New theory on what happened last week

There have been many rumours and theories floating around, trying to explain how a broad index in the largest stock market in the world can drop more than 5% suddenly and recover almost immediately. Adding to the mix, The Globe & Mail quotes a story in the Wall Street Journal speculating on a new theory:

One hefty trade in Chicago last Thursday may have played a big role in the afternoon stock market meltdown, The Wall Street Journal reports today. With markets already under pressure from global developments, the $7.5-million bet in the Chicago options trading pits may have served as something of a spark about 20 minutes before the heart-stopping plunge of almost 1,000 points in the Dow Jones industrial average, the newspaper says.

The trade was made by Universa, a hedge fund that, ironically, is advised by Nassim Taleb, who authored Black Swan: The Impact of the Highly Improbable. Universa purchased 50,000 options contracts betting that stocks would continue to fall. Those contracts would pay about $4-billion if the S&P 500, which stood at 1145 points when the trade was made, hit 800 in June.

That appeared to ripple through the markets, The Journal reports, leading traders on the other side of the deal to sell, in a bid to bring down their own risks. Among those on the other side was Barclays Capital, according to the report. “Then, as the market fell, those declines are likely to have forced even more ‘hedging’ sales, creating a tsunami of pressure that spread to nearly all parts of the market.”

This theory looks as weak as the 'fat fingers' theory of last week, which claimed a Citigroup employee was responsible. I dismiss this latest speculation because it is hard to fathom how $7.5 million can cause such a big decline. If it were $7.5 billion then it's a bit more plausible; but it's not. It's just $7.5 million (admittedly, like most derivatives, this trade had super-high leverage but that shouldn't matter; those on the opposite side wouldn't enter the trade if they weren't wiling to lose $4 billion—or another way of thinking is that those on the opposite side would only enter the trade if they could hedge properly.)
 
If such a little amount could cause such a big move, market maniuplators and criminals, not to mention terrorists and foreign hostile agents, would be attempting it all the time.