Covered Call: ACH reject the stock being optioned

xtanda · 11 December 2008

Hi guys,
Just want to share my experience with this unreasonable policy by Australia Clearing House (ACH) related to covered call a.k.a buy-write or "share renting"

You will not believe this:

I did covered call on OZL for Dec 08 expiry on late November
Early December , as we know, OZL request to suspend their securities pending some refinancing issue
Several days later I got margin call for my broker requesting to deposit cash margin despite I have 100% coverage on the call option with OZL own stock.

It's covered call: I have covered it with the stock itself (OZL stock for OZL option), why I should still deposit some cash margin? I cannot figure out any possible explanation except ACH does not know what they are doing. The cash margin is just to make sure the writer can buy the stock at market and sell it cheaper (hence making a loss) in case of exercise, but if I have the stock already - end of story, right? What do you think ?

Frankly, I thought firstly that this is just the broker playing up. But after they provide me with ACH formal notice and received 'release from cover' letter then I realize it's not the broker...

What do you guys think ? Is it me drinking too much or ACH is to blame ?
(I have the summary of the incident on this post should you want to have a look a bit further detail)

Thanks !

sails · 11 December 2008

Perhaps this is one of the lesser known risks of covered calls. If the ACH has rejected the stock as collateral, I expect they would then want to margin the sold call.

It would be a difficult situation where you can't close the position either. I also see there is a notice today that there is planned legal action against OZL - so your call option might expire worthless anyway.

Have you checked the ASX option notices for information. Here's one - http://www.asx.com.au/products/pdf/notices/2008/Clm22308.pdf and another dealing with implication of OZL options on expiry day if it is still in suspension: http://www.asx.com.au/products/pdf/notices/2008/Clm22708.pdf

Would pay to check regularly for notices from the ASX here: http://www.asx.com.au/products/futures_options/index.htm. There are two sections under options on this page.

Hope it all works out OK for you

cuttlefish · 11 December 2008

It does seem pretty illogical though that OZL stock is not considered adequate collateral for a written OZL call. If there's a good explanation I'd love to hear it.

alphaman · 11 December 2008

Yeah that seems rather silly.

Do you know what will happen to the calls next Thursday if OZL remains suspended?

sails · 11 December 2008

cuttlefish said:
It does seem pretty illogical though that OZL stock is not considered adequate collateral for a written OZL call. If there's a good explanation I'd love to hear it.

Pretty much explained here: http://www.asx.com.au/products/pdf/notices/2008/Clm22308.pdf

I'm no expert on this, but it does appear that the ACH don't allow suspended securities to be used as collateral. I didn't realise that either until now

alphaman said:
Yeah that seems rather silly.

Do you know what will happen to the calls next Thursday if OZL remains suspended?

All explained here: http://www.asx.com.au/products/pdf/notices/2008/Clm22708.pdf

alphaman · 11 December 2008

sails said:
All explained here: http://www.asx.com.au/products/pdf/notices/2008/Clm22708.pdf

Do you know what it means? Because I'm not really sure.

My interpretation is that ACH will automatically exercise ITM options, using 55c, the last close as the reference price. This can lead to rather bizarre results.

xtanda · 11 December 2008

sails said:
I'm no expert on this, but it does appear that the ACH don't allow suspended securities to be used as collateral. I didn't realise that either until now

Yes, suspended material (since it's non liquid anymore), must be removed from collateral. For example: people doing naked put on BHP can lodge OZL security as collateral instead of cash. On this kind of situation, of course this OZL frozen security is no longer elligible for collateral.

But I totally disagree if the same reasoning apply to covered call. For covered call there is no other better collateral than the stock it self, not even cash.
For example: let say on the day of expiry, the stock jump 100%. If you have OZL securities as collateral then ACH just simply hand in the stock to the option holder who will certainly exercise his right. But what happen if the collateral is cash, the option writer still need to hand in further cash to patch the gap (which in this case 100% in value).

The maximum the holder of the option can get is OZL security, so if the OZL security itself is not eligible then it's a joke...

