macrocephalopod

But their knock-in gets, well, knocked-in. So they have protection that covers that $2.50 shortfall. *phew*. Now comes the interesting part. Crodeet Swish tells joe they’re sorry but they will now liquidate his XYZ and he should surrender his shares of the for a residual payment

Residual payment? Where did that come from?! Remember the knock-in we didn’t account for before? Well, it’s way way up in price, so joe probably will get like $0.50-$1.00 back. But, uhm, who sold the knock in? They’re probably pretty displeased by this scenario. Not great, bob.

Enter Dealer Z (tad niche). Dealer Z is an options dealer and market maker, and they regularly sell these options, but they hedge, they’re not in the business of betting on ABC direction, just making markets. So, the knock-in goes from having effectively a zero delta to 50+ delta

Dealer Z does the rational thing and hedges as soon as they’re knocked in (IRL options pros: I know I’m simplifying but why are you even reading this) by selling $50 ABC ($200, minus a 50% loss, times 50 delta). But hey, the market is thin and crashing it just went -35% in a day

liquidity is terrible, why are they doing this? Well, they have to. Won’t it cause the price of ABC to crash further? Yes. And the faster it crashes the more Dealer Z (who is now short gamma) has to sell. This is often how those crazy moves you see near market bottoms happen.

Anyways: Crodeet Swish and Dealer Z come to an arrangement, net their positions out, and the residual gets paid to Joe. It’s over.

Postscript 1: This is why I don’t subscribe to narratives of “capitulation” or “retail throwing in the towel” or “mass panic”. None of what happened is affective in nature, all of it is just a necessity of the structure of that market under a particular set of conditions.

Post Script 2: If John had bought a 3x note before Joe bought his 2x, John’s would have knocked-in first, and the hedging by Dealer Z could have caused the price to move lower and knock-in Joe’s. This is what a cascading crash or waterfall market is, in effect. It’s all mechanics