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Behind the massive trade that spooked the market

After a positive start to Wednesday's session, the stock market took a serious intraday slide that saw it lose more than half a percent in half an hour, and took the S&P from positive to negative on the day.

While an especially strong five-year Treasury note auction is another likely culprit in the intraday decline, many traders blamed the turnaround on a massive bearish options trade on the S&P 500 that was effectively a multibillion-dollar short bet on the market.

Traders at an options pit at the CBOE Chicago Board Options Exchange
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Traders at an options pit at the CBOE Chicago Board Options Exchange

Read MoreTreasurys extend earlier gains after strong 5-year auction

Starting at 11:57 a.m. ET, a major player started buying May 1,995-strike put options on the S&P 500 for $133 per contract. The trade was not executed in a single block, but over many smaller trades between 11:57 and 1:12 p.m. (and the prices of the contract varied, getting as low as $131.70). On the whole, 15,450 contracts were purchased. And since each contract controls 100 shares, this trade cost about $200 million.

Since a put gives its buyer the right, but not the obligation, to sell the underlying security at that given strike price, this implies a bearish bet on the market that will make money if the S&P 500 is below 1,862 (1,995 minus $133) at May expiration.

However, since this trade was deeply "in the money," the trader does not appear to be making a speculative options bet, but rather to be expressing a significant bearish view on the market as a whole. Indeed, this trade is effectively a $2.8 billion short bet on the S&P.

"It puts pressure on the market in the short term," said Brian Stutland of the Stutland Volatility Group. "I don't know if it necessarily means that the market's going down, but that's definitely weighing on the market today."

Still up for debate, however, is the mechanics by which the trade is hurting the market.

One theory is that it is weighing the S&P down directly.

The fact that the trade occurred in several blocks, many of which were separated by just a few seconds, would seem to imply that the firm executing the trade was waiting for sellers of the options contracts to find S&P e-mini futures to short.

Since the market makers who stepped in to sell the options contract don't necessarily want to make the bullish bet on the market that being on the other side of the trade would imply, they likely hedged their exposure to the options by shorting the S&P e-mini.

Eventually, these market makers could have run out of willing buyers of the S&P e-mini futures, taking down the market.

"They tried to dribble this trade into the market. So what might have happened is for a good half an hour, market makers offered the e-minis out," Stutland said. "That had this short bid sitting there on the e-minis."

Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

The second theory is that investors simply saw the size of this trade and got worried—due to a major misunderstanding of the trade's intricacies.

As traders started to notice the options trade, word got around that the buyer of the puts also bought the S&P futures at the same time. That would make this a very different sort of trade, which a firm would put on not to express a bearish thesis, but more likely to square an options trading book that was heavily short options.

If a firm is short more options than it is long, that leads it to collect less premium than it could otherwise, due to the cut of premium that clearing firms take.

"From what I'm being told, this trade was neutral, so there is not going to be an impact from the standpoint of a large amount of futures for sale," said David Seaburg, head of equity sales trading at Cowen & Co.

Still, in that scenario, traders who weren't aware of the real reason why the trade was occurring could have gotten scared off anyway.

"It definitely spooked the tape," Seaburg said. "But I think it was the trader's thesis, and what this trade implies, versus any actual pressure. So it speaks to what people's mindsets were at the time."

In other words, when a firm effectively shorts $2.8 billion worth of the S&P 500, people take notice and rush out of the way—no matter why that firm is actually doing it.

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