Tag Archives | Reg T

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

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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.

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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:

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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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