Taiwan Insane index options market on 0206 Martin Liu, CFA, FRM, Attorney I have been trading Taiwan index options(TXO) for the past fifteen years. I am here to tell you the most sobering story in TXO’s 16-year-old history. On Feb. 6 of 2018 (also called 0206 in this article), local time of Taipei, the options market opened at 8:45 in the morning relatively calmly after we woke up to see the US stock plunge at the dawn. But what we didn’t expect is that with the futures down only 3%, the prices of calls and puts grew into the sky, with some 10% out of the money near-month calls jacked up by 10900 times of its previous closing prices. It’s like when you pick up pennies in the north-bound rail and all of sudden you are hit by a south-bound train. Many options sellers, with calls and pubs sold faced the forced offset clause stipulated in the contract between them and futures brokers. But the flash flush market made traders no time to wire more money to their account and made it impossible for them to adjust or stoploss. Technically, they received their warning (if account balance falls below 75% of the maintenance margin, according to the contract, traders will receive a warning letter to urge them replenish more money to boost that ratio back to 100%) two minutes before the forced offset and the chance for a trader to be able to wire the money into their trading account is virtually zero. The total losses associated with that day for sellers were estimated at nearly NT$5 billion. The 0206 accident caused many option sellers to go broke in a whim of 15 minutes after the opening bell and caused the largest default in this history of TXO (NTD1.44 billion), far outpacing the amount on August 8-9 of 2011 when US treasuries rating was downgraded and August 24 of 2015 when China market collapsed, not to mention the 319 event of 2004 and 430 event of 2009 when the market was limit down and limit up individually. After the accident happened, the futures exchange of Taiwan (Taifex) claims no wrongdoing. But what left unanswered was the lack of price protection mechanism by Taifex for TXO market. Ironically, there is one for Index futures market put forth by Taifex on January 22 of this year. And if there is one for futures market, why this is none for TXO market. To be fair, on 0206, the transaction volume for index options (TXO) outpaced that of index futures by nearly four times and Taifex have been very proud that TXO transaction volume was ranked in the top ten of all index options traded in the world. And as I mentioned above, since we have fair price protection mechanism for index futures, why we cannot have one for index options? And after the 0206 tragedy, Taifex's press release told us that there is already one in Korea and India index option exchange. We believe, in this regard, Taifex has gross negligence and possible class action suit by option sellers is not out of picture. Some people criticized those victims for being too aggressively placing their bets. But no one in this world would have anticipated a moment when there is a lack of ask orders and when the market makers all abandoned their role in market making, the prices of calls can grow 1000 points (1 point equal to 50 NTD) in a second and their prices in the next second can shrink to 0.8 points WHEN the futures market was down by only 3%. Had Taifex had some sort of price stability mechanism system in place, the trajectory price movement could have been avoided and some option sellers may not have experienced such a huge losses associated with the forced offset executed by futures brokers. TXO sellers just paid too much tuition on that day. The problem of liquidity collapse on 0206 is partially due to there is a lack of penalty when the market makers ceased to provide liquidity in turbulent market like 0206 and there is no cancellation clause in Taifex’s rulebook. But even if there is a penalty, market makers(MM) may still abandoned their role as MM in search of much higher return by deploying their capital to sell options at ridiculously high prices (some call prices’ implied volatility soared to 190% at around 9am local time when the market opened at around 15 minutes). Some proprietary trading firms in the MM list by Taifex (there are ten MMs listed in Taifex official website) made a windfall on 0206, including Yuanta Securities, Capital Securities and a foreign prop firms from Holland. Some challenged that when MMs backed off from their role on 0206 and focused on the railroaded money, they may as well violated Section 106 and 107 of Taiwan’s futures exchange act which bans market manipulation and insider trading. For Yuanta securities, its market share in options brokerage business is ranked as No.1 in Taiwan and their profits in option selling prop business on that day far outpaced that of other firms. People are curious how this company’s profits were made and what algos were they using on that day when the company has an role in MM and its brokerage clients were under severe distress. Is it a fair market or a rigged one? A last but not less important issue is the lack of fiduciary and reasonable care in the process of forced offset executed by the brokerage house on behalf of options sellers. Brokers, when making forced offset, should take reasonable care to prevent from liquidating their clients’ sold call position between 8:55 and 9:05 due to the liquidity dry-up at that time. Had the brokers orderly executed their clients’ calls after the most tumultuous period, their clients’ losses could have been reduced by a hefty percentage. The contract stipulated that when the clients’ maintenance margin falls below the threshold, the brokers have the obligation to execute the remaining positions. But it is allowed that the brokers choose to liquidate their clients’ position in an orderly way for the sake of protecting their clients in the liquidating process. The fiduciary duty and reasonable care doctrine should still hold in the process of forced offset, and if a broker liquidates its clients’ positions in a very rash way, the doctrine may be breached and the broker may be held liable under Financial Consumer Protection Act.
I have never traded options. Would it be accurate to say that the lesson learnt is to avoid selling options when volatility is low? On 0206, volatility shot up and option prices shot up as well. Option sellers who sold during low volatility periods were killed as a result.