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Posted on 20 March 2011 | 10,189 views

Predicting Stock Market Crashes With Stock Options

A stock market crash is a sudden drastic decline of stock prices across a significant cross-section of the market. Crashes are often driven by panic amongst the investors.

At such times, external economic events combine with crowd behavior and psychology in a loop where selling by some market participants drives more market participants to sell. A predetermination of market crash can help investors save their money that is at stake due to investments in the stock market.

Stock Option put-to-call ratios can even help one profit before the market crashes by hinting beforehand, the right time to buy options such as a put option which gives the holder the right to sell at a predetermined high price. Large volume trades and open interest within a strike price and date can forewarn of impending news.

Financial transactions in the days before the 9-11 attack suggest that certain individuals used foreknowledge of the attack to reap huge profits. The evidence of insider trading includes:

* Huge surges in purchases of put options on stocks of the two airlines used in the 9-11 attack — United Airlines (NYSE: UAL) now United Continental Airlines and American Airlines (NYSE: AMR)

* Surges in purchases of put options on stocks of financial services companies hurt by the 9-11 attack — Morgan Stanley – (NYSE: MS) and Bank of America (NYSE: BAC)

* Huge surge in purchases of call options of stock of a weapons manufacturer expected to gain from the 9-11 attack — Raytheon (NYSE: RTN)

Portfolio Insurance is a method of hedging a portfolio of stocks against the market risk by short selling stock index futures. Index Options along with Index Futures is often associated with the October 19th, 1987 stock market.

On the weekend before the 1987 crash, an enormous overhang of sell orders had built up, for in the previous week the Dow Jones Industrial Average had fallen 250 points, or about 10% (with half of the drop on Friday). During all this, managers of “insured” portfolios were selling index futures and dumping their portfolio stock.

On Monday all the programmed sales kicked in, the market dropped 100 point by noon, another 200 points in the ensuing two hours, and 300 points in the final hour. As Peter Bernstein notes, “The cost of portfolio insurance in that feverish market turned out to be much higher than paper calculations predicted.”

Unusual activity in Stock Options, Index Options and Index Futures often do lead to imminent news in the financial markets.

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  • free share tips said:

    Deatiled analysis bases article !!! Readers will surely like it !! please keep sharing such articles !! Thanks !!!

  • Candy said:

    Very true! Makes a cnhage to see someone spell it out like that. 🙂

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