Trading Traps for the Unwary II

Continuing yesterday’s horror stories, Tristan submitted another:

Something doesn’t seem right about this. I was short the 115-116 call spread in SPY 55 times during March expiration. I was assigned on the 115 call (the short part of my spread) on Thursday after the close (found out Friday morning). This resulted in being short 5,500 shares on Friday morning versus my long 55 116 calls. On Saturday, I was debited from my account a significant charge because I was short the shares when SPY went ex-dividend on that Friday.

Am I responsible for the entire dividend payment for that quarter because I was short the stock on that one day of ex? Seems like stealing. I feel like if I had bought the stock that day, there is no way I would have gotten credit for an entire quarter of a dividend payment. Anyone know how this works?

***

“Anyone know how this works?” This is the stuff that drives me nuts. If you don’t know how it works, why are you trading a product where it is essential that you understand how it works?

Dividends are paid on specified dates. Whoever is short on that ex-dividend date pays the dividend. Whoever owns the shares collects. Very simple, very efficient and it has always been this way. It’s also fair and reasonable – for owners of the shares. When the stock (or ETF) pays a dividend, the stock price declines by that amount. Gain the dividend, lose in the share price. No one gains or loses.

Alas, it’s not so simple for option owners. When you own an ITM call option that should be exercised to collect the dividend – WARNING: NOT ALL ITM OPTIONS SHOULD BE EXERCISED FOR THE DIVIDEND – failure to exercise results in a real monetary loss. The trader who submitted the question above did not know about the dividend, did not know he should have exercised his calls, and donated his money to some lucky trader who had been short those SPY 116 calls.

To reply to the comment: You are correct. If you bought shares that day (Friday) you would NOT get any of the dividend. You would be too late by one day.

I do agree with the lamenter’s opening thought. There is something not ‘right’ about this situation. What’s wrong is that you should not yet be trading options because your education is far too incomplete.

More Questions from Tristan

For instance, what to do if long puts are automatically assigned upon expiration

If you know in advance that you cannot meet the margin requirement, then do not allow yourself to be assigned at expiration. BUY THEM BACK before expiration. There is no solution that’s any easier. If you are not short the options, then you cannot be assigned an exercise notice.

or if short legs are assigned in spreads

There is almost never any reason to be assigned earlier than expiration (other than exercising a call option to collect the dividend). However, this is a recurring problem for SPY options. It ALWAYS goes ex-dividend on the third Friday of the month. Not knowing that – in advance – is just a huge mistake. If you fear being assigned on any position, then the answer is very simple (Honest. This is a deadly serious situation) Answer: Get out of the trade. Do not hold to expiration. Ask yourself why would you decide to hold to the bitter end? It is so unnecessary. For goodness sake, get out when you may be assigned and especially when you cannot meet the margin call.

If you are assigned on one leg of a spread, and if margin is not a problem, keep the position. Someone handed you a gift, and if the stock makes a big move (down if you were assigned on a call option or up if you were assigned on a put option) then you will score a nice big payday. It’s unlikely, but it has happened before and will happen again.

However, if you are unable to hold the trade and must liquidate, do not decide to exercise your long option to get out of the position – unless this option has zero time premium. It is more efficient to buy back the short stock and sell your long calls [Or sell your long stock and sell your long puts].

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.

There is a lot of stuff on your list. The truth is that most people have no need to understand most items on the list. That raises the question that concerns you: Why are people allowed to trade when they don’t understand the rules? And how do you know what it that you must know when there is no one to provide a list.

The answer to the first question is easy. They are allowed to trade because it is profitable for the brokers. Nothing else matters.

There’s not much that the average trader can do about the items on your list. If he/she becomes a pattern day trader (not a common situation), that’s when he/she will learn about those trading limitations.

Most beginners have no need for conditional orders and have plenty of time to learn how to use them.

However, bid/ask spreads and limit orders are essential items. I assume that anyone who teaches options classes or writes books for beginners includes that information. Traders who jump right in with no education may have some painful experiences when entering market orders. Not everyone can be protected. Would you open an account and enter orders with no advance study or preparation? Of course not and there is no protection for those who do.

You have one advantage. You are aware that dangers exist, and although you may not ask every question, you will be frightened enough to ask questions about any situation that occurs to you. That may not be enough – but you would have to be very unlucky to not have discovered what you need to know when you aware that you don’t know what it is that you don’t know.

Some answers

Don’t pay the offer; don’t sell the bid.

Never never never use a market order. Limit orders only.

There is no need for fancy order types. Limit orders and stops (I don’t like stops for option traders) should be sufficient.

Buy back shorts when they get very cheap – just in case you do temporarily go into a coma through expiration.

The Pattern Day Trader classification is not a concern, unless you day trade. And if you do, you will soon learn the limits.

