Panic Selloff in a Stock? Here's How to Make Money

 | Jul 16, 2017 | 2:00 PM EDT
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When markets go into panic mode, market makers cannot be expected to be constantly making accurate, reliable markets. Thus, the bids and offers you might see on your trading screen at such time should not be considered as firm, or "real."

The problem created by panic selloffs is that even with today's sophisticated computerized market, when panic sets in human chaos joins the fray. Chaos being in control of the bid and ask in options is more erratic and unreliable at, and during, these times. Those bids and offers we see should be thought of as mere suggestions. And, while this panicked period is ephemeral, it is during such times that the excellent money can be locked in!

So how does anyone who is long puts in a market that is in chaotic panic selling mode close out a long put for a presumably very nice gain? The answer is: you should buy the stock and immediately exercise your long puts!

During the crash of 1987, this is precisely what I did. After all, I was net long over 700 puts that literally overnight went from junk status (i.e., market values and cost basis of $0.10 to $0.25 per contract) to about as good as it gets when closing out winners at premiums of $5, $10 and even as high as $23 per long put.

I quickly realized that the panic that set in that day created such a mess in my own pit, in which I was trying to make markets. None of us, the market makers in our pit, could keep up with the enormous price changes of our pit stocks. Those underlying stocks (four in my pit) were changing prices (crashing) so fast that we could not keep up with those changes -- the basis of our job, so to speak, of making markets on those underlying stocks' puts and calls.

So, not wanting to miss out closing for those wonderful gains, what I did was to begin the buying of the underlying stocks. Then, and almost immediately, I exercised my long puts on the stocks just bought on a one-to-one basis.

In other words, if I bought 2000 shares of the stock, I exercised 20 long puts. By that day's end, I had bought well over 200,000 shares of those four stocks and exercised those long puts -- on that ratio of 100 shares bought to long one put. A week later (clearing back then took one week in time) all those trades cleared and my position "sheets" looked quite bare.

Key to employing the early exercise tactic is that you must have the available capital/margin funds in your account. If you do, then the next time around, when the market gets into a crazy panic mode, you at least will know that this method could be employed if you chose, or were sort of forced, to use it.

This article originally appeared Friday on Real Money Pro, our premium site for active traders. Click here to learn about this dynamic market information service for active traders and get great columns like this from Skip Raschke and others.

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