Mark to Market Nightmare

Hi Mark:

Good morning and just curious — By the "Flash Crash" on May, 6th,
2010, By what you know personally, is it still possible that a bull put
spread (sell high strike and buy low strike) makes a trader get a "flash

Although at the end of that day, the market was down only
3.6%. How should people choose the strike price difference to avoid a "flash

Is "total position worst case scenario" the only way???


Henry Tzuo



 A very interesting question.
I do not believe you can do anything by choosing different strike

If the problem exists, I don't believe worst case scenario pricing would solve

I suggest calling your broker and asking what they do if very wide bid ask spreads
suddenly mark your account to a deficit – when that deficit cannot
possibly be real. i.e. it results in marking such a 10-point spread at
$15. I plan to make such a call and will share the results if I learn anything.  Option trading would become difficult if brokers hurt their customers in this way.

I'd want to know what protection you, their customer, has from such wide bid/ask spreads.

1) First the margin situation:

For the majority who trade with Reg T margin requirements, there is
never supposed to be a problem because margin requires enough cash to
meet the worst possible outcome. But you are asking about worse than
worse case – and who knows what would happen. This is one of those things that 'cannot occur in the real world' -  but I would want an guarantee of some kind.

2) Next the 'account value' problem.

With gigantic market moves and very wide bid ask spreads, much depends
on the fairness of your broker's method for calculating account value.
For example, to be extra conservative, some brokers always determine the
value of any short option as the 'ask' price. They simultaneously
determine the value of any long option as the 'bid' price.

You can see where that leads. When you sold a spread that can never be
worth more than $10, this method can easily result in a spread valued
(marked) at $15 or $20.

Similarly, owners of such spreads that can never be worth less than zero can see the position marked at a negative $5.

Here's an example of a 'fast market' situation:

INDX Nov 700 put:  35 bid; 55 asked

INDX Nov 710 put:  40 bid; 60 asked

The spread market is -15 bid; 25 asked

Spread owners may have their spread marked at negative $15 and shorts may have it marked at $25.  A disaster for both.

If your broker uses midpoints, the spread is marked at $5, and you would be safe.

I don't know whether such brokers immediately
liquidate an account that suddenly is worth less than zero (in deficit) –
or whether there is some fail-safe mechanism to override their absurd
method of valuing an account.

The above is a nightmare. Every position closed results in another
large loss. The entire account can be liquidated, leaving the customer
owing gobs of money. That is easily the basis of a lawsuit.

I hope such a possibility does not exist.
If your broker is more reasonable, but still strict, it's difficult to
know how your broker handles the situation without asking the broker. My broker
immediately liquidates (the minimum possible amount) when a customer
goes beyond the margin limit.

There is no thinking, no
deciding if the marks are bogus, no verification that the marks are reasonable. 

Pretty dangerous situation for the customer. And I don't
know whether such a broker would tell us the details if asked.
If you have an old-fashioned broker who gives you a day or two to meet a
margin call, then this is not an issue. It may pay to use such a
broker, even though they charge higher commissions.
This is truly a case of discovering what your individual broker does to
handle this potential problem.



I wish everyone a happy Independence Day holiday

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16 Responses to Mark to Market Nightmare

  1. Edgardo 07/05/2010 at 12:42 PM #

    Hi! At the Flash Crash moment, my ThinkorSwim by Ameritrade showed in lots of options bid 0 ask 8000, so my account was in the red some 120 million bucks 🙂
    I see they had some kind of fail-safe mechanism, as my account was not liquidated!

  2. Mark Wolfinger 07/05/2010 at 2:27 PM #

    Thanks for sharing.
    At Interactive Brokers, I noticed markets that were a bit better than yours: 0 to 2000!
    My liquidating balance remained above zero – and I also suffered no forced liquidations. Maybe the industry has a safeguard.

  3. Joe 07/05/2010 at 5:50 PM #

    Also at Optionsexpress my portfolio margin account was significantly in the red on EOD prices with very wide bid/ask spreads. Positions were’nt not liquidated.

  4. Mark Wolfinger 07/05/2010 at 6:06 PM #

    That’s a big deal because portfolio margin users get a lot of leeway and can easily have an account in deficit. I’m glad to hear that these accounts were not obliterated by overzealous computer programmers.