You can get much of this information from your broker. But get it in writing. The people in customer service may be as bad as your correspondent found them to be (yesterday)

The CBOE stories scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problems in the first place. It is not asking too much to know when a stock/ETF you are trading goes ex-dividend.

It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

I understand how you feel. The bottom line is that people are trading – and they intentionally did not bother to learn the rules. They make bad assumptions and get stuck with the bill. When you sell a call option, you must know that the owner is allowed to exercise at any time prior to expiration. It seems to be a natural question to ask – why would anyone exercise early? That’s when the trader would learn bout dividends.

You may be frightened, but it seems to me that you are taking care to learn about lurking dangers.

928

No one is forced to trade. Information is available to everyone.

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14 Responses to Trading Traps for the Unwary II

  1. davmp 03/17/2011 at 8:32 AM #

    Having just decided to try a new broker because I want API access, I can attest to the fact that a good amount of information (Pattern Day Trading, risks of options including dividend risk, Reg T, the OCC’s background on options, etc.) are covered in disclosures you have to agree to when opening an account in the US. I do not understand why people don’t read this stuff they’re agreeing to before trading at least!

    FWIW, disclosures for Swiss options trading are much more basic and informative. Though I guess for a complete newbie they’d be overly confusing. But all the more reason to educate yourself before trading.

    • Mark D Wolfinger 03/17/2011 at 10:01 AM #

      davmp,

      We have been trained that so much stuff comes with details that are difficult to read, intentionally difficult to understand, and that we can get by very nciely without reading. That includes information from banks and credit card companies. Thus, when it comes to trading, we (as a group) decide it’s not necessary to read the fine print. Sure it’s a stupid decision, but we have gotten away with ignoring the fine print all out lives and thus, it’s a (bad) habit.

      Agree with your bottom line. The problem is convincing the new trader that such suggestions apply to him. Arrogance/ego get in the way. At least, that’s my guess.

      Thanks for sharing

  2. Jim 03/17/2011 at 8:37 AM #

    Groan!

    We have all made rookie mistakes but these are whoopers!! Hopefully he won’t venture into the forex market where the leverage is much greater.

    • Mark D Wolfinger 03/17/2011 at 10:03 AM #

      Jim,

      The problem was not leverage per se, because he used far more leverage that he was allowed to use. Had those put options not been exercised, there would have never been a leverage issue. I still believe this is one situation where the actions of the broker are indefensible and even biased arbitrators would recognize that fact.

      Thanks

  3. SpeakingGreek 03/17/2011 at 10:27 AM #

    Dear Mark,
    You said: “The bottom line is that people are trading – and they intentionally did not bother to learn the rules.”
    I 100% agree with you. The problem is not lack of information. You can easily find very advanced options knowledge on internet. Rookies (me included) cant afford to study all information before trading options. Also, they cant prioritize their learning curriculum optimally. I have to trade while learning (cant learn pure theory), so I consider my mistakes as cost of education! However I dont trade large lots while learning.
    Defining a syllabus for my learning and limiting my trades to my knowledge level was very helpful. In other words, dont trade advanced strategies or complicated assets (SPY vs. single company stock) right after learning “options 101”. Some paid courses teach Iron Condors to people who never traded plain vanilla options before. That is too risky!
    Your books are great in this regard (organized syllabus).

    Best wishes from Texas

    • Mark D Wolfinger 03/17/2011 at 11:19 AM #

      Hi Tex,

      Trading small size when learning is such an obvious thing to do. However, I’m assuming that the two horror stories involved people who believed they were more knowledgeable than they were. It’s really difficult to know what it is that we don’t know. That makes it impossible to know just when we are ready to advance to something a ‘bit more’ complex.

      In my opinion, the exchanges and brokers don’t go out of their way to prevent horror stories from happening. Yes, they provide the information, yet they know most won’t read it. One simple example of something they can do: Whenever anyone enters an order to trade VIX options, the following warning can flash: “Are you certain you know what the underlying asset is for this trade? It is not the VIX index.”

      How difficult is that?

      Regards,

      Thanks for the kind words.

  4. SpeakingGreek 03/17/2011 at 12:58 PM #

    I was imagining to leverage your great audience (is it the largest among Options Blogs?) to come up with some sort of Syllabus, using POLLs.

    Examples (simplified):
    – Sort these options strategies based on level of difficulty for you to understand: Buy Put, Sell Call,…..Diagonal Spread…..

    – Which Options Strategy/ies were you most successful with so far? Buy Put, Sell Call,…..Diagonal Spread…..

    – Sort these asset classes as good candidates for options trading (Simplicity, Less Risk): Dividend paying Stocks, Tech Stocks, ETF’s, SPY, DJIA, UUP….

    – Sort these options strategies in the order you recommend others to learn: Buy Put, Sell Call,…..Diagonal Spread…..

    – Which of these was your first Rookie error: Selling instead of buying (or vice versa), Volatility crush, waiting to get that last dime…..

