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Option Traps and Gotchas

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sails

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16 June 2005
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I'll start this thread off with a shapshot of Friday morning's course of sales for ANZ. ANZ closed at exactly $14 on Thursday (Nov08 expiry) and some think their short options are safe from being assigned. See below for the list of $14 options exercised.

The codes EP and EC obviously distinguishes whether they were puts or calls.

The biggest danger of being assigned is that you either end up owning the underlying shares or are short them, leaving full exposure to any overnight gap. Probably even worse for credit spreads where the short side is assigned and the long one expires worthless. What was a limited risk trade is no longer protected.

Also, most option brokers automatically exercise in-the-money positions. How much ITM can vary between brokers, so it pays to know their policies. If long are long an option that is 1c or so ITM and it's not worth incurring fees to close, it would be advisable to check with your broker and request them not to auto exercise if necessary.

Will add to this thread as time allows - hopefully others will also add any useful nuggets and experiences to this thread ...
 

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Hi sails, good idea for a thread,

Its interesting how quite a few $14 series where assigned, if I were short I probably would have slept well that night thinking I was safe, I assume those exercise/assignments were result of arbitrage positions? that may have ended up half baked in the end.
 
...called "pin risk", when you don't know whether you'll be assigned on your short option or not.

Great idea for a thread M.
 
Another gotcha is volatility crush/rush AKA vega risk.

This catches many unawares particularly as there are option "education" companies out there promote dodgy strategies in the name of sales. (No strategy is dodgy, but the circumstances can be)

Example:

One prominent mob of clowns as part of its introductory seminar, promotes the buying of straddles immediately before price sensitive announcements, to profit from a move in either direction.

Sounds like a good and clever idea.

The Problem:

Those options start getting jolly expensive as a) market makers price in the likely magnitude of the move, and b) speculators who've been to one of these introductory seminars (there's thousands of them) start bidding up the straddle. The whole option chain rises due to arbitrage.

You only profit if the magnitude of the move exceeds the volatility priced into the options. If it doesn't, you lose heaps of premium, even if it moves somewhat. This is called volatility crush.

Gotcha.
 
wayneL said:
Another gotcha is volatility crush/rush AKA vega risk...
Click to expand...

And while on volatility crush/vega risk - placing calendar spreads where the purchase of long, further out options when IVs are high and likely to fall. (Markets are currently in this phase now where we have had exceptionally high IV and large percentage falls are likely if the markets continue to rise at a steady pace.)

Options further out in time have much higher vega readings than those closer in time - meaning they can lose significantly with a large drop in IV and any selling of the front month could be hard pressed to repay those losses.

It's also a trap for scared stock holders who decide to buy put protection on the lows when IV is usually the highest...
 
original quote from
sails

Options further out in time have much higher vega readings than those closer in time - meaning they can lose significantly with a large drop in IV and any selling of the front month could be hard pressed to repay those losses.


so on the flip side of the coin long dated options would have the present iv factored into them
have noticed lately some far dated puts which are way out of the money with quiet hefty premiums attached

example
mqg June o9 $10 put with a bid of $0.80
i was tempted to sell 1 contract into this but at the time not sure about the long term commitment
wondering others thoughts on this
 

Yes Jackson, you are correct on the flip side. However, it looks like MQG goes ex-div before June 09 expiry and this would be adding some premium in those puts in addition to the high IV premium. So that 80c is not all IV.

If MQG stays continues up or sideways, it could be a good trade. However, if it goes down, not only will further IV increases hurt the position, the dividend factor will also increase the premium significantly as it moves closer to the money.

It would pay to enter all the correct imputs into Hoadley (incl. estimated dividend and dividend date) to get a visual picture of the risks otherwise hidden in that trade.
 

Not sure exactly why they are exercised, Cutz - just know that it does and has been for the 5 years I've been trading options. NAB was another this month - closing at exactly $19 and there were $19 options exercised the day after expiry.

My guess is that it may be part of MMs closing positions...
 

if in theory the exercise price is $14.00 and the sp price ends up closing at exactly that price could it be that the automated system will close out all positions as theoritically the exercised price has been reached

in other words does the system recognise it as such because it is the exercise price

not sure if this makes any sense
 
Quick question, does anyone here use options for longer term trading (2-5yrs?)?
 
Some positions need good timing

When I started I anticipated a for example rally and put on a bull call spread with a month to expiry- because its a bullish position (derrr). After a few days the rally occurs, and I look at my spread and it has hardly widened out. Later on the underlying reverses and the spread is worthless.

The same goes for OTM butterflies - on Hoadley's analysis shows it is cheap and on expiration the return is great. But if the underlying gets to the ATM strikes well before expiration - the spread is hardly profitable.

