If you have been in the markets as long as I have, you know a couple of things. First, the unlikely occurs almost every day and second, the impossible happens at least once a month. The markets are a probability model. Forget earnings and new products. The option chain tells us all we need to know about the chances of an event occurring. Based on where the ATM (At the Money) straddle is trading tells us about the chances of any event occurring before the front serial expires.
Folks that went home Friday night September 13th short naked calls in the oil market learned that lesson in spades when the market opened Monday morning. Depending on how much of their portfolio they had invested in crude determined whether or not they were just nauseous on the opening Monday or whether they were physically ill. I have seen this movie so many times in my 40-years in the market that I can’t possibly write about all of them in the space allowed.
In case you have been living in a cave, Sunday September 13th, Iran decided they had had enough with the oil sanctions and the hardliners thought it was a good time to blow up Saudi Arabia’s production facilities. They launched some drones and rockets and they hit the mark destroying about 5% of the of the Saudi infrastructure. Boom! In ten seconds, the oil market was 15% higher. This time it was real, and the talking heads were predicting $80 oil in less than a month. When the equity markets opened Monday, small producers saw their stocks open up as much as 70% higher. It was time for The Duke Brothers to get in there and “Buy Wilson Buy” (a famous line from the movie Trading Places.)
Despite the move, veteran oil traders saw something that the guys on TV and small-time investors would never notice. In the U.S., Crude Oil is traded in monthly contracts that go out several years. The only contract that was higher was the expiring “spot” serial. The rest of the market was unchanged. This indicated that the big investors in the market not only felt that this was a panic move, but it was time for Wilson to start selling oil. The real risk was either owning spot oil that was unhedged or buying the suddenly overpriced equities. As the day went on and the shorts continued to bid up the price to cover their losses, it became more evident that the near-term price was going to collapse.
On Tuesday morning the shorts became the strong hands and the cash market swiftly moved south. Near the end of the trading day, the spot market was actually lower than it was on Friday, but it did rally a little on profit taking to end slightly higher than it was on Friday’s close. None of this mattered to the naked call shorts. They were the ones bidding up the price on Monday to stop the pain. Price didn’t matter, they just wanted out. They got out, but the damage was done. Once again, the folly of selling naked options was exposed. If you got caught in the mess, learn your lesson and move on. If you are a naked option seller, but avoided this trap, it is only a matter of time until it happens to you.