Anatomy of a Blown Trade: Part 2

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Editor's note: This is the second installment of a three-part article. Please check out Part 1 -- and look out for the final installment later this afternoon!

Now, here is what makes the whole thing so overwhelming in its power. The amount of put-buying amounted to billions of dollars worth of bets, bets that -- because they are done in puts , with a specific fuse -- can't just be forgotten about. If these hedge funds were patient fellows they would hold on, or, alternatively, they would wait for Cisco(CSCO Quote - Cramer on CSCO - Stock Picks) to lift and then short it. But they did neither. They put the trade on and then they gave it a little time. When no new selling developed, they looked at their positions and they said, "Hmmm, now what do we do? If we just wait and nothing happens, we have a wipeout."

The quickest-witted, the first to do the trade, the ones with the two- or three-minute advantage (typically the guys with the cell phones and instructions to put a Code Red in place, as Cramer Berkowitz always had) were instantly up a point or two on the trade, but they wanted bigger game. The others, seeing the stock down three already, were reluctant to sell it because, after all, Chambers didn't announce a shortfall. He just gave guidance that very well might have been "in the stock" down at 33. So they took no action.

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Meanwhile, everyone else who wasn't at the meeting and didn't hear how negative Chambers really was, figured, "What's the big deal? Here's a stock that is down huge, the only one that hadn't yet guided things down, and now is, so what else is new?" Suddenly, by late afternoon, you could feel a change in psychology occurring. It went something like this: "If this is the worst thing that is going to happen to Cisco (that is, it sees a little less visibility), well, maybe this is the time to buy Cisco." Volume increased enormously, but there were just as many buyers as sellers with just enough money to keep the stock from falling.

By the end of the day, those who had trained their big machines on Cisco realized that they had created their own havoc (through the selling of the underlying stock and the indices by the brokers who bought the puts for the hedge funds). The massive selling pressure engendered by their own put-buying had created a buying opportunity and they didn't take it themselves. The longs did.

On the next day, a new day, with new data points, the Cisco story was old news. It wasn't like someone came out the next day and said, "We downgrade Cisco on this new lack of visibility." Nothing was said. The tacit lack of a downgrade, coupled with no serious preannouncements, made portfolio managers move on to the next stock. The hedge funds couldn't do that, though. They had that existing short bet both on the market and on Cisco, the bet with the short fuse that could leave them exposed. Seriously exposed.

To make matters worse, once again word spread on Thursday that the Fed might have to hold an emergency meeting and lower rates again. That put a solid "bid" under the market, as mutual fund buyers, not wanting to miss a big move, committed their capital. That left the hedge funds no choice but to unravel their short bet positions. These bets, so huge, so powerful, so overwhelming, can't be easily unwound. You can't just go into the brokers you put the trade on with and say, "Hey, give me a do-over, the trade didn't work." Instead, you have to go, hat in hand, usually to the folks you put the trade on with, and say, "Hey, I need to get out of this Cisco trade, it didn't work."

When you go flying in to put the Cisco short on, every broker on the derivative desk hears it and calls all of his funds that he covers and says "smart guy buying Cisco puts." That follow-on money comes in and mimics the trade. Next thing you know, 200 to 300 funds, all worth billions of dollars, have the same trade on. Now, when the sellers don't materialize, and the fuse is burning wildly, and one of these short-sellers breaks ranks and sells the puts, it sets off a chain reaction that can easily take the target stock higher than when it started.

That's what happened Thursday morning in Cisco. The short-fused short-sellers, one by one took the trade off. By the end of the day, Cisco was above where it was before Chambers spoke.