Don't Punch Yet
Vol #171: March 21st, 2024
Smoque BBQ. Giordanos Pizza. A breakfast platter from Champs with extra bacon, home fries and two pancakes. The fat, grease, and salt of expiration.
If you ate that on every 0DTE, you’d be fit for a mortgage backed securities desk in the 1980s. But when gamma potential energy turns into hard stock deltas every day, the waistline protests. Expo is more of a process, less of an event.
Long before tech companies mollified their denizens by the buffet, prop shops have been feeding the employees that had to stay after the close. Or come in early once a month on a Saturday.
When the bell rings at 4pm ET, open orders get canceled and options stop trading. There are 15 extra minutes for index and certain ETF products. Most of the stock liquidity evaporates too. But stocks can still trade up until 8pm over the counter, and there’s only an unwritten rule that says news can’t happen early Friday evening, or afternoon on the west coast.
The threshold for automatically exercising an option is $0.01 in the money, so there’s nothing to do for the vast majority of expiring contracts. Even in 2008 when the threshold was lowered from a nickel, that didn’t leave a lot of ambiguity. It helped that there were no dollar strikes.
But 1% happens 1% of the time. With a couple hundred positions, there were always contrary exercises to punch in. Prior to the penny change, participants had to explicitly say what to do with the $15 strike call on a stock that officially closed at $15.03. There were also marginal cases where in the flurry of pre-close portfolio tidying you ended up long or short some extra deltas. If you were long the 15 puts and also long a few hundred extra deltas, punching something out of the money costs you three theoretical cents but grants you a stress free weekend.
Contrary exercise forms had to be time stamped at the clearing house by 5:30pm. These carbon copy sheets had hand written badge numbers and positions, and were then processed by the breaks room and forwarded along to the OCC. Firms would run their own expiration program, converting all of the in the money options into stock to be delivered or received. Four days hence of course.
As every contrary form gets processed, there were edge cases that percolated down randomly post settlement. Whether it’s savvy positioning, or obfuscation by market bureaucracy, not every 15 strike call gets punched in that scenario. And some of the puts you thought were clear, turn into a stock position. The shorts are apportioned the assignments randomly, and who skates and who gets dinged is a Saturday morning problem. That’s what the pancakes were for.
We would refer to these as “adds versus assignments”. While it sounds and intuits like “adverse”, that wasn’t always the case. This cut both ways, and somewhat randomly. Like any noisy process in trading, it was best to minimize it and make an effort to close pin risk. Paying up pennies hurts, but not as much as a slug of stock exposure you were too cheap to avoid.
That goes for buy side trading strategies also. If you’re short a just out of the money put, it’s probably worth closing. That’s frustrating, because the liquidity is terrible. Even if everyone’s theo is a fraction of a penny, markets are at least a nickel away, because what sane liquidity provider gets out of bed for anything less?
Assignments also can pop up because something happened in the time after the close and before 5:30pm. In this after hours dusk, stock could trade differently than the official close, and put different strikes in the money. All those newly ITM or OTM options become contrary exercises.
In a world of pico seconds, the gap between the close and the exercise cut-off is an eternity. Where mostly nothing ever happens. But even as far back as 1988 there were concerns about what manipulation could happen in this window - or just outside.
On Friday, the 17th of June 1988, OTM put holders in Farmers Inc exercised their puts almost 90 minutes after the exchange cut off time. This was fortuitous, because the California Insurance Department had just barred a takeover, causing the stock to plummet after hours. A spate of lawsuits and arbitration proceedings followed.
Rulemaking came next, though it was not added to the Federal Register until 1994. Now, the only exceptions to Rule 63 of the NASD and Rule 805 of the OCC are to remedy errors made in good faith, reconcile an unmatched trade, or where there are exceptional circumstances related to the communication of exercise instructions. The after hours window closes at midnight.
By carving out these exceptions the SEC made it clear that “the submission of a Contrary Exercise Advice on the basis of material information released after the Exercise Cut-Off Time will be activity deemed inconsistent with just and equitable principles of trade.”
“On the basis of material information” - why else would you change it? With justice prescribed by the broad catch-all language that regulators love; if what you’re doing smells fishy, we’re going to get you. And just to be sure, even if you’ve made a good faith error, the penalty has started at $20k, increased to $75k in 2008, and again to $250k in 2020. And that’s per strike - you’d better have a big position or a big error to make that worth it. It’s also going to get a lot of scrutiny.
While these are the rules at the exchange and clearing member level, mileage may vary across retail brokers. It’s usually complicated bordering on impossible to submit a contrary, let alone a late exercise notice. It’s not directly available in the software, and getting client services on the phone after hours is not a high expected value way to spend a Friday evening.
That’s unfortunate, confusing, and not particularly fair! While not quite as egregious as the Farmer’s case, B. Riley had some Expiration Friday backstabbing just this past Ides of March.
Embroiled isn’t a hot enough word to describe the company’s situation, and they missed an audit filing after being given a grace period. After everyone shut their machines and assumed a skate, stock traded down over a dollar before expiration notices were due. This is why the pros don’t fire the laser until 5:29pm.
That turns three strikes of puts into stock. Lots of contraries. Premiums have been incredibly fat, but an unspoken risk is that the market plumbing gets clogged up. For all theoretical intents and purposes, $17.58 is the close price. But not practically.
The burden of this quirk falls on retail investors. Players with better operational access have an advantage, while the four figure account wakes up Monday morning with deltas that could be down almost 15%. The ironic post script here is that you wanted to keep those shares, as stock is trading $20.50 today. But you shouldn’t have to take them.
For many of the reasons I love and support the expansion of cash settled options, this expiration quirk should be automated. The financial settlement of a contract should be at a price that is tradeable and accessible to all participants. If the bell rings at 4pm, don’t let the clerks on the floor shuffle tickets for another 90 minutes.
This operational vestige not only accrues an advantage to liquidity providers who can capture over-priced closing trades based on a risk that is orthogonal to the financial purpose of the contract, but to all professional participants with the ability to actively manage their exercises.
Delivering shares to retail accounts that thought they had a butterfly or short put spread on introduces unnecessary fragility. The defined risk spread now becomes an unbounded risk for no benefit.
As stock settlement windows narrow further, and the US system heads towards T+1, the potential for late exercises is likely to go away. Just at the start of this year, the OCC filed to eliminate this possibility as stock clearing tightens up. There are enough kinks in the pipes that make delivery impossible under that paradigm.
This only solves a small part of the expiration issue. Options are derivatives based on underlyings, used to manage risk and speculate. For them to be traded fairly, there should be one closing time, not two. Cash settle while you’re at it.