PUT options liquidated at worst possible prices

Ghost of Cutten · May 15, 2010

Quote from jimrockford:

Let me first explain it with cash-settled options, and then with physically settled options.

If you are trading a spread on American style, cash-settled options, then you face the following risk of extreme uncontrolled loss:

A strong market move puts the spread deep in the money at the close of trading. The short option leg is exercised, generating a huge loss. You take comfort in your long option leg, which will limit that loss, with profit left over to spare. It is, however, too late to exercise your long option leg on the same day, because you didn't receive notice of assignment on the short leg until after it was already too late for you to issue early exercise instructions (note this will always be the case). So you resolve to exercise the long option leg as soon as possible, which would be the following trading day. So you are perfectly safe, right? Wrong.

You wake up and learn that the market has gapped open violently in the opposite direction from yesterday's big move. It keeps going and never looks back. Your long option leg becomes worthless by the close. You issue exercise instructions, but you get no cash because your long option leg is now worthless. You are now stuck with the entire loss generated by the short leg.

But there is another thing that can go wrong. Suppose the loss generated by the short leg so severely reduces your account equity, that you are in violation of margin rules. The long option leg counterbalanced this loss by becoming extremely valuable, but because it is an option, its value DOES NOT count toward measuring your account equity or satisfying your margin obligations. The broker now has the right to liquidate your long option leg by selling it before you have a chance to exercise it. The broker wishes to do this in order to generate some cash, which would count toward your account equity and reduce your margin obligations. What if there is no reasonable bid at the time of sale? What if the bid is near zero? This scenario also sticks you with most or all of the loss generated by the short leg.

Here is another nightmare scenario, which applies to physically settled, American style options. You have incurred a massive loss on the short option leg, and you have been stuck with a long or short equity position by assignment of your short option leg, and you resolve to exercise your long option leg in 24 hours, so as to reverse your massive loss. But - oh no! This massive loss triggers a margin violation! Your long option leg is extremely valuable, but because it is an option, its value does not count toward measuring your account equity or satisfying your margin obligations. So, the broker has the right to liquidate your account, and your long option leg is sold at an unreasonably low price before you get a chance to exercise it, and once again, you are stuck with most or all of the loss generated by the short option leg.

A variation on that nightmare scenario might occur where your long option leg is not liquidated, but the long or short equity position resulting from your short leg's assignment is liquidated instead, because you don't have enough margin to carry that equity position. You are confident you will be OK, though, because you plan to exercise your long option leg in 24 hours. But oh no! By the time you get the proceeds from exercising your long option leg, they have dwindled to near zero, because the market moved hard and fast against your long option leg! And once again, you are stuck with most or all of the massive loss generated by the short option leg!

Here is another variation on that nightmare scenario, which can occur when you are using options in order to get a great deal of leverage, to benefit from price movements on notional underlying quantities so large you could never afford to swing them around as underlyings. Your long or short equity position is liquidated, but your long option leg is left intact, and the market does NOT move against your long leg before you can exercise it. This successful exercise results in a new long or short equity position. You resolve to play it safe by closing that equity position at tomorrow morning's open. But oh no! The market gaps hard and far against you, and because you were excessively leveraged, the gap wipes out your entire account!
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Ok, interesting post. It seems a bit like pin risk at expiration, except that a major market crash or reverse-crash artificially brings forward the "expiration" in an unpredictable manner.

Are there good ways to mitigate these risks, or are some unavoidable?

jayelliii · May 15, 2010

Said but that's the power of the brokerage houses: if your history of buying power does not sustain the underwitten trade, they can cash it out without any previous notice.

First they might try to call you and ask for a flash deposit into your account; assumed you have kept that account at safe levels but, if your history with them does not support that, they simply wipe you clean.

Bare in mind that your post mentions "should at least be worth" which means you did not really know the exact value of them at the time and, when you put that much volatility into effect, your long put sky rocketed and your short put skyrocketed AGAINST YOU.

If those where naked options without the underlying stocks, you, like someone else suggested, should just put this as the cost of learning.

If your account was well maintained cash wise and you have all the records, google for "stock market lawyer" and you might find someone that will help you.

I had a case in 1999 against TD Waterhouse where they wiped me out on a SICAMOR's trade where they executed a pending order to buy 200 shares at $64 and they executed it at $269 bringing my account to zero - $50K instantly. I was able to recoop pnly 1/2 of the original money because my lawyer was bought out by TDW ... I am sure. Oh, by the way: I borrowed money around and made the trade valid but, since I deposited a check instead of cash, they claimed that my account was bad for over 5 days (back them it was 5 days rule).

