Lessons from a Flash Crash

04/30/2013 7:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

The recent AP tweet hoax provided lessons for traders, notes Dan Passarelli of Market Taker Mentoring, and they should take opportunities like this to learn from the market and make money off it with what they learn.

Recently, the market had a moment of panic that resulted from the false information disseminated on the hacked AP Twitter account that there were two explosions at the White House and the President was injured. Of course, this information was not true. However, as a result of the initial tweet, the market sold off sharply. Within minutes it was made known that the tweet was false and the market rose back up to where it was trading moments before as if nothing ever happened. This quick, but big, move is being called a “flash crash” by many writers in the financial media.

Tuesday’s flash crash provides five lessons for option traders.

Lesson 1: Protecting with options can be better than using a stop. Traders with bullish positions in the market who had protective stop losses on were the big losers in the flash crash. They sold their longs at a low price that existed only temporarily. It was an extreme whipsaw, that should have never happened—but it did. The whipsaw really hurt traders who thought they were being conservative by using a stop loss. If instead they had protective puts, or an otherwise limited risk option position, they would not have endured any losses.

Lesson 2: I Repeat, protecting with options can be better than using a stop. Indeed, some of the stop losses may have been filled at the absolute worst possible price. The way a stop works is that if the market either trades at or is offered below the stop price, a market sell order is triggered. Probably many of those orders executed far below the stop price. It’s not hard to imagine that many of the orders were filled at the absolute bottom price of the day. And what if the story turned out to be true and the market continued lower? For one, those stops could have been executed even worse! But traders protecting with options would have been protected the whole way down.

Lesson 3: Have your profit-taking orders in at all times. Traders with bearish positions had an excellent chance to steal a profit out of the market that day—at least, those who had profit taking orders in. If you were long puts and had an order to sell those puts in the market on Tuesday, you probably would have gotten filled and locked in your profit.

Lesson 4: Don’t believe everything you hear. That one is pretty self-explanatory. In this world of electronic media, this stuff is bound to happen.

Lesson 5: Be quick! Traders who were quick on the draw could have banked some quick (and potentially big) profits on the AP’s bogus tweet. When something like that happens, whether it’s true or not, there is bound to be some immediate selling. The first guy to buy puts makes a bunch of money (presuming he’s quick on the exit too). The last guy locks in a loss.

The most important asset a trader has is knowledge. Take opportunities like this to learn from the market and make money off it with what you learn.

By Dan Passarelli, Founder, Market Taker Mentoring

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