  5. Henry Tzuo 07/07/2010 at 3:50 AM #

    Thanks a lot Mark. I believe that your info will be helpful for many readers. Sorry I didn’t reply immediately. Have a great day.
    Henry Tzuo

  6. Kim 07/09/2010 at 6:40 PM #

    Hello Mark,
    I’m a big fan of your blog and very thankful for the info and help you provide. I have a question regarding open interest and expiration day.
    Lets take a stock trading at around $8 at average daily volume of 700,000 shares. There is an open interest of 17,000 $10 calls and I assume that most of them are owned by the public in anticipation to a takeover deal.
    If the stock is still around $8-9 by expiration, does it mean that market makers will have to buy 1.7M shares to unhedge their positions and this will virtually garantee a big spike in the stock price at expiration Friday?

  7. Mark Wolfinger 07/10/2010 at 8:53 AM #

    Hi Kim,
    No. There are many ways to hedge option positions, and owning 100 sharaes of stock per short call is not a reasonable hedge (think of the downside risk) unless the call option is very deep ITM.
    When the stock price is in the range stated and the call strike price is 10, It is far more reasonable that the market maker owns other options as a hedge, and not stock.
    The MM may own 11 calls, and 9 calls (if one-point strikes exist), turning the trade into a butterfly. That’s just one example – and not a very good one because the butterfly is not a risk-free position. Especially in a takeover candidate.
    If the MM does own stock (and most will), then it is virtually a guarantee that he/she also owns the 10 puts, turning the position into a ‘forward conversion.’
    At expiration, the MM exercises the put, thereby selling the long stock position. This has zero effect on the stock price and its supply/demand – assuming the people who are short the puts are adequately hedged in their own accounts.

  8. Kim 07/10/2010 at 10:15 AM #

    I was actually referring to a real example –
    As you can see, there is 16,000 open interest in $10 calls, 6,000 in $7.5 calls and almost none in puts. How would market makers hedge in situation like this (considering that there could be $11-12 sale announced at any time)? And how would they unload the hedge on expiration Friday if there is no sale by then?

  9. Mark Wolfinger 07/10/2010 at 12:23 PM #

    Clearly I don’t know. I can only surmise.
    But you are assuming the hedge is long stock. It is NOT long stock. No one is his/her right mind owns 100 shares of stock against one OTM call option and considers that to be a good hedge. Yes, covered call writers make this play, but it is a trade from the long side and although it technically counts as a hedge, it is a far from a good hedge – and no MM would do that.
    Part ONE
    First, in a take over candidate, or a firm that may announce significant news, most MM do not take excessive risk. I know that if I were short any of those calls, I would have already bought the back by paying $0.05.
    Any news must be expected after July expiration, but I don’t care. I pay the nickel to cover.
    Next, I anticipate that a significant portion of the short open interest is being held by individuals and probably by people who own shares.
    The latter are probably covered call writers who want to own stock and thus, do not have to unload stock at expiration. In fact they will probably write Aug 10 calls after expiration.
    Part TWO
    That was my response based on your premise. But now that I look at the option prices, it’s clear that this is just a stock. There are no take-over rumors. There is no big announcement pending. There is no need for people who are short those Jul 10s to cover. [I would still cover, but that’s me]. THERE IS NO NEED TO UNLOAD ANY HEDGE
    The price of the Aug 10 calls tells you that there is no rush to buy call options and that there is no rumor of a take-over. Anyone who is afraid of such can buy those calls for a pittance.
    My question is: Why do you think there is a takeover rumor? Perhaps there was at one time, but apparently no one believe that now.
    Under those conditions many traders are perfectly willing to carry a umber of Jul 10 calls as a naked, unhedged short. That’s what I see here. There is no reason for anyone to want to cover those shorts – except for those of us who do cover on a regular basis.
    The MM will allow their shorts to expire worthless – regardless of whether they are long or short those calls. Any hedge they had at one time has probably already been sold, and these calls are being carried naked short.
    Again, today’s MM does not take the risk that some of us used to take (very intelligent of them), but being short some of these is not much of a risk. And as stated, they can be covered at 5 cents if anyone wants to do that.
    There will be no massive unwinding of hedged positions in this stock.

  10. Kim 07/10/2010 at 12:45 PM #

    The takeover rumor is not a rumor. The company officially announced on March 1 that “it Retains Financial Advisors to Explore Strategic Alternatives” –
    They confirmed several times that the process is ongoing. I know that most of July 7.5 and 10 options were purchased by the public during March and April, which means that market makers are on the other side of the transaction. The chances of the deal announced in the very near future are very high.
    Now I understand and accept your point that owning the stock might not be a good hedge, but what is? If they are short those $10 options and $11-12 deal is announced before Friday, they would be totally exposed.