Within a week or so, SICAMORE shooted to $600 (peek of Nasdaq). I should have been able to retire on that law suite; that's why I believe my lawyer was bought out.

Good luck!

sprstpd · May 15, 2010

Quote from Ghost of Cutten:

You are missing the point. Trading at a rational broker does not expose you to the risk of an instant portfolio-wide margin liquidation just because someone high-ticked 1 share of one of your short positions at 100 times the last traded price. It never has done and it doesn't now - except possibly at IB.
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There is no proof that IB would fail to ignore such a ludicrous print in terms of its auto-liquidation bot.

zdreg · May 15, 2010

Quote from RichardRimes:

Impossible Stefan..I said earlier this guy is the biggest IB apologist on the boards. EVEN IB SAID THAT AUTO LIQUIDATION DID NOT FUNCTION "OPTIMALLY" ...they needed to "tweak" the system.... so give it up...you ARE talking to a wall. No one who trades options gives a flying F what the guy thinks.
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I would not read too much into IB's statement . they are perfectionists by nature

stock777 · May 15, 2010

What if you're short an illiquid stock that goes apeshit or manipulated to 10X its normal price. There's no borrows on the street so no one can sell it (only natural longs)

Same thing happens, you get bought in at a crazy price (if your margin gets wiped out in the move) and there's nothing you can do about it.

hippie · May 18, 2010

Quote from Ghost of Cutten:

Yeah I generally agree with the options you have presented. IB mean well but their whole corporate dogma goes against reform in this situation. The fact is, we've found a situation which no computer can handle and only a human can make the right call. That is the achilles heel for an all-electronic broker.

The choices are i) expose yourself to grey swans ii) don't use margin or shorts with IB iii) don't use IB until they recognise this problem and fix it.
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A computer program could easily had checked for a long put protection against the short put. If IB robot can't do that, it is super dumb!

ewoewo · Jun 17, 2010

Hi!

I had my margin call when going throug IB application form and reading "must have 1000 trades". I called there and asked why it is necessary to have 1000 trades done and they told me "because we do not explain everything now anymore!" - so I stayed with my traderwoman, because I immidiately understood from the subtone of the kind voice that it is better to NOT know everything.

Take the Communication Advice from the Pro!

Erwin

dj1102 · Jul 6, 2010

I had a number of SPY option positions auto-liquidated by IB at very poor executions (in some cases significantly below intrinsic value). I have complained to IB and sent a PM to IBj who told me that he would look into my situation but never followed up with me (see below). I have received responses from IB denying my request and accepting no responsibility. I was wondering how others in a similar position have dealt with the issue; I'm currently evaluating other avenues to continue pursuing this issue including arbitration. I have spoken with attorneys interested in pursuing my case. Feel free to post here or PM me. Any suggestions or ideas would be greatly appreciated.

Thanks.

Author Message
IBj
Interactive Brokers

Registered: Aug 2003
Posts: 229
Re: IB Complaint
Probably me. Do you have a ticket number or account number?

I should set proper expectations: market conditions were such that poor quality executions were inevitable and the valuations of may asset classes had statistical measurement error rates that were vastly larger than normal periods. We are adjusting our definitions of execution quality to these circumstances that were completely outside of our control

To put it more simply, I will look at your complaint but please understand if we do not change our position.
Thanks

Jon

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dj1102 wrote on 05-25-10 06:33 PM:
Hi IBj,

I filed a complaint with IB on the liquidation of my SPY put options and the poor execution. I heard back via a written response and was disappointed by the response. Is there someone you can put me in touch with at IB that could help me?

Thanks,
Deepak

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noob_trad3r · Jul 7, 2010

This is why I use etrade.

No such thing as a free lunch.

I would rather pay 10 bucks in commission than risk the IB computer going crazy and trading on my behalf without my knowledge.

Bob111 · Jul 7, 2010

i've been relatively happy IB customer for years,but how they execute my order today is just another proof that all brokers are full of shit and trying to reap the customers as hard as they can..
yes...everything looks legit and i did place an order to sell those 160 shares @ 1.85..the problem is-when IB bought those shares from me to themselves("SMART")-the bid was already higher by at least 2 cents.
Thank you IB!