Tag Archives | stock market panic buying calls buying puts panic buying desperate need to buy puts

Downside Panic vs. Upside Greed

Mark,

It's informative to hear your candid, albeit infrequent, opinion
on the state of the market. My sentiments are in line with your summary
and I feel this will be a flat, if not down year (once people realize
that mostly the wrong people are benefiting from government stimulus).

I recently read an article that made a frightening analogy between our
economic state and the fall of the roman empire… a tad extreme, for
certain.

I was wondering why VIX spikes are correlated with market
drops and not rallies… is it simply because the majority of options
are bought as protection against market collapse? Shouldn't options
trading be just as brisk during rallies or any other periods of high
volume, where investors may use options for speculation, or to protect
profits made, etc?

Andy

***

My track record tells me that my opinion on the state of the market is best kept to myself.  I am not a good prognosticator.

The 'wrong' people who are benefiting – they own Congress. Bought and paid for.  No Senator seems courageous enough to set things on the path of fair play and decency.  Wall Street owns America.

***

In 1984, a huge spike in the market drove IV higher.  Today, things are different. Rallies are never a panic situation because so few people are short the market.  People may want to jump on the bandwagon, but the sense of urgency isn't the same as when you see your life savings melting away.

Buying calls in an attempt to profit is not an act of desperation. There is no urgency to buy now and pay any price.  In addition, there are always investors willing to accept profits and they are in the marketplace, willing to sell calls to the buyers.  You said it in your question:  People who want to protect profits are more likely to be selling calls – dampening the effect of supply exceeding demand.  That helps keep option prices low. 

There are too few natural put sellers taking profits as markets decline.  Thus, the major volume is composed of panic buyers, and option prices soar. 

Since 1987, people understand that the market can be demolished – essentially overnight.  Thus, the 'need' to buy puts for insurance far exceeds the desire to buy calls to profit.

Human psychology is beyond my ken.  But people's reactions to events is sometimes predictable.  It's well known that losing a given amount of money is psychologically far more damaging than earning that same amount.  Losing what you own is devastating and people pay any price necessary to buy puts.  And they buy them right now, with no delay. 

Add to that the fact that when market makers sell puts, they are taking on an immediate risk.  They hedge as quickly as possible, but their desire to hedge adds to the problem because they must buy other options.  They buy calls plus stock to create synthetic puts or they buy other puts.  That places further upwards pressure on option prices, and IV grows with that demand.

Even when there is no panic, the skew is already in place.  Options with lower strike prices trade with a higher implied volatility than options with higher strike prices.

That's the way it will be – unless there is a change in human nature.

627


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