One of the major mistakes, made throughout this thread and throughout retail options trading, is to assume that the long leg of a put spread always limits potential losses from the short leg. This does not actually hold true in all situations. It is reasonable for a broker to liquidate a put spread, including even a debit put spread, if it involves American style options in a cash or margin account. This is because such put spreads do create a risk of extreme and uncontrolled losses, through often overlooked mechanisms. Suppose, for example, that the put options are like those held by the OP: American style with physical settlement. Suppose, further, that the short leg is exercised prior to expiration, so that the strike price of the short option is debited from the account, and long stock is put into the account. If the account has sufficient margin to hold onto the long stock, then the following day, or on any subsequent day, the long put can be exercised to limit any loss generated by the short put. But now suppose that the account lacks enough margin to hold onto the long stock combined with its protective (long) put. This can happen in a cash account or in a margin account, for example, when values of other positions unexpectedly decline (like in a crash). It can also happen in a margin account, which did have enough margin to cover the put spread, but never had enough to cover the long stock with protective put. The broker can then liquidate the long stock and/or protective long put in a matter of minutes. IB's policies, as announced on its website, do warn and require that such liquidation will occur within minutes. Automatically. The long protective put would not, in a cash account, be of any help in reducing the margin required to hold long stock. It would help in a margin account, because then the long stock and long put can be considered a protective put position, requiring less margin than long stock; but in an IB cash account, protective put positions are ignored, and require exactly the same margin as long stock. Either way, in a cash or in a margin account, a danger exists that there will not be enought margin to cover the long stock received by assignment of the short put, either with or without the protective long put. The account's inability to hold the long stock would make it impossible to exercise the physically settled long put. The only alternative would be to sell the long put. It might, however, be temporarily or permanently impossible to sell the long put for a reasonable price, in the event of a market crash or other dislocation. The customer might not be able to realize the long put's value before the underlying soars and erases the long put's value. If the only way to realize the long put's value is to exercise it, but the customer lacks the margin required to perform the exercise, then the long put can entirely fail to limit the losses caused by the short put. Another such nightmare scenario can occur if the options are American style and cash settled. If the short option is assigned, then its strike price will be debited from the account after the market close. The customer now plans to exercise his long put, in order to limit the loss created by the short put. But he won't be able to do this until the close on the trading day after the day the short put was assigned. This one day delay can be fatal to the customer. The underlying stock or other quantity might soar between the time the short put is assigned, and the time the long put can be exercised. This could destroy the long put's value, so that it does nothing to limit the loss imposed by the short put. One possible way to limit this problem would be for the customer to purchase the underlying stock at the open the day after assignment of the short position. The customer could hold that position all day, sell at the close, and then exercise his long (cash-settled) put. But there are three scenarios in which this won't work. If the customer lacks sufficient margin to purchase the underlying, then this strategy won't work. OR if the customer does have enough margin, but fails to use it because of stupidity, communication breakdown, negligence, or some other problem. OR if the customer does have enough margin, but the underlying gaps to a high opening price which destroys the long put's value, then again, the strategy won't work. Question: Is there another nightmare scenario, which can occur involving physically settled European options? Suppose a put spread expires deep in the money. The long put must be exercised in order to limit the loss created by the inevitable assignment of the short put. This would require a long stock position to be added to the account by the short put's assignment, and then debited away by the long put's exercise on the same night at expiration. BUT can the broker legally do this, if the account lacks sufficient margin to support the long stock position (with or without protective put)? Can a broker do this by providing a quickie margin loan, even if the account is a cash account? If a broker is permitted to do this, can the broker be required to do it? But getting back to the case at hand, the OP was trading SPY puts, which are American style, so that there were scenarios in which the long put leg would fail to limit extreme and uncontrolled losses generated by the short put leg. So there are circumstances in which it might make sense for a broker to liquidate the OP's put spreads. These might involve, for example, violation of IB's Gross Position Value margin rule in a cash or margin account (see IB's website). Or they might involve failure to meet the requirements for holding naked short puts in a cash account, since put spreads are not recognized by IB's liquidation rules for a cash account.
