The system is broken, and the little guy gets screwed again.
It makes for an eye-catching headline, but isn't completely accurate.
The system is antiquated, and it favors big money or those with the best/most influential contacts.
There's the headline that tells the accurate story, although the end result of the little guy getting screwed remains the same. I'm talking about the options market, and while your first thought may go toward expecting an article on how Softbank may or may not have used the weekly options market to jam tech names significantly higher, you'd be wrong.
I want to talk about options settlement.
First, let's discuss the 10-cent version of the nuance of option settlement for both weekly and monthly options. We're going to leave quarterly out of the conversation for now. Let's cover some quick basics:
- We associate option expiration with Friday, though options don't technically expire or exercise until Saturday.
- Because they don't expire until Saturday, even after the market closes regular hours trading on Friday at 4 p.m. ET, option holders have until 5:30 p.m. ET to notify the OCC (Options Clearing Corporation) if they would like to exercise an option or not.
- Individuals brokers set their own cut-off time, generally 5:15 p.m. ET, but it is up to each one
- You won't know if a short option position (meaning you are short a call or a put) will be exercised until the next day. That includes short positions that are part of a spread or combination position
- Long calls or long puts at least $0.01 in-the-money will auto-exercise unless a trader calls to instruct a do-not-exercise. This instruction must come before the cut-off time
- Almost all brokerages will require you to have the buying power/margin to exercise your long call or put exercises
Here's where the challenge comes into play. In order to DNE (do not exercise) or to exercise an option after the market closes at 4 p.m. ET, a trader must call his/her broker-dealer and input the order. Maybe that's no problem if they have 60 or 75 minutes, but what happens when we have a situation like this past Friday?
At approximately 5:15 p.m. ET, changes to the S&P 500 were announced. The three new additions (promotions from the S&P 400) all saw their stocks jump 4% to 5%. One snub, Tesla (TSLA) , watched its shares drop sharply to $400 from a close just above $418. Just minutes before 5:30 p.m. ET, they dropped below $400 and kept going for a bit.
And this is where our story takes a very ugly turn. I've heard my fair share of horror stories over the weekend, but to keep things fair, we'll go over mine specifically. It's not pretty. If you have children, you'll want to have them leave the room.
Today, you're going to pay absolutely nothing to receive a lesson that cost $7,500 and lots of hand-wringing and self-berating over the three-day weekend.
As Friday came to a close, I felt comfortable with my Tesla combinations. I had hedged the options, or so I thought to clear out with zero shares after auto-execution based on the closing price. My positions expiring on Sept. 4, 2020, looked like this:
Calls
Long 1 $385 call
Short 3 $400 calls
Long 1 $405 call
Long 1 $438 call
Puts
Long 1 $440 put
Short 2 $420 puts
Long 1 $410 put
Long 1 $400 put
At the end of the day, I was staring at the calls leaving me short 100 shares and the put position leaving me long 100 shares to net out with zero shares. I was not naked on either side of the equations. In fact, I had a few higher strike calls and lower strike puts leftover from an old combo, so I was net positive in terms of long calls and long puts.
Then, the S&P 500 exclusion news broke around 5:15 p.m. ET, and Tesla dropped hard. I immediately worried that the holder of those $400 calls I was short might walk away and not exercise. Unlike many traders, I understood my risk just went from a perceived nothing to warp speed. After taking a minute to breathe and assess the situation, I called the broker on this one. It was a smaller trading account as I try to keep some things separate.
My call was greeted with hold music. The minutes ticked by and kept ticking. I immediately launched into instructions that I want to exercise my $410 put and not exercise my $405 call. Am I too late? What's the cutoff time?
Unfortunately, the gent on the other end didn't know and asked me to go on hold to check the cutoff time. My immediately reaction was, "Shouldn't he know?" Then, I kicked myself and asked, "Shouldn't I know?"
But each broker-dealer is different.
He comes back and says, "Maybe we can push something through."
It's now past 5:30 p.m., but fantastic if we can work something out. If they push through for me, then the cutoff is more of a guideline, which is a flag, actually. Those with bigger money and better connections can probably get more "pushed through" than a little guy like me.
