When Option Trades Go Bad

10/14/2010 12:01 am EST


By Josip Causic, instructor, Online Trading Academy

Recently, a student e-mailed me for help on a losing trade, which she wanted me to analyze. She knew that she was losing money on an option trade, yet when she was assigned almost two full weeks before expiration (meaning she was short actual shares), she needed some explanation. After e-mailing me back and forth several times, I asked her for permission to share her painful lesson with our readers. Permission was granted under the condition of anonymity.

Here is a fragment of one of her e-mails.

Hello Josip,
... I logged into my account this morning and I had 2,000 shares of Verizon. I am confused. I still have almost two weeks until the expiry. Twenty of my long VZ calls are still in my account and I do not have much money in that account. How's that possible? I was under the impression that in a spread trade, I am protected?

After reading her e-mail, I was not sure what type of spread she had on and why she was telling me these things instead of calling her broker. At any rate, I did get answers to these questions within a few minutes of sending her an e-mail. For the sake of the flow of this article, I will just sum up what she communicated to me.

Basically, she was fearful that the brokerage company might go after her house—on which she was already struggling to make payments—since her account was so small and she was now short 2,000 shares of Verizon (VZ). She had no money to wire in, so she was understandably paralyzed by fear. The last thing that she wanted to do was to talk to her broker, and that is why she sought my help.

After she had provided me more details about her trade, I convinced her that she ought to contact the broker and get out of her 2,000 short shares of Verizon. Holding this position overnight could in fact accumulate margin. Anyhow, here are the specifics of her initial trade, which she jumped on following a tip from a more experienced trader. The figure below visually lists all the specifics of it.

Click to Enlarge

She had a short vertical spread, also known as a bear call. In essence, she shorted Verizon, an up-trending stock with solid fundamentals, using options due to a comment that VZ was creating a “shooting star.” On Wednesday, September 22, 2010, while VZ was at $32.40, she sold 20 contracts of the October 32 calls and bought 20 October 33 calls. The credit received for the spread was 0.43 per share, or $43.00 per contract. Had this worked out for her, she would be rewarded $860 ($43 times 20 contracts). The prospect of making nearly a thousand dollars really excited her, so she completely overlooked many other relevant factors, which she had initially been made aware of in our option class.

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She forgot that selling the 32 calls was an aggressive trade, for it required VZ to actually drop in price. At the time of her entry, the 32 call was still in the money (ITM) by 0.40. No wonder the premium was so juicy, as I like to say.

Secondly, VZ does not move in isolation from the technology sector to which it belongs, and the techs were also in a strong bullish trend.

Pointing out all these obvious facts did not help her much, for what she really wanted to know was how was it possible that she was assigned so early? I wrote to her that American-style options are a two-way street, unlike the European-style options, which can only get assigned and exercised on the last trading day. She replied in her e-mail that she understood American options intellectually, but that she actually never had this happen to her. Then she pointed out that she had received an e-mail from her broker in the early morning of the day she was assigned with the subject line “OPTION ASSIGNMENT.” In fact, she cut and pasted the text. (I have blocked out some parts of it.)

Dear XXXX,

This message is to inform you that you have been assigned on 20.0 VZ 100 OCT 10 32 CALL in your account ending in XXXX. The adjustments have been made to your account and may be viewed in your account statement page under cash balance. If you have any questions, please email us at tradedesk@XXX.com or call us toll free at 8XXX.

Should this assignment of stock result in negative buying power, we MAY trade the position to prevent you from receiving a margin call.

Thank you,

Trade Desk

This type of e-mail is a standard type that is generated by assignment and is sent out by the brokers with very little textual variation. I pointed out to her that the last sentence contains the answer to her question. Her position was assigned because she sold the call, which means that she took upon herself an obligation to sell VZ for $32 per share, which meant that she sold 2,000 shares at $32, equaling $64,000 worth of a short position. Unfortunately, the day prior to her assignment, VZ was trading at $33.60.

By the time she had gained an understanding of what she had done and was able to buy back to cover 2,000 shares, VZ was no longer trading at $33.60, but at $33.28, thus lessening her loss. On this trade, she sold 2,000 shares through assignment at $32, equaling $64,000, and bought back 2,000 shares with her broker's assistance at $33.28, equaling $66,560. At this point, her loss, the difference of the two ($66,560 minus $64,000) was $2,560. At the same time, after buying back the short shares on the phone with her broker, she also sold her 20 October 33 calls, which offset her loss even more. I am glad that she did this at that time, because now, at the time of me writing of this article, VZ is trading below $33, and had she kept those long calls until expiry, she might have ended up losing even more money on them.

At any rate, she had initially sold the spread for 0.43, which would mean that if the trade worked out the way she anticipated with VZ closing below 32, she would gain $860. However, the moment she unwound the legs separately, the whole calculation changed. So let me go leg by leg.

Long Leg

As shown in Figure 1, she paid out 0.22 for 20 contracts of October 33 calls, which she later sold for 0.54. She actually made money on the leg that was initially supposed to expire worthless. The exact amount for that leg follows: 0.54 minus 0.22 equals 0.32 per share. In other words, she made a profit on the long leg of $32 per contract (32 times 20), or $640 total, for all 20 contracts.

Short Leg

Also as shown in Figure 1, she received a credit of 0.65 for the short October 32 call. Since this leg was assigned to her, she gets to keep this credit in her account. The math goes like this: $65 times 20, or $1,300 for all 20 contracts.

For simplicity's sake, let me place all these numbers in a table in Figure 2 below.

Click to Enlarge

Hence, her final loss was only $620, plus commissions and an assignment fee of $15.

If she had simply exercised her 20 long calls at $33, buying VZ at $33 while VZ was actually trading at 33.28, she would have lost the value of 0.28 per share. I was glad to read in her e-mail that her broker's trade desk disclosed that to her.

In conclusion, what have we learned from her unfortunate experience? I would say simply three things: 1) Do not trade on tips; 2) Do not trade with money that you are not able to risk, such as your rent money; and 3) Know your option spreads in and out before you actually trade them with real money.

By Josip Causic, instructor, Online Trading Academy

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