macrocephalopod

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

Post Script 3: Dealer Z may not have wanted the risk, so Crodeet Swish could have had to find an alternative buyer for it by structuring it so that the premium was paid as a coupon to someone willing to take that risk. This called “tail risk recycling” see also: autocalls. Fin.

This is a v interesting thread but 1 thing I don’t get — how is a knock-in put where the barrier is between the strike and the current price any different from a regular put? The prx must go thru the barrier on its way to the strike, if it expires ITM it must have been knocked in