Black Monday Anniversary: The Most Dangerous Trade Right Now

A crash-themed Q&A with one of our top volatility traders

Oct 19, 2017 at 9:42 AM
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Today marks the 30th anniversary of the infamous 1987 "Black Monday" stock market crash, and -- despite a geopolitical environment that's fairly riddled with risk and uncertainty -- the major equity indexes have soared to multiple consecutive record highs. Meanwhile, over the last six months, the average daily CBOE Volatility Index (VIX) reading has been a mere 10.82 -- well below the VIX's five-year mean of 14.66. So, given that we're smack in the middle of the worst month for market crashes, is this price action pointing to another imminent bout of mayhem for U.S. stocks?

For an expert's take on the odds of another crash -- plus, pro tips on how to protect your portfolio in the worst-case scenario -- we turned to Schaeffer's Senior Trading Analyst Bryan Sapp. As one of the strategists behind our straddle-driven Volatility Trader series of options trading recommendation services, Sapp knows a thing or two about sudden, volatile stock moves.

Elizabeth Harrow: The official Fed essay on the 1987 stock market crash discusses both "portfolio insurance" derivatives and "triple witching" expiration as contributing factors in the Black Monday sell-off. To what extent do you think the 1987 crash still colors the average investor's perspective on options trading, if at all?

Bryan Sapp: In my opinion, the 1987 crash is the furthest thing from anyone’s mind right now. I’ve seen a few articles on it this week just because it’s the 30th anniversary, but I’m guessing it’s writers looking for content since the market is so riveting lately. [Editor's note: Accurate.]

How could the average investor in 2017 make good use of options to gain protection against a market crash?

Buying put options -- and especially index put options -- has been a great way to lose money for a few years now, but that’s probably the best way to protect against a crash, here and now.  It all comes down to the timing of it, should the market roll over hard -- but given how cheap index options are (and for good reason), a trader who could time a big move lower would be set up to make a mint, given the current options pricing.

Do you recommend buying put options on broad, equity-based ETFs (like SPY, QQQ, IWM, etc.) for those looking to pick up crash protection? Why or why not?

Index puts have been a preferred way for hedge funds to protect against downside for some time now.  It’s been a "waste" of money for a while -- but generally, it makes sense as a hedge in the event that someone is looking for protection against a multi-sigma move, because the implied volatility of the index options will be much less than that of most individual equity names.

When stock prices are crashing and VIX is spiking, how can traders determine whether buying put options at inflated implied volatility levels is "worth it," in terms of the premium paid vs. downside protection gained?

In order to determine if an option is "worth it," a trader must make some sort of prediction about future volatility of whatever instrument they’re looking to trade. In the event that current implied volatility is less than perceived future actual volatility, then the option is "cheap" on a relative basis.

Are there any trading strategies that you view as particularly risky in the current market environment (or regardless of environment)?

To me, the trade that looks the most dangerous here and now is shorting volatility. Yes, it’s worked for a very long time now, and appears to be free money, but it’s a super-crowded short at this point. In fact, per the Commitments of Traders (CoT) reports over the past two weeks, total short open interest on VIX futures is currently at an all-time high. 

Sure, it’s most likely that the VIX will continue to move lower, given what’s been going on lately.  However, in the event that we get some sort of shock -- whether it be geopolitical, market-related, etc. -- risk/reward is very skewed here. Should the VIX see some sort of spike, it will most likely move disproportionately to the upside, making it tough (at least in my mind) to stay short volatility for a prolonged period here.

As a trader, how have you reacted to some of the drastic short-term crashes in recent years (like May 2010 and Sept. 2015, for example)?

In the event of big crash-type moves like you mentioned, if you’re not prepared or positioned for them ahead of time, it’s generally too late to react, unless you’re very nimble and can position short term. The best way to react is to de-risk and wait for a good spot to re-enter the market. 

These types of moves happen so quickly now, with all of the algorithmic trading that takes place, that trading on a very short time frame can be difficult from a trade execution perspective. For those who do trade during these types of events, defining and respecting risk is key. When markets get that volatile over short periods, big risk can happen in a hurry.

What types of indicators would signal to you that the market is at risk of a sudden, "crash"-type decline from a technical perspective and from a sentiment perspective?

From a technical perspective, I look for parabolic price action. When stocks, indexes, etc. accelerate to the upside, it increases the potential for an outsized counter-trend move. From a sentiment perspective, I like to watch for extremes in put/call ratios, anecdotal sentiment (via Twitter, media coverage, etc.), and various sentiment polls that we follow at Schaeffer's (including Investors Intelligence, the American Association of Individual Investors, and CNN Fear & Greed).

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