ACH have all the reason to remove OZL security as collateral for all other type of collateral , except covered call. I think this is reasonable.

cuttlefish · 11 December 2008

sails said:
Pretty much explained here: http://www.asx.com.au/products/pdf/notices/2008/Clm22308.pdf

I'm no expert on this, but it does appear that the ACH don't allow suspended securities to be used as collateral. I didn't realise that either until now

I can understand the mechanics of it, and I can understand why they won't accept suspended shares as collateral for other transactions, but it seems bizzarre not to allow stock to be lodged as collateral for a call option written over that very same stock.

A gotcha I didn't know about that I'm glad to be now aware of.

I wonder what other ones are lurking out there.

sails · 11 December 2008

alphaman said:
Do you know what it means? Because I'm not really sure.

My interpretation is that ACH will automatically exercise ITM options, using 55c, the last close as the reference price. This can lead to rather bizarre results.

I'm not really sure either - but I think auto exercise is done by brokers, not the ACH. Could be wrong...

It also looks like OZL options market will be open from 2pm on expiry day (18th Dec) and normal expiry processes will continue even if OZL is still in a trading halt. Could be interesting to watch - I expect the MMs will have very wide spreads.

cuttlefish · 11 December 2008

alphaman said:
Do you know what it means? Because I'm not really sure.

My interpretation is that ACH will automatically exercise ITM options, using 55c, the last close as the reference price. This can lead to rather bizarre results.

Thats my reading of it as well which also seems odd. And what happens to holders of ITM puts - do they get auto exercised as well, and is the reference price used and are they just cash settled based on the reference price? (since they can't source stock).

I'm assuming there wouldn't be many holders of ITM calls anyway.

sails · 11 December 2008

xtanda said:
Yes, suspended material (since it's non liquid anymore), must be removed from collateral. For example: people doing naked put on BHP can lodge OZL security as collateral instead of cash. On this kind of situation, of course this OZL frozen security is no longer elligible for collateral.

But I totally disagree if the same reasoning apply to covered call. For covered call there is no other better collateral than the stock it self, not even cash.
For example: let say on the day of expiry, the stock jump 100%. If you have OZL securities as collateral then ACH just simply hand in the stock to the option holder who will certainly exercise his right. But what happen if the collateral is cash, the option writer still need to hand in further cash to patch the gap (which in this case 100% in value).

The maximum the holder of the option can get is OZL security, so if the OZL security itself is not eligible then it's a joke...

ACH have all the reason to remove OZL security as collateral for all other type of collateral , except covered call. I think this is reasonable.

Yes, agree that it does seem unreasonable on the surface. Perhaps there is more to it.

At least you still own the shares, so if you were assigned on the calls, one would assume that your shares would fulfill your obligations and would close out your position entirely. Might be a question for your broker so you know what you can and can't do before the 18th.

If you are not assigned, perhaps you could buy an ITM put between 2pm and 4pm on the 18th and then exercise it to close out your share position and put the money to better use elsewhere. Something to consider perhaps, but definitely not advice as it may not fit into your trading plan and the MM spreads on the day may make that idea useless - just my

Definitely talk to your broker to see what options you have.

cuttlefish · 11 December 2008

cuttlefish said:
I'm assuming there wouldn't be many holders of ITM calls anyway.

Actually there were a few seriesi with 40, 50 and 60c strikes and there is a bit of open interest in them so there are holders of ITM calls. So are these cash settled based on the reference price as well or do they end up holding suspended stock. I'm assuming cash settled which means the writers have to front up the cash - if that is the case I think I'm starting to see why the OZL stock isn't suitable collateral for the call writers.

I guess with the price down where it is the margin lodgement requirement for cash collateral in place of scrip would be relatively small anyway.

sails · 11 December 2008

cuttlefish said:
Thats my reading of it as well which also seems odd. And what happens to holders of ITM puts - do they get auto exercised as well, and is the reference price used and are they just cash settled based on the reference price? (since they can't source stock).

I'm assuming there wouldn't be many holders of ITM calls anyway.

