factors in option price modeling.

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Yes, time decay may actually work for you, but I would prefer if the stock would move strongly in either direction or if IV rises. Often, when a stock declines, it does so with an increase in IV, as institutional traders may buy puts to protect their stock positions. So consider the IV risk graph (figure 9), which tells you what profit/loss you’d have if there is an increase in IV.

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This risk graph shows how a potential spike in IV would result in an increase in the value of our position. If IV on AAPL goes to 40%, my position may produce profits as large as $10,000. In fact, IV did go up as a result of the flash crash. So let’s take a look at the trade on May 6, 2010, the day of the crash (figures 10 and 11 below).

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The entire risk curve is moved to the right, and the volatility results in a profit of 30% on capital and 170% return on risk. Because IV spiked during the flash crash, all PCCRC’s in my portfolio produced good returns, so I closed most of them in the days to follow. The appropriate way to look at this trade is through the volatility risk graph (figure 11). As IV spikes, the profits quickly accumulate. Keep in mind that volatility can go down as quickly as it goes up, so one must be nimble and exit the trade or at least sell some of the long puts and/or calls.

The PCCRC has given me excellent results in bullish as well as bearish markets, and in markets with low IV leading into high volatilities, provided the careful rules I have laid out are followed to the letter. I don’t keep any secrets, yet there is a lot of healthy skepticism about what I have been doing over the last five years. My philosophy is that I can show you what I know and what I do, but it is up to you to proceed in your very own path to success. The PCCRC is not just another bearish trade; it is also profitable in momentum stocks that move strongly in either direction. But a surprise move in the markets will not catch you by surprise. So if you are fearful of the current markets, consider the PCCRC as one of your main forms of trading.

By Juan Sarmiento, DVM, MSc, PhD, trader and blogger,

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