I got the direction right, but my timing was off

Gotcha
 

Well, if you look at IB and OX - the instructions are that they will automatically exercise any options $0.01 ITM - in this example $14.01.

So the $14 strikes wouldn't be exercised hence the pin risk problem - otherwise no one would worry if it were automatic.
I also suspect its the MM's as well.....
 
Double and triple checking the order pad before pushing the trade through, it got me a couple of times.


Ageo said:
Quick question, does anyone here use options for
longer term trading (2-5yrs?)?
Click to expand...

Not me personally, 1 month is the norm in my case. This gives me room to maneuver.
 
Another one that nearly got me was relying to much on TA, early Sept 40 seemed like a good area of support and IV seemed high at the time for MQG, so I put on a couple of naked short puts, well the price plunged through 40 then the short sell ban came on which pushed MQG back up so I got out even but it was enough to give me a little fright.

Two valuable lesson learned, use TA as only a guide, (I know I’m gonna cop it for this)

And don’t go in without some sort of hedge, or wing especially on stocks.
 
 
Ageo said:
Quick question, does anyone here use options for longer term trading (2-5yrs?)?
Click to expand...

Sorry Ageo, I'm front month mostly - better liquidity. If IV levels are looking OK (ie. low and likely to rise again) - short term calendars work quite well.

I don't like going too far out because of horrible liquidity (in the Oz market) and slippage. Also, if one gets IV wrong, it can do lot more damage further out.


cutz said:
Double and triple checking the order pad before pushing the trade through, it got me a couple of times....
Click to expand...

Yes - been caught a few times as well. I remember one classic a few years ago now and was very new to options. Wanted to put a double butterfly on NCP (now NWS) which had very liquid options at that time. On the day this happened, BHP and NCP shares were ironically trading at exactly the same price and were moving almost instep throughout that trading day.

This was the most complex order I had ever done and there were no spread facilities - was with AOTonline and had WebIress and it all had to be legged in online. I carefully worked the order in one by one in such a way that I was hedged as much as possible while I built the trade.

Got to about the last leg when I realised I had been so carefully entering all my orders in BHP. I felt sick, because the analysis had been based on NCP I ended up losing a bit out of it because the mistake clouded my judgement over the following couple of weeks. However, if I had traded it without that crippling fear, BHP actually made a large move up - enough to close the short puts and roll up the lower long calls. Then it proceeded to fall heavily and would have made quite a windfall on the way back down. It was actually the best one to have put this trade on!

One of the problems with these types of multi-leg positions which need adjustments to profit are Aussie brokerage and exchange fees - can really put a hole in the profit.

Lots of lessons from that trade - some practical ones but mostly how much fear can interfere with the ability to think clearly...
 

I found a simple checklist for options taped to the monitor helped eg:

Account

Stock

Buy/Sell

Open/Close (if needed*)

Month

Strike

Call/Put

Quantity

Entry price (high for credit / low for debit)

Total amt

* re Open/Close above - my WebIress doesn't bother with open/close. Much like stock and futures, they automatically close out. eg if short, buying that same option will close it.
 
Ageo said:
Quick question, does anyone here use options for longer term trading (2-5yrs?)?
Click to expand...
I don't believe options are optimum for "set and forget" strategies of that time frame.

However, I believe if you have a 3-5 year outlook and goal, but actively use options around a base share holding (or phantom holding ) to protect, achieve and enhance, options are ideal.
 

Well Wayne basically i wanted a better alternative to investing in shares (i.e not having to outlay huge sums of cash etc....) im talking about buying direct call (and puts if opportunity arises) options in the view of a big move (but trying to guess in short term is kinda hard thats why i choose longer term options).

For instance we all know the market will bounce (when will it happen who knows), and some stocks will probably rocket in the next few yrs, so id rather outlay a couple of thousand in premium and know thats my maximum loss (instead of buying the share outright and increasing my risk and profit potential).
 
Further to my original post on this thread, I should point out that not all options at $14 would have been exercised.

Went back and had a look at the stats for ANZ $14. On Thursday morning, there was open interest of 433 for calls and 325 for puts. Volume for the day was calls 204 and puts 173. Volume may not may not be all closing out volume - there could have been some trading in and out around that $14.

For simplicity, if we assume that the volume was closing out that would leave 229 open interest in calls and 152 in puts. Only 30 calls were exercised and 71 puts - so a lot expired worthless. What we don't know is if the MMs were predominantly short or long - so we don't know how many retail traders were assigned on their short positions.

The main thing is to be aware of the possibility and if short in this instance, IMO it would pay to close it out to be safe.
 
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