If normal expiry processes happen as it states in the ASX document, it would appear that holders of ITM puts would be able exercise and effectively dispose of their shares.

If so, wouldn't be so good for put sellers. Will check this out on Thursday and see if there are any option exercises on Friday morning.

sails · 11 December 2008

cuttlefish said:
Actually there were a few seriesi with 40, 50 and 60c strikes and there is a bit of open interest in them so there are holders of ITM calls. So are these cash settled based on the reference price as well or do they end up holding suspended stock. I'm assuming cash settled which means the writers have to front up the cash - if that is the case I think I'm starting to see why the OZL stock isn't suitable collateral for the call writers.

I guess with the price down where it is the margin lodgement requirement for cash collateral in place of scrip would be relatively small anyway.

It looks like only the December series that are subject to normal expiry processes which wouldn't indicate cash settlement at this stage. If OZL were to go completely belly up, then the ASX usually work on a cash settlement basis and often only on each expiry date.

Slightly off topic - but somewhat related: A question I have asked both brokers and the ASX, but no-one can tell me is that if I am in a long put calendar spread and the underlying goes bust and the ASX decide in their wisdom to cash settle options on the pre-determined expiry dates. This would mean that I would be liable in cash for the front month puts and then have to wait a considerable time before receiving a cash payment for the long puts. This could incur a large interest payment during that time. My rule now is to always have a very cheap front month put that would not entirely limit the liability, but would reduce the problem.

Suspension of the underlying and options can certainly cause some headaches

cuttlefish · 11 December 2008

Cheers sails.

I seem to recall reading a document once that had quite a lot of detail about what happens with options on expiry when the stock goes into suspension, but for the life of me I can't find it on the ASX site.

(Then again I think that I recall you provided quite a bit of information about this in another thread quite a while back, so maybe thats where I rember reading it )

sails · 11 December 2008

cuttlefish said:
Cheers sails.

I seem to recall reading a document once that had quite a lot of detail about what happens with options on expiry when the stock goes into suspension, but for the life of me I can't find it on the ASX site.

(Then again I think that I recall you provided quite a bit of information about this in another thread quite a while back, so maybe thats where I rember reading it )

I think it was how Pasminco was handled. It's in the ASX notices somewhere - perhaps do a search on Pasminco in ASX - or even here at ASF. Would look it up, just a bit busy atm!

cuttlefish · 11 December 2008

I just did a search. I found the thread with the links to Pasminco but they are defunct - the documents must have been moved or removed from asx site. (quick search on pasminco on asx produces nothing either).

sails · 11 December 2008

cuttlefish said:
I just did a search. I found the thread with the links to Pasminco but they are defunct - the documents must have been moved or removed from asx site. (quick search on pasminco on asx produces nothing either).

Here is one of them: http://www.asx.com.au/products/pdf/notices/2002/Clm02702.pdf

I started with the archives on this page: http://www.asx.com.au/products/options/notices/1999.htm and thenusing the "find on this page" function with IE (found under "Edit" on the tool bar) - typed in "pasminco". You might be able to find the others that way

PS - and another: http://www.asx.com.au/products/pdf/notices/2001/Clm16101.pdf

wayneL · 11 December 2008

Gee!

This should go into the option gotchas thread.

sails · 12 December 2008

wayneL said:
Gee!

This should go into the option gotchas thread.

Yeah - it's a nasty one - will add a link to this thread.

Anyway, I had a look the course of sales of BNB the day after Nov expiry. BNB went into suspension a few days earlier which presumably is similar to the plight of OZL. See course of sales below - only puts were exercised - most unpleasant for short put holders.

If anyone has any of BNB November codes, we could look at the course of sales for the 27th November to get some idea of the trades going through and see if that gives any clues as to how OZL Dec options will fare should it still be in suspension next Thursday.

Covered Call: ACH reject the stock being optioned

xtanda

sails

cuttlefish

alphaman

sails

alphaman

xtanda

cuttlefish

sails

cuttlefish

sails

cuttlefish

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sails

cuttlefish

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cuttlefish

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wayneL

VIVA LA LIBERTAD, CARAJO!

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