As we work our way through earnings season, many clients try to speculate on the outcome for certain companies. Buying calls on Microsoft Corp. paid off handsomely; on Morgan Stanley, not so much.
The point is that earnings surprises can cause significant stock price swings after hours and, as such, it’s important that investment advisors ensure their clients are protected against unforeseen losses – particularly if excessive exposure is preventable.
I am reminded of a conversation I had some years ago with a confused options trader. He was bearish on the short-term outlook for Google Inc. and had purchased 10 Google October 460 puts in early September.
Fast-forward to the third Friday in October, which was the last trading day for the Google October options. Throughout the day, Google traded in a narrow range around the US$460 strike price. The trader entered an order to sell his puts at a limit price that was never achieved. He decided to let his puts expire rather than pay the commission to sell them or engage in the process of exercising into a short position in the underlying shares.
That strategy made sense because traders who buy short-term calls and puts are speculators and have no interest in exercising their options. Why swap limited-risk metrics for the greater risk associated with being long or short shares of the underlying company (i.e., the stock price could decline to zero or rise to infinity)?
The trader’s decision turned out to be a horribly bad strategy. Although investors and their advisors believe that a long option has limited risk, that holds only if the trader is willing to exit the position prior to expiration; allowing an options position simply to expire can expose the investor to the risk of “automatic exercise.”
The U.S. Options Clearing Corp. (OCC) has provisions for the automatic exercise of certain in-the-money options at expiration. The relevant point is that options do not expire at the end of the trading day. Options actually expire on the Saturday following the Friday (Friday is the last trading day) of the expiration month. So, even though an option ceases to trade, it still exists as a legal entity until the next day.
On the Saturday following the last day of trading, OCC implements a procedure referred to as “exercise by exception.” The idea is to make good on the contractual obligation of the options contract for investors who may not have realized their position was expiring.
This rule states that the OCC will automatically exercise any expiring equity call or put in a customer account that is US5¢ or more in-the-money and will automatically exercise index options that are US1¢ or more in-the-money.
Because Google closed at US$459.67 on that Friday afternoon, the Google October 460 puts were automatically exercised the following day. The confused trader discovered on the following Monday that he was short 1,000 shares of Google at US$460 per share. A position that he did not have the financial wherewithal (i.e., margin) to support.
In the vein of “never letting a good deed go unpunished,” Google decided to release important news over the weekend that it was acquiring YouTube Inc.; based on that, Google’s shares opened for trading on Monday at US$478 a share. Our weary trader was forced to buy back his short position at US$478 a share, which created an unexpected loss of US$18,000 in addition to any losses on the initial purchase of the puts.
Clearly, this was a preventable error for any clients in the same position. The clients’ advisors should have discussed possible alternatives: the Google put should have been closed out on the last day of trading or, at the very least, the client ought to have been advised that he could request that his option not be exercised, which would override any potential action by the OCC.
Aside from this specific example, what about all too common price swings in after-hours trading? What happens, for example, when options expire out-of-the-money, but, because of action after hours, trade in-the-money?
In fact, Google did trade up to US$462 in after-hours trading, but the Google October 460 calls expired worthless based on the closing price of US$459.67. The “exercise by exception” rule is tied to the value of the underlying stock at the 4 p.m. close of trading. However, traders can request that options be exercised even if the stock’s 4 p.m. closing price is out-of-the-money.
My particular example is enlightening from a number of perspectives: it speaks to the role advisors have in monitoring client options positions from inception to expiration; it raises the bar in terms of the advisor’s responsibility to inform clients of alternatives at expiration; and it posits whether a position should be exercised automatically if the client does not have sufficient margin to maintain the position.
I am not aware of any court challenges to these types of scenarios. Most likely because the disclosure language in the options risk disclosure statement deals with automatic exercise. Still, I suspect the rule may be challenged eventually from either a fiduciary or suitability perspective.
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