Dazed and Confused

OK, Now I will try to do this...and not lose the entire post.

First, let's lay out the scenario. The big move in Eurodollar actually happened AFTER the market crash itself. The move started in the Asian markets, but after Paul Volcker assured the markets that “we will provide whatever liquidity is necessary”, the short term rates moved 325 basis points down on the open.

In the session before, implied volatility remained fairly steady. The locals (as always) sold premium and the paper did not really buy it up, either. Implied was up just a few %.
Yet, in the S&P pit acorss the floor, futures were down over 8,000 points. Leo Malamed made an appearance on the floor assuring that the markets would remain open, even when the NYSE was ordered to shut down trading early. Over in the currencies, the dollar was in a freefall.

So, being the conservative risk-adverse trader that I was, I got as delta neutral as possible, while buying up some gamma, just for the sake of it. After all, the stocks had moved 7 standard deviations. It did not make sense to me that this was a premium-selling event, certainly in the short run.

I have cobbled the following position together for the sake of example. I am in no way recommending a trade or even a methodology. I don't expect this event to repeat any time soon.

A market maker's job is to probvide lkiquidity to public orders as executed by brokers.
So, a trasder will accumulate an inventory of positions that often refelects the opposite side of what the institutional paper happens to be doing.

Using the following somwhat random delta neutral position, let's analyze a portfolion the night before the big market move.

Assuming: 91.00 EDZ87
Volatility, 17%, 47 days to expiration.

EDZ87 +264

Strike***Puts***Calls
92.50****-----*** +45
92.00****----****-56
91.50****-25***+172
91.00****-05****+45
90.50****-25****+223
90.00***+102****-25
89.50****-54****+35
89.00****+75-----****





Because of Put/call parity, we can strip out the corresponding boxes. This somewhat simplifies the position for the purposes of analysis. We can strip out the following box spreads;

5 91.00-90.50 boxes
25 90.00/89.50 boxes
Leaving:

EDZ87 +264

Strike***Puts***Calls
92.50****-----*** +45
92.00****----****-56
91.50****-25***+172
91.00****-05****+40
90.50****-20****+218
90.00***+077**** 0
89.50****-29****+10
89.00****+75-----****

Now, since we are delta neutral, we can talk of gamma and vega exposure by strike, meaning that we can net the puts and calls together. Gamma and vega analysis is considered to “2nd derivative analysis”. So, by netting the position, you can just multiply the position by the component rates of change. And it makes it really simple to see what further risk is implicit in the position.

EDZ87 +264

Strike***Net
92.50****+45
92.00**** -56
91.50****+147
91.00****+35
90.50****+198
90.00****+77
89.50****-19
89.00****+75

Obviously this position is heavily gamma and volatility exposed. It is readily apparent that were the futures to move one strike higher and volatility to die, the position would lose thousands. On the other hand, the market maker could make six figures on the anticipated market move.