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.

927

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11 Responses to Trading traps for the unwary

  1. 5teve 03/17/2011 at 4:52 AM #

    Hi Mark
    It is really sad way to loss money due to lack of knowledge on trading rules. I’ve been thru there. I once put market order on option trading instead of limit. lol
    I have a question regarding ITM options. They should have intrinsic value plus time value. I found a very strange situation, for VIX (current price at 29.4), ITM call options have less intrinsic value compare to underlying. for instance, the price for Mar 11 call, strike at 20, is only 5.4. To my understanding, it should be 9.4 at least. It really confuse me. Thanks

    • Mark D Wolfinger 03/17/2011 at 9:57 AM #

      Hello Steve,

      It is sad, but I don’t know why anyone would exercise $2,300,000 worth of puts with $32,00 in the account. He did the best he could and his broker broke his back with stupidity.

      The dividend play appears to be something everyone must learn for him/herself. I don’t know why that is.

      The ITM VIX options DO NOT have less intrinsic value than the underlying asset.

      This is just another one of those products that was built to destroy individual traders. That may nt have been the intention, but it is the result.

      I pay no attention to VIX options, but I can tell you this much: The underlying asset is NOT the VIX index. It is a futures contract. And it’s often not clear exactly which futures contract underlies the options for any given expiration month. I believe that you must find the value for the VIX Apr futures contract to find the underlying asset for those March VIX options.

      Absurd? Not really.

      Unnecessarily convoluted? Yes indeed. In my opinion, this problem is easily fixed by ALWAYS listing the underlying futures contract next to the option quotes. But they would make for a fair playing field, and I suppose that’s not something anyone wants to offer.

      Here’s my question for you: Why do you assume that the underlying asset is the VIX index? It just seems to be the natural choice. Right? Why would you even consider looking for something else?

      That’s how traders get trapped. Not really your fault – how would know to ask – except for the fact that you know what you see now is not ‘possible’ – and that’s why you are asking now.
      Regards.

      • 5teve 03/17/2011 at 6:57 PM #

        wow, I never knew that. First time hearing about this. Thanks for the explanation. Mark

        • Mark D Wolfinger 03/17/2011 at 8:21 PM #

          Steve,
          It’s okay that you never heard about the fact that the VIX index is NOT the underlying asset for VIX.
          As long as you have never traded these options.

  2. Kamal 03/27/2011 at 11:49 AM #

    Mark,

    One question please….Its something about Tristan’s that I am nor able to understand:

    1. For instance, what to do if long puts are automatically assigned upon expiration…..
    2. I just bought straight puts……

    My understanding (Or the lack of it?) is that if I have bought Puts, I choose to exercise it, right? How can I be assigned these? Or is Tristan saying that when s/he had bought the Put and the underlying went down before expiry, but s/he couldn’t do anything to profit from it?

    Might be a ‘naive’ question Mark, but please, would appreciate your clarification…

    Kamal

    • Mark D Wolfinger 03/27/2011 at 2:05 PM #

      Kamal,

      1) Long puts – THAT ARE IN THE MONEY – are automatically EXERCISED.

      That means that you, the put owner (who made the huge mistake of not selling those in the money put options) are going to be SHORT STOCK on Monday, following expiration.

      2) You are correct: You cannot be assigned when you are long any option. BUT if expiration arrives and the option is in the money and you still own it, it is going to be automatically exercised for you – UNLESS you give your broker ‘DO NOT EXERCISE’ instructions.

      This is true for all options, American or European.

  3. Kamal 03/27/2011 at 12:04 PM #

    Because, as I see it, when I own the Put (that is, I’ve bought it), I can’t do anything till the expiry date, as the optios referred are European. On the date of expiry, either I choose to sell the Put, in case the underlying’s price went ITM (in my favor that is), or if it doesn’t, leave it to expire.

    When I leave it to expire, either my account gets credited (in case it went in my favor) or nothing happens, the Put expires…

    THis is how it happens in case of European stock options traded in India. May be I am missing something here in Tristan’s query and your response…

    Kamal

    • Mark D Wolfinger 03/27/2011 at 2:09 PM #

      Kamal,

      When you own European options you can do something before expiration date. You can SELL them any time. As you know, you may not exercise them, but don’t say you cannot do ‘anything’ when you can sell them.

      Because European options are CASH SETTLED, no shares of stock change hands. You just get the cash or you get nothing.

      Here is what you are missing: Tristan’s discussion was about options on an individual stock. Those are American style options, and upon exercise, shares change hands. Put owners sell stock and call owners buy stock. They are NOT settled in cash.

      There is no reason to be confused. Don’t you also have American style options on the Indian exchange?

      Regards

  4. Kamal 03/28/2011 at 2:32 AM #

    I guess I have got this cleared Mark, thanks.

    Tristan’s was a case of a Long American Put holder, whose underlying went ITM on expiry and he had to ‘SELL’ those underlying shares without any other choice. Irrespective of whether he owned those shares or not, he had to sell them, by rule.

    I was mistaken in thinking, even if I have bought American Put, and leave it to expire, money will be credited to my account automoatically, in the case that Put goes ITM on expiry.

    In India, Index options are European; Individual stocks’, American. Guess its the same everywhere?

    Kamal

    • Mark D Wolfinger 03/28/2011 at 7:55 AM #

      Kamal,

      Hapyp to help and pleased that you understand the differences – before getting into trouble.

      He did not ‘have to’ sell them. That’s why the story is so sad. He could have told his broker ‘DO NOT EXERCISE.’

      As far as I know, it is the same everywhere. European style options are easier to trade and more efficient at expiration. Cash settlement is a wonderful idea – but some traders do want the shares.

      Regards

  5. Kamal 03/28/2011 at 9:24 AM #

    Thanks a lot, Mark !