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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
bankruptcy"???

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
bankruptcy"???


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

Thanks!!

Henry Tzuo

***

Henry,

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

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

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.

Regards

732

I wish everyone a happy Independence Day holiday

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