Tag Archives | margin call

Trading traps for the unwary

Hi Mark,

I’ve read a few books on options, including one of your books, The Short Book on Options, and I’ve written a few cash-secured puts and covered calls.

Recently, I’ve read of a few cases of new traders blowing up their account due to practical details of the mechanics of trading (described below) and I was wondering if you would recommend any books, education, etc. on these mechanics. For instance, what to do if long puts are automatically assigned upon expiration, or if short legs are assigned in spreads, as well as simpler topics such as bid/ask spreads, order types, conditional orders, orders I should place in advance in case I temporarily go into a coma through expiration, the Pattern Day Trader classification, the same-day substitution rule, Regulation T, etc.

Basically, I’m somewhat shocked that one can even get access to a brokerage account without knowing Regulation T, PDT [Pattern day trader], etc. The stories below scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problem in the first place. It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

Thanks,

Tristan

***

Tristan,

Thank you. These are very important situations, and a thorough discussion can help many traders avoid a nasty situation. And the truth is that these situations arise because we seldom know what we don’t know. We don’t know what questions must be asked, nor are we aware of potential problems. No one warns us.

However, some situations are 100% the fault of the trader. We are responsible for knowing what an option is before trading. We are responsible for understanding risk before we sell naked options. However, we just have no way of knowing when something we do has repercussions that are far from obvious. I don’t blame you for being frightened.

No books necessary

Here is all the education required for the situations described (I am not belittling you, or the poor folks who were hurt – but the truth is that far too many people trade options without following this advice). And I’ve never seen any books on these topics.

1. Know what you are trading. Never take a position if you do not have 100% confidence that you know the rules of trading options.

2. Never trade any options without knowing whether the stock pays a dividend, how much it is, and when it goes ex-dividend.

3. Know the difference between American and European style options.

***

I’m afraid my trade was fairly simple as I used options quite sparingly over the past few years, and have apparently never known the real hidden danger of options. I just bought straight puts.

On March 20th, I was having a pretty good day and thought that I would take a long shot on CME falling. I put in an order for 100 puts strike 230 at .10 and they filled for $1,000. (Right not the obligation.) In the last seconds of the day the shares plunged and ended at 228.62 putting me in the money $1.38/share…but with no time to sell.

I’d never had this happen before. I looked it up and read the statement please have sufficient liquidity or shares in your account. I had neither, so I called the broker to see how I could get the difference. The first lady said they would auto-exercise. I asked if I would need $2.3 M in the account and would I receive the difference (like an index option) [MDW: He is referring to European style options where the option owner gets the intrinsic value in cash – with no shares changing hands] and she responded they would auto exercise after talking with her manager.

I was unsure, so called back. The gentlemen said he thought I did need the $2.3M or the shares, and they wouldn’t extend it on an account with $32K in it (Sensible enough) but was not sure. He suggested I wait until Monday and call the options desk.

On Monday, the stock gapped up pre-market. My account sold at 230 and bought back at 235-236, losing all my money and then some. I guess this is normal. My question is, what are the limits of margin. If $1K got me $2.3MM, would $10K get me $23MM? Is there a limit? From the archives of Pete Stolcers:

***

Tristan, this situation wakes me shudder on so many different levels that I don’t know where to begin.

What makes this an especially horrible story is that two people at the brokerage firm – and one has a managerial position – told the customer that they would auto-exercise the options and that he should wait until Monday.

Anyone with a working brain would have told the customer to do one of to things:

  • Find a broker-dealer who was open for business and try to buy up to 10,000 shares under 230. I recognize that the customer did not have the buying power to cover the cost, but owning puts than can be exercised should make the margin requirement for that long put/long stock close to zero.
  • But an even better solution – in fact, the solution so obvious that these two people should lose their jobs over not telling the client about it – was to simply fill out a ‘DO NOT EXERCISE’ form. Sure, that would appear to be throwing $13,800 into the trash, but if questioned by any investigator – the truth (inability to buy the shares) should justify the non exercise decision. That step would remove 100% of the risk and kill the problem

But telling the customer to wait until Monday? Can you imagine the anxiety of that customer? When Monday morning arrived he would still have the same problem – dealing with more people who could not help.

Those calls did not have to be exercised and the broker should be held accountable. in the real world, the shares had to be bought – no matter the price.

I’ll save Tristan’s other example for another day.

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Options Expiration. Six Things to Know, Before you Play the Game

Over at the Options Zone, this post (slightly edited) was published on April 14, 2010.