Thanks. To take it to the next level: It's the petal-to-the-metal / no-money-down custs who make cheap commish for everyone else possible. Their losses from autoliquidation lubricate the gears at the brokerages that use that procedure. In that sense, those custs are a public good, to use the economics term.
Not true. I can't say what the implications of trading a retail cash accout are, since I've always traded as a market maker. However, barring the retail cash account issues, if you are long an SPY put spread, the only risk you would have from exercise of an ITM p would be carry risk. Carrying cost over one day at the long stock rate is such a minimal risk, as to be almost completely negligible. (.75% times your $$ stock total divided by 365). A call spread could potentially be a different story if the stock goes super hard to borrow, or if there is a large dividend.
Can you please explain specifically, what is not true about my explanation? And if you don't know anything about the limitations of trading put spreads in a retail cash account, how can you say those limitations don't create grave risks? And how can you possibly assert that the risk created by assignment of a put spread's short leg are limited to such an absurdly small number (0.75%/365), after I have shown that those risks can be extreme and unlimited for cash settled American style options? or can be extreme and unlimited for physically settled American style options where the customer lacks sufficient margin to hold stock long or short so as to exercise the long put? Can you please give some specific support for your assertions, and explain exactly where and why my explanation is not correct? Are you arguing that because market crashes and dislocations are rare, the danger that one might occur can be reasonably ignored, even though it might cause extreme and unlimited losses on put spreads in these situations? Or are you arguing that even in the worst case, the losses would be limited to 0.75%/365, and if so, can you support this assertion?
he said carrying costs were the .../365 price ,not the odds of being assigned, i can agree, u would still be hedged put against stock,isnt that roughly the same as put vertical
No, not in all situations. I just made a lenghty post explaining some of the situations in which your assertion would not be true. Please read it and tell me why my detailed explanation is wrong.
the only part i had trouble with was the firm worrying about your margin on stock,they are only at risk if you leg out of the option 1st and the computer they set up probably wouldnt let you
Sure thing. And if you don't know anything about the limitations of trading put spreads in a retail cash account, how can you say those limitations don't create grave risks? [/QUOTE] Well, for starters, I did say "barring retail account issues." Even there though, a long stock/long 100 delta put position is equivalent to a long put spread. In fact, if you are assigned your short lower strike put, you have succeeded in locking in your maximum gain, which is the best case scenario. if the broker needs to liquidate, it wouldn't make sense to liquidate one side, without liquidating an equal portion of the other side. I am not saying it doesn't happen (just like something similarly redicilous seems to have happened to the OP). I am saying that you would have a reason to be pissed and switch brokers if they did that. Furthermore, I would go to arbitration or sue if that happened in my account. i have read through hundreds of arbitration and have never seen this situation. If this happens to you, I will defend you in the arbitration process myself. The biggest concern to a retail trader should be over losing money in a different position that forced liquidation of your low risk put spread at a horrible price, given a wide market, such as some in this thread have experienced. Even in that example, the risk came from some other position besides the long put spread. And how can you possibly assert that the risk created by assignment of a put spread's short leg are limited to such an absurdly small number (0.75%/365), after I have shown that those risks can be extreme and unlimited for cash settled American style options?[/QUOTE] We weren't discussing cash settled options. We were discussing SPY options. Are you arguing that because market crashes and dislocations are rare, the danger that one might occur can be reasonably ignored, even though it might cause extreme and unlimited losses on put spreads in these situations?[/QUOTE] First of all, what is a market "dislocation". Frankly, it doesn't matter. The risk of a long put spread is the price you paid for it, even if there is a "market dislocation." Or are you arguing that even in the worst case, the losses would be limited to 0.75%/365, and if so, can you support this assertion? [/QUOTE] The .75% is the current wide long stock rate that most small time traders pay. Paying this rate for one day of stock carry is your loss if you are assigned your shorts, and you exercise your longs the next day to flatten out your stock position.