  11. Mark Wolfinger 07/10/2010 at 1:21 PM #

    To reply to the question:
    The best hedge is to pay $0.05 to cover every last call that the trader is short.
    The next best hedge is to buy Aug 10 calls instead of Jul 10 calls. That gives the call owner one whole extra month in which the takeover may occur – if it does not occur before Friday.
    My next favorite hedge is buying some Aug 7.5 calls. I would not want to own as many of those as I am short July 10 calls, but if one believes in the takeover then a 1:1 ratio makes sense.
    There are alternatives, but these are what I would be bidding to own if I were short Jul 10 calls and refused to pay a nickel to get them back. i would never own stock.
    To supply the truth:
    1) The company is exploring alternatives. That means they are begging for a bid. That is not the scenario in which they can expect to get a high price for the stock. If such a bidder were to materialize, my bet is that the ‘takeover’ would really be a ‘take-under’ and the deal price would be a bit below the then-current market price.
    2) The price of the options tells you that there is no takeover. Who do you think would offer to sell Aug 10 calls at 20 cents (note that the last trade was even lower) in the face of a takeover.
    Look at the Aug 7.5 calls. There is less than 50 cents of time premium in that option – and that’s paying the asking price.
    This is not how options are priced when there is the odor of a takeover in the air.
    3) If you truly believe the chances of a deal are very high (and how can anyone know that?) then the takeover price is estimated to be well under $10 per share, and probably very close, if not less than, current price. I don’t ‘know’ that. The option prices are telling me that.
    4) You cannot be the only one who ‘knows’ that the chances for a deal are very high, so combine that knowledge with option prices and that makes me ask:
    Who would be offering to sell calls at these prices?
    Why isn’t everyone buying these options?
    Answer: No one would sell them at these prices. Other answer: Because no one thinks this deal can occur at a price above $8.50. You can by Aug 7.5 calls at an equivalent stock price of $8.45. That is not how options are priced when facing a takeover possibility, let alone a high probability.
    5) The market makers may be short the 10 calls, but they are NOT hedged with stock on a 1 to 1 basis. There is just too much downside risk in that position.
    6) Yes, if the future unfolds per your scenario, they would be exposed. If you were a market maker, would you be offering to sell those calls at 5 cents?
    If you were a market maker and someone else was offering to sell those calls at 5 cents, would you cover any shorts you had in that option?
    If they are exposed, they are staying exposed INTENTIONALLY. They can buy the options at 5 cents. They are offered at that price. Obviously they choose to be exposed, and MM do not take such risk.
    I would cover all of them if I were short. But Kim, the market is telling everyone that there is no takeover pending – at least not in the traditional sense – at a higher price. It’s more likley to be a merger near current prices.
    I’ve argued with the market before. You may be right. The market may be wrong. But the option prices are screaming that this stock is not moving higher anytime soon.
    Thanks for the discussion.

  12. Kim 07/11/2010 at 9:53 AM #

    Thank you very much Mark for the detailed answers, it was very helpful.

  13. Kim 07/15/2010 at 1:36 PM #

    The stock is up 20% in the last hour on record volume (4M shares, average is 700k), and pretty big volume on July $10 options while the stock is below $9. What does it tell you? The sale might be announced today or tomorrow or am I still dreaming?

  14. Mark Wolfinger 07/15/2010 at 1:59 PM #

    It tells me that something’s in the rumor mill, and no you are not dreaming.
    But it does confirm that remaining short a nickel option into expiration – especially with a takeover rumor – is foolish.
    But Kim, the option prices are not sky high. This ‘takeover’ is not going to come at a big price. Right now, the options market is still saying (to me) no more than about $9.50.
    Do you have a position?

  15. Kim 07/15/2010 at 6:31 PM #

    This is the reason for the spike –
    It’s now confirmed that there are takeover talks. It was clear to everyone that there will be a deal, the only question was the price and the timing. It is still unclear, but July $10 options still have some value and had a decent volume today with the stock at $8.50 even after the spike. The final volume of the stock was 6 million in just two hours, the highest in the company history.
    I have some $7.5 and $10 options and few thousand shares as part of company stock plan.

  16. Mark Wolfinger 07/15/2010 at 9:24 PM #

    Splitting up the company may result in a higher price. You must look at the option prices to determine what the ‘world’ thinks the buyout price will be.
    As to July 10 calls, with the news released today, who knows if a deal can be announced by tomorrow? Most takeovers are announced on Monday Morning.
    I wish you good luck on your calls. I hope your job is secure. That’s more important.