Trade like animals and try to make that money back by Friday!

Everyone who reads this site knows that trading is a funny business.
Sometimes you can do really stupid things and make money. Sometimes you can do
really clever things and lose money. Sometimes your best trade is taking a loss
on a crappy position, or maybe even not trading at all, and sometimes your worst
trade might be one where you made money, but not enough, or started its life as
a good trade that was mismanaged. The possibilities are endless.

My Worst Trade Ever

In 1987 I was trading options on T-bond futures at the CBOT with a small group
of traders. Bonds (and the dollar) had been going down relentlessly that year
while stocks seemed to defy gravity and keep pushing higher. We knew that it was
only a matter of time before stocks would take a hit, and we knew it would be a
big hit.

In late September things started to unravel in stocks. The sell off really
started to snowball into October. The dollar was getting hit and bonds were
crashing as well. During the week of October 12th stocks really started to get
hit and closed badly on Friday. It was evident that a climax was coming and it
came on Monday, October 19, 1987.

At that time, implied volatility in the T-bond options was screaming. I don’t
recall the exact levels, but back then implied volatility in t-bond options had
a strong inverse relationship with price, meaning that as yields rose and bond
prices fell, implied volatility would rise, and as yields fell and bond prices
rose, implied volatility would fall. On the morning of October 19th bonds were
lower again and volatility was higher again. Trading was very active. However,
as the day wore on people began to stop and watch the big price boards on the
west wall, all eyes on the S&P futures.

It was like watching fireworks on the Fourth of July. The prices we were seeing
were amazing and you would hear “Ooh!” and “Aah!” as we saw the ticks roll by.
It was clear we were seeing history being made, and it rapidly transitioned from
being something very interesting to something very scary. Even the guys who were
short stopped high-fiving each other.

Flight to Quality

I had told my group that a flight to quality might happen in the T-bonds, and
that we should start planning for a rally. With volatility on the highs this
meant a bullish position with a short-volatility bias was desirable. Guessing
that bonds might possibly bounce 3 or 4 points (i.e. rally from 78-00 to 82-00)
we began putting on ratio call spreads, buying the 80-00 and 82-00 strikes,
selling the 84-00 and 86-00 strikes. We put on thousands. Late in the day as
S&P’s continued to get pummeled, T-bill and Eurodollar futures began to rally as
did t-bond futures. The flight to quality was on, and volatility offers started
to pour into the pit. We were geniuses.

Back then the CBOT had a night session. We stayed downtown, drinking beer and
eating pizza at Boni Vino’s and laughing about the stock market. We were long a
few hundred bond futures and short a lot of volatility, and we were sure we had
it right. We went into the night session and bonds were limit up, putting them
in the low 80-00’s (I may be off a handle here or there, this is all from
memory), right where we thought they were going. Everything was looking good; we
traded a bit and then went home.

Moon-shot to Quality

When I woke the next morning I called in and spoke to my partner, Bruce. He
said: “Did you buy any bonds last night? “I responded “No why?” “Because they’re
trading 10 points higher in London.” Oh sh__. My life flashed before my eyes.
The flight to quality had turned into a moon-shot to quality and the t-bonds had
blown through the short strikes of our position in a big way. We were screwed.

I got in and we calculated our losses. It was going to be multiple millions if
things stood as they were. We had a bit of luck however; at that time the CBOT
had 2-point price limits in the bonds while London had none. This meant that
even though bonds were really trading 10 points higher, they would only be
allowed to trade 2 points higher on CBOT. In our inventory we happened to have
quite a lot of a very common options position known as a “reversal”. A reversal
is an arbitrage strategy used by professionals where one would buy calls, sell
puts of the same strike and expiry, and sell futures, locking in a small profit.

Because the CBOT only allowed bonds to move up 2 points, but our long calls and
short puts had no limits, it created the illusion that we actually made a lot of
money. The problem was that the CBOT bonds would eventually catch up to London,
and then it would be clear how much money we really had lost. At that point we
would be yanked off the floor for good.

I explained the situation to our group. I recall saying: “Guys, we’ve lost all
the money we’ve ever made, all our children will make, and all our grandchildren
will make. We have five days before the clearing firm figures out we’re bust.
We’ve got to get in the pit with guns blazing. Trade like animals and try to
make that money back by Friday.”

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to read how Joe and his traders made all of it back…and more.