Can you believe this?

What some brokers do

I recently read a trader’s lament in an online form. It turns out that his broker forbids him from buying options on an unspecified day during of expiration week. Why? Because if he still owns the calls at the close of trading on Friday, he would not have enough cash in his account to meet his margin requirements if the options were exercised.

I’ve heard that at least one other broker enforces the same rule, but at least they allow their customers to buy options from Monday through Thursday of expiration week.

This practice is nothing short of stupidity in action. There is no rational reason why customers should be prohibited from trading.

This firm willingly granted him clearance at the appropriate permission level to buy and sell calls and puts. It now seems that the permission is strictly limited and only available to certain customers on certain dates. If their customers do not have enough cash to exercise the options, this firm does not trust the customer to exit the trade in a timely manner.

It now seems that ‘permission to buy options’ now depends on how much time remains before the options expire and how much borrowing power is available to the customer.

Isn’t this why many investors trade options? They don’t have the cash required to trade the shares, so they own options instead. It’s called leverage and reduced risk. This firm does not allow a customer who had $50,000 in his account to buy a 10-lot of calls for a quick trade. That’s all this customer wanted to do: Hold the position for a very short time. However, because buying 1,000 shares would cost more than this customer can borrow on margin, the call purchase was forbidden.

It is beyond belief that any customer would accept this. To his credit, this trader accepted the denial of trade and the lament was his way of asking whether anyone else had seen that happen.

As a disinterested reader of the forum post, I was horrified. I recognize that the brokerage firm must protect itself against customer losses that cannot be recovered, but this specific ruling startled me.

Weeklys

Weeklys options have become a star attraction, as many traders love the idea of playing with short-term options. I don’t know if this firm blocks everyone who lacks sufficient buying power from trading Weeklys, or whether this individual was singled out for a specific reason. It would not be a wise business decision to forbid a significant portion of your customers from trading in Weeklys.

Protecting the broker

The brokerage firm has other methods to protect itself from the possibility that this, or any, trader would incur a margin call that he cannot meet. For example:

  • If trader the calls one hour prior to the market close on Friday, liquidated the position
  • Trader must submit ‘Do Not Exercise’ form no later than (pick a time) on Friday, or else options are sold
  • If trader fails to sell calls, firm locates broker-dealer and sells short 100 shares per call.
    • If the fill is not at a good price, I’m certain that the firm could not care less

To me, these are three viable alternatives to prevent the firm from incurring risk. At this point it seems fair to ask, just what is that risk? How bad can it be for the firm would to take such drastic measures to protect itself?

For the firm to suffer a substantial loss, these items must occur:

  • The trader must forget to to close the ITM option position
  • The stock must undergo a large price gap (in the wrong direction) on Monday morning
  • The gap must be large enough to place the customer account into deficit
  • The customer must be unable to re-pay that debt
  • The customer must have so little remaining assets that the firm cannot recover via lawsuit

I don’t believe there is a person on this planet who deems this to be an event with any reasonable chance of occurring. I agree that the firm wants to avoid even this much risk, but it has better ways to accomplish that task than by preventing a customer from making a trade.

Brokers have dissed their customers for decades. I never thought it would reach this level.

905

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4 Responses to Can you believe this?

  1. Tim 02/18/2011 at 7:01 AM #

    So who was the broker?

    • Mark D Wolfinger 02/18/2011 at 8:10 AM #

      I don’t want to say. At least not at this point. I had a story to share but am not looking to make enemies.

  2. Sam 02/18/2011 at 11:33 AM #

    Hi Mark,

    Just wondering what you thoughts are on a index buy-write
    (ATM, 2% or 5% OTM?) strategy that uses either options or
    short selling to hedge the residual beta i.e. shorting a
    high correlating index? The idea being to be market neutral
    and just collect the premiums. Would this work?

    Many thanks, Sam

    • Mark D Wolfinger 02/18/2011 at 11:49 AM #

      If you are familiar with the CBOE Buy-Write Index, BXM (Covered calls on the S&P 50o0 index), then you should know that they have an equivalent index on writing 2% OTM calls instead of ATM calls. It has performed better over the years. Obviously that’s because the market has trended higher.

      You cannot ‘just collect the premiums’ because a bear market will hurt. However, writing calls that are 2% OTM is viable. To me 5% is just too bullish – but there is nothing wrong with that idea – in principle.

      What I may not understand is your question about shorting. A buy write just shorts the calls. If you want to be market neutral, rather than long, one way to do that is to overwrite – i.e., take the risk of selling extra calls to reach delta neutrality. Many brokers won’t allow that play (naked short calls, but you can get around that by selling call spreads instead. But please – do not sell too many calls. I don’t understand why this market does nothing but move higher, but it’s foolish to fight reality – and selling extra calls is a bit risky.

      Instead of shorting a high-correlation index, why not just short the index you are trading? Correlation guaranteed to be 100%. You do that by owning fewer shares – or by selling more calls.

      This strategy works best when the market does not make a major move in either direction.

      Regards