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Options expiration.  When you sell options, it's an anticipated event.  When you own options, it's something to dread.

At least that's how most people view it.  There's much more to an options expiration, and if you are a newcomer to the options world, there are things you must know and steps you should take to avoid unpleasant surprises.  However, if you enjoy nightmares, feel free to disregard this entire post.

Many investors come to the options world with little investing background.  they consider the 'options game' to be simple:  You buy a mini-lottery ticket.  Then you win or you don't.  I have to admit – that's pretty simple.  It's also a quick path to losing your entire investment account.

It's important to have a fundamental understanding of how options work before venturing onto the field of play.  But not everyone cares.  It you are someone who prefers to keep his/her money, and perhaps earn more, then those option basics are a must for you.

No one takes a car onto the highway the
very first time they get behind the wheel, but there is something about
options, and investing in general, that makes people believe it's a
simple game.  They become eager to play despite lack of training.

Today's post provides some pointers for handling an options expiration.  Options have a limited lifetime and the expiration date is always known when options are bought and sold.  For our purposes assume that options expire shortly after the close of trading on the 3rd Friday of every month. (Expiration is the following morning, but that's just a technicality as far as we are concerned)

***

Please don't get caught in any of these expiration traps.

1) Avoid a margin call 

New traders, especially those with small accounts, like the idea of buying options.  The problem is that they often don't understand the rules of the game, and 'forget' to sell those options prior to expiration. If a trader owns 5 Apr 40 calls, makes no effort to sell them, and decides to allow the options to expire worthless, that's fine.  No problem.  However, if the investor is not paying attention and the stock closes at $40.02 on expiration Friday, that trader is going to own 500 shares of stock.  The options are automatically exercised (unless you specifically tell your broker not to exercise) whenever the option is in the money by one penny or more, when the market closes on that Friday.

In my opinion, this automatic exercise 'rule' is just another method that brokers use to trap their customers into paying unnecessary commissions and fees.

On Monday morning, along with those shares comes the margin call.  Those small account holders did not know they were going to be buying stock, don't have enough cash to pay for the stock – even with 50% margin – and are forced to sell the stock.  Rack up more costs for the investor and more profits for the broker.  Please don't forget to sell (at least enter an order to sell) any options you own. 


2) Don't exercise

If you own any options, don't even consider
exercising.  You may not have the margin call problem described above, but did you buy options to make a profit if the stock moved higher?  Or did you buy call options so that you could own stock at a later date?  Unless you are adopting a stock and option strategy (such as writing covered calls), when you buy options, it's generally most efficient to avoid stock ownership.  Here's why.

If you really want to own stock, when buying options you must plan in advance, or you will be throwing money into the trash.  For most individual investors – at least inexperienced investors – buying options is not the best way to attain ownership of the shares.

If the stock prices moves higher by enough to offset the premium you paid to own the option, you have a profit.  But, regardless of whether your investment has paid off, it seldom pays for anyone to buy options with the intention of owning shares at a later date.  Sure there are exceptions, but in general: Don't exercise options.  Sell those options when you no longer want to own them.

Example: Here's the fallacy.  The stock is 38, you buy 10 calls struck at 40, paying $0.50 apiece.  Sure enough you are right.  The stock rallies to 42 by the time expiration arrives.  You know a bargain when you see one, and exercise the calls, in effect paying $40.50 per share when the stock is worth $42.  This appears to be a good trade.  You earned $150 per option, or $1,500.

Before you congratulate yourself on making such a good trade, consider this: The truth is that you should have bought stock, paying $38.  If you are of the mindset that owning shares is what you want to do, then buying options is not for you.  And that's even more true when buying OTM options.

If you are an option trader, then trade options.  When expiration arrives (or sooner) sell those calls and take your profit (or loss).  There's nothing to be gained by exercising call options to buy stock.  Why pay cash for an option, then hope the stock rises so that you can pay a higher price for stock?  Just buy stock now.  If you lack the cash, but will have it later, that's the single exception to this rule.

If this exception applies to you and you are investor, not a trader, then buying the Apr 40 calls is still the wrong approach.   Buy in the money calls – perhaps the Apr 35s.  You might pay $3.60 for those calls.  If you do eventually take possession of the shares, the cost becomes $38.60 (the $35 strike price plus the $3.60 premium) and not $40.50.  Buying OTM options is not for the investor.

to be continued…

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