There are many complicated option strategies available, and many people spend hundreds of hours looking for the perfect strategies to generate "guaranteed income." Most of these strategies work great when the markets are range-bound--which they are most of the time. Then along comes the inevitable big rally or watershed decline and all these people get hosed. For a period of years in the mid- 1990s, a lot of traders and funds made a nice living selling naked puts. These are put options whose writers do not have a short position in the stock on which he or she has written the put. The goal here is that the options expire worthless, and the put writers collect the premium. Many books started popping up on the shelves about "taxi-driver millionaires" who discovered this "amazing get rich quick" trading strategy. Then along came October 27. 1997.
The markets had been drifting down through October, and many of the taxi drivers, as well as several large funds with a few hundred million in assets, were busy selling naked puts.
The brokers who worked with the funds started getting nervous because the positions had gone against the funds to the point where it wouldn't take much of a further decline to start forcing margin calls. The brokers, who didn't quite understand the strategy being used by the funds, started to place discreet calls to other traders asking what would happen "if the Dow dropped a couple of hundred points" over the next week or so. The answer was easy--these funds would be forced to dump their positions because of margin calls, and this would create tremendous downward selling pressure in the overall markets. The S&P 500 floor traders at the CME got wind of this and started prepping for the slaughter.
On October 16, 1997, the Dow broke through its most recent uptrend line.... The Dow then rallied and closed at 8034.65 on October 22, just below its broken trendline..... This is a common occurrence in all markets-once a trendline is broken, the markets will come up and test it last time before rolling over. I call it, "kissing the trendline goodbye." On October 24,....., the Dow closed at 7715.41, down 319.24 points. This started the round of forced margin calls after the close, which was on a Friday.The margin call selling would take place on Monday. The Dow opened Monday at 7633.14, down 82.27. Then the forced selling via the margin calls began-- and the S&P pit traders, who knew what was happening, simply stepped back and walked away from the bids. With no support in the markets, the Dow dropped quickly and closed at 7161.39, down 554.02 points on the day..... By the time the closing bell rang on Monday, everyone who was selling naked puts for a living had lost a substantial amount of money. The funds that were involved not only lost all the money under their management; they ended up owing money to the brokers. Well, more correctly, the people who had invested in the fund lost all their money, and ended up owing more than they had put into the fund.