    By the way, I was trying to search for only all Polls on your website and couldn’t come up with a good phrase/Keywords to find them. It will be a concise set of information for all readers, if available.

    Another suggestion: ask readers to come up with POLL ideas. If you collect these polls under a category, after a while they will become a great source of compact information online for options traders. It is like an investment that will grow and add to your readership.

    There is too much information in the world. The problem is how to filter the good info, summarize them and prioritize learning them.

    Thank you for the wonderful blog (I am a follower for 3 years now).

    • Mark D Wolfinger 03/17/2011 at 2:26 PM #

      SG,

      I have so much to say that I could go on forever. Look for reply in a blog post – probably tomorrow morning. Maybe Friday.

      Regards

  5. Robert 03/17/2011 at 1:34 PM #

    Mark,
    I have a question regarding paper trading. I want to sell an iron condor (RUT expiring May 11), I see huge spread between ask (@8.40) and bid (@1.40).
    If it is a ‘real’ account I could imagine that someone would buy it from me at the price that for him is acceptable, it might be something between ask and bid. In case of paper trading there is no one (or I might be wrong?) on the other side. What is a price I can sell my IC? If it has to be market (@1.40) what is a value of paper trading if I cannot get real live prices? In case of very liquid stocks there are plenty of bids, here seems nothing? Maybe I should use an ETF instead of index?

    Could you please advise how to use it.

    Thanks,
    Robert

    • Mark D Wolfinger 03/17/2011 at 2:38 PM #

      Robert,

      After being a huge supporter for paper trading (I still am), I was looking at the offerings of a variety of stockbrokers. I was amazed to discover that all but one is programmed not to give a fill unless the trader sells at, or very near the bid. For example, just this week I tried a paper trade for an IC that was $1.10 bid to $4.20 offered. I could not get a fill when asking $1.15!

      The only broker (at least in my current search) who offers something near realistic is thinkorswim. The problem with them is that they give fills that are too good. They are unrealistic fills and there is zero chance the trader could get that much when entering a real order. Nevertheless, their fills are nearer to reality than any other paper trading software that I found.

      Any reader who can suggest another place to paper trade, please let me know.

      The value of paper trading when you cannot get real prices is to manage the position. Make the trade, Adjust the prices – in your records – to something realistic and then manage the position. Don’t be concerned with seeing a real profit or loss using the broker’s numbers because you know the prices are ridiculous. However, the greeks are real and risk is real. Treat the trade with respect, adjust or exit when necessary and once again, manufacture your own prices. The experience you need is not the price for entry. It’s in managing position risk.

      When you don’t know what to choose as a price, I suggest using the midpoint and then taking a fill about 20 to 25 cents worse – when the bid/ask spread is as large as the one in your example. As a seller, I’d choose $4.65 to $4.70.

      Alternative: Instead of looking at the quotes for the IC, look at the bid/ask market for the call spread and put spread separately. That may make it easier to guesstimate a fill price.

      Of course, your idea to use SPY or other ETF with tighter markets makes sense. It gives you the opportunity to practice, and the prices for your trades will be much nearer reality.

      good question

  6. Tristan Grayson 03/17/2011 at 6:14 PM #

    Mark, thanks for answering my questions about these horror stories that I read about. To close the loop:

    I have been informed that some brokers, like thinkorswim, allow timed orders, so one can setup an order to close a position on the day of expiration (or earlier), just in case one forgets or goes into a coma.

    I asked the OCC when is the earliest that one may submit a Do Not Exercise form and they said it would be the Friday prior to expiration. They suggested asking the broker to accept my instructions earlier (and then the broker would submit the form to the OCC on the Friday).

    I looked up the SPY prospectus and it says that it goes ex-dividend the third Friday in March, June, September, and December.

    Thanks again.

    • Mark D Wolfinger 03/17/2011 at 8:26 PM #

      Tristan,

      I was unaware of the TOS solution. It is a decent idea.
      I know some brokers forbid opening orders on expiration day when the account cannot exercsie them.

      I believe there is a misinterpretation in the OCC communication. Remember that Saturday is expiration day, so when they tell you the ‘Friday prior’ they are probably stating that expiration Friday is the earliest, and not one week earlier. You will have to ask again to get that clarified. As far as convincing the broker to do it earlier – good luck with that.

      OK. I thought SPY went ex-dividend every month. But I don’t worry about it because I don’t trade those options.

      Thanks for sharing.

      • Tristan Grayson 03/21/2011 at 3:09 PM #

        I asked the OCC to clarify “the Friday prior to expiration” and they said they meant the day just before the Saturday expiration (not one week earlier). Thanks.

        • Mark D Wolfinger 03/21/2011 at 3:33 PM #

          That’s the reasonable explanation
          I’m pleased to learn they accept those all day (not specified, but implied in their response). It allows a trader to avoid this problem.

          Thanks for verifying.