I Suspect Options Writers
By Arnold Kling
Count me among those who maintain that buying high and selling low is unlikely to be a successful trading strategy. But if enough people believe otherwise, they can wreak a bit of havoc on the rest of us before they themselves go belly up.
There is a class of traders who will buy high and sell low as a hedging strategy: option writers. Suppose that you rode the rise in oil prices by writing put options on oil. When oil was at $90, you collected a fee for giving somebody the option to sell at $85, which would only be worth something if the price went back down. When oil got to $100, that option looked pretty worthless.
When you write an option like that, if you want to stay solvent, as prices decline you have to start to sell oil short in order to hedge your position against further declines. Suppose that when the price was $110, you wrote a put option with a strike price of $102. While the price is $110, you do nothing. But as the price falls to $105 and below, you short oil in order to avoid having a huge risk exposure.
By the way, note that the folks who were in the business of writing call options on oil had to buy oil futures any time the price went up.
Any time there is unstable market behavior, I always suspect option writers. “Portfolio insurance” in 1987 is one example. Credit default swaps are another. I think that is all too easy for option writers to adopt strategies that seem to make sense individually but which collectively cannot be implemented when the need arises.