I started to walk through the situation again, but apparently wasn't clear enough. That was a mistake on my part because he put me back on hold. When he came back, we walked through why I wanted to do what I wanted to do, and he finally understood. I go back on hold. When he comes back, he tells me that now we're too late to push anything through. No wonder, as we are now past 5:45 p.m. ET.
He tries to comfort me by saying, "Based on where the stock was trading between 5:15 p.m. and 5:30 p.m., you'll probably be all right." I wasn't. He doubles down by saying, "This situation is nothing compared to some of the other things I've seen lately. Some have been really bad." As if this is supposed to make me feel better. It didn't.
So, I woke up to long 300 shares of Tesla on Saturday morning. My aim on Friday was to mitigate my risk. I calculated my highest probability was to wake up Saturday long 100 shares while waking up with zero shares was the lowest probability. Being short 100 shares was the next lowest probability with short 200 shares as the next most likely. And I would've been OK with any scenario, but also I would have been right with my expectations.
That said, I woke up Saturday morning knowing what to expect. I've talked to others over the weekend who were completely blindsided. Traders with TSLA put spreads such as $407-406 or $410-406 that expected they would expire worthless only to wake up long 100, 200, or even 500 shares at the $406 level. They didn't understand how a defined risk trade like a $1 wide put spread could have them waking up to losses of $3,100, $4,700, or $15,500. They are also facing large margin or federal maintenance calls as the cash required to purchase that many shares often strips a trader dry of cash.
It's possible the same things happened with Etsy (ETSY), but that stock had small volume and tiny open interest coming into Friday's close. Tesla's volume and open interest was likely to impact tens of thousands of traders. I can't begin to imagine how many will be ruined.
Don't get me wrong, these risks are discussed. Options traders all sign off on the OCC disclosure documents, but these risks aren't discussed enough or even taught. Honestly, until weekly options rolled around, the likelihood of something like this happening was 1 in a million, maybe more. But here's where I think the system is failing us and needs to be updated. I see a few possible solutions:
- The OCC changes to an earlier time such as 4:15 p.m. ET and all decisions need to be made at or before the closing bell.
- Exercise or do not exercise can be done via an automated process. Needing to call in while many brokers have skeletal staffs or inadequate call lines only serves to help the rich get richer and leaves the little guy/retail trader left paying the bills.
- The OCC changes to a later time such as 8:00 p.m. ET (the end of after-hours trading) and all decisions need to be in by 7:45 p.m. ET.
Let's be honest, the 5:30 p.m. ET cutoff time feels arbitrary these days, and it is antiquated. With the proliferation of after-hours trading and weekly options, this system needs to change and it needs to change now before it leads to more retail traders getting ruined in a black swan type of event that has the likelihood of becoming a normal event.
Lastly, I'm going on record here saying the timing of the Dow Jones press release on the S&P 500 changes did people dirty. In my view, the announcement should have come after 5:30 p.m. ET or immediately after the close. By timing it when they did, on a Friday (and before a holiday weekend, no less), and understanding the impact it would have on the three additions and one non-addition (and let's not play dumb and pretend they don't know what impact they will have on a stock), it was poorly conceived at best or intentionally done to help institutions at worst. It's no secret that institutions have the direct line and connections to make the changes to options in that tight of a window while 99.99% of retailers will get shut out and wind up losers on the other side.
And you thought the traditional initial public offering (IPO) system was bad? Wait until companies realize they can do this same thing with Friday night PRs at 5:15 p.m. ET to create amazing squeezes. It will happen. Heck, I just opened the door to how a company can use it to create incredible short squeezes because if you pair this same concept with good news, you can watch the opposite price reaction unfold.
After a long weekend, taking the L (loss) on Tesla immediately in the pre-market relieves a small stress from my mind and a big chunk of recent gains from my trading portfolio. It's a reminder of the subtle risks that even seasoned traders neglect to consider or remember at times.
I don't want sympathy. Also, I'd appreciate avoiding any "you deserve it" notes as well. But I do hope this helps even one trader understand this risk going forward, and I truly hope the OCC addresses this inequity and the archaic rule for option exercise that, again, favors big money and institutions.
