The flash crash is a classic pattern, but how do you survive it?

There is a smart way to survive a flash crash. But before we get to that, let me tell you about the not-so-smart way I discovered.

 

The Day It All Changed

It was Tuesday, April 4th, 2000. I stood on the floor of the Pacific Exchange, trading ADBE options as a market maker. The market had just experienced the “dot com” rally of 1997–1999, and there was no sign it was going to end any time soon. We were about to get that sign — and we were going to get it good and hard.

Early that morning, I watched as the ADBE stock price, which had been fairly bullish, began to move slowly down. And then it began to move down not so slowly. As a small trader, I typically held a net long option position, meaning that while I might be short some options, I had protective options that would profit from significant market moves. This usually meant I was long gamma — as the price went up, I had stock to sell, and as the price went down, I had stock to buy.

However, when I looked at my risk report, I was shocked to find that I was getting longer on ADBE despite the falling prices. What had I missed?

Short puts. That’s what I had missed. With the stock dropping below $95, I realized I was short the $85 puts, and a lot of them. This position had been so far out of the money and so close to expiration, that I had forgotten about it. But those puts were about to become quite important to me.

(If, at this point, you are asking, “what kind of moron forgets a large short option position?” The answer is, this kind of moron. The kind who is writing this article 24 years later. But remember, the best stories don’t start with “I once did something smart and thoughtful.” They start like this.)

The Flash Crash Nightmare

As the stock price continued to lower, I finally realized the potential and very ugly losses I was facing. Abandoning my position in the trading pit, I walked quickly (no running on the trading floor) to our Bloomberg machine. I knew no one in my pit would sell me the options I was short — not with the stock dropping like a rock. I had to sell stock against the position to manage the risk.

Having put myself in an ugly place through stupidity, I thought I’d give being smart a try. I looked at what my delta would be if the stock price were $1 lower than it was at that moment. After all, if the price were going to crash hard from $95, it had to go through $94 first. So, I sold the number of shares needed to get me delta neutral at $94, if the price did drop to $94.

Less than a minute later, the price was at $94. Well, that was quick. So, I tried it again. What was my delta at $93? Long 2,000 shares? Great, sell them. Oh my lord, we’re at $93. OK, what’s my delta at $92? Sell it.

And so it went. Price down, sell some stock. Price down more, sell some more stock. Down, down, down.

By 8:45 am Pacific time, the price had reached roughly $76 — way through my $85 strike price. I had sold 50,000 shares at an average price of (I’m relying on memory here, so this very precise number might not be exactly right) $85.04.

Then, after I had sold all that stock, the price took a very brief pause. Then stock price began to climb. Holy crap. Was I awake? Was this a really, really bad dream? Nope. It was real and I was about to get ripped to pieces on the way up.

So, you know the strategy. Remember, I had sold 50,000 shares, so my delta was going to be very, very short if the price rose. The stock is at $78? What was my delta at $79? Buy it. Delta at $80? Buy it. The market did the opposite of what it had done 30 minutes earlier. So I did, too. I bought and bought and bought.

By 9:30 am, the stock had rallied back into the low $90s. I had bought back 50,000 shares. In fact, I had sold 50,000 at $85.04 and bought 50,000 at $85.06.

I had lost $1,000 — only $1,000. I was covered in sweat. I was still short gamma. And the market wasn’t going to close for another 3 1/2 hours. I had more than half of the day left to survive.

The Real Loss: Opportunity Cost and Potential Gains

So, where does the $250,000 loss come in? After all, I only lost $1,000 on the trades mentioned above. The $250,000 represents two things: opportunity cost and potential position gain.

First, the opportunity cost. During large market moves, there were often resting orders you could trade. You could sell calls or buy puts on the way down to gain a short position. In fast market conditions, you could even widen the bid-ask spread, totally justified by the volatility. On the price bounce, fewer opportunities existed, but there were still some.

Finally, I was paying a seat lease to be on that floor. These opportunities weren’t free. I was paying to access them. So, you have to make the most of it.

Second, the potential gains from a long gamma position. Having paid for options time decay over months, it was a real loss not to benefit from a long gamma position when the market moved significantly. Given my position sizes at the time, making $100–200K from long gamma on a move of that magnitude was a reasonable expectation.

This combination of missed opportunities and lost potential gains added up to a lot of money I missed.

The Smart Way to Handle Flash Crashes

Now, I promised to share the smart strategies for handling flash crashes, and there are several:

Long Options: You can always be long options, but this comes with a cost. Time decay, especially on equity options with higher implied volatility, isn’t cheap. You risk going broke while waiting for the market move.
Limit Leverage: Limiting leverage reduces downside risk but, of course, also caps potential upside.
Stop Losses: Knowing the limit of your possible loss is crucial. However, stop losses can be run, and optimal placement is challenging.
Or, you could use our platform, Outcome Trading. We designed it specifically to avoid the pitfalls of flash crashes, stop running, and liquidations. Every trade is bounded, and every risk is known. You can wait out any market move against you if necessary. With Outcome Trading, you can focus on the opportunities in front of you rather than desperately trying to control damage.

I learned a lot from that horrible day in the spring of 2000, but you don’t have to live through it to learn the same lessons. Outcome Trading offers a smarter, safer way to navigate the market.

But whether you use our platform or someone else’s, look out for those tricky short puts.


07.01.2025
Outcome Labs