Crashes, Beauty Queens, and the Hangman’s Noose

  1. If they know for certain that the market will drop on 11/3, they can make a profit by buying puts accordingly.
  2. However, the market makers writing said puts also know the market will drop on 11/3, and can price the puts according to rationality (factoring in the 10% drop). This follows directly from the Law of Surprise, one of my previous posts. This will lower demand for puts accordingly (since there will be no profit to be made off of a certainty here, keeping people from buying puts.
  3. Similarly, if they know that a crash will certainly occur, they can also share their sells and rebuy later, right? Accordingly, if everyone knows that their shares will drop 10%, they will all sell their shares before the event, crashing the market before the event.
  1. Prevent a crash — This can be illustrated simply. If we know about a crash in advance, historically the market rebounds quickly enough during crashes. As a rational market participant, I could wait out until the crash and buy at the lowest point. This works for the individual, but applied over the entire market, this implicitly prevents the crash, because there will be enough buying power (or more) to match the selling power.
  2. Cause the crash to occur at a different time — As I mentioned earlier, if we could all for sure time a crash, you could save yourself by selling before the crash at the last high, and buying later for pure profit (at a discount). This however, isn’t a unique idea — in fact, if you assume the market is rational, every individual in the market would do exactly this. This would cause the crash to occur before the event, as everyone liquidates their holdings (a panic). This would not be predictable.

Beauty Queens

The Hangman’s Noose




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