Dangers of Owning Puts Without Owning the Stock

Some risks of owning put options while not owning the stock, are typically not well highlighted in mainstream options education materials. This is beyond the standard issues with options such as needing to be right in the direction (puts or calls), timing (before expiration), and magnitude (must cover the premium) of the stock movement.

If you own put options without owning the stock (regardless of whether you are hedging a long position on the stock through calls, or you are just a short seller betting the stock will fall), you can get into a bad situation in the following scenarios:

SCENARIO #1

The stock is halted for some reason on the exchange (e.g. SEC investigation, exchange requesting for information, company wishes to announce major news such as auditor resignation), and the halt extends past the expiration date. When the stock gets halted, trading for the stock’s options will also be automatically halted. That means that you will not be able to sell your long put position. Note that no advance warning may be given for the trading halt, and the stock/options can be halted even in the middle of a trading session. The key question then is, are you able to exercise your put options during the halt.

There are many websites that say that yes you will be able to exercise your put options during the halt because a stock halt does not affect the rights and obligations of the options contract (read here, here, here). They basically advise that when you exercise your put options, you will end up with a normal short stock position, which you can then cover later when the stock resumes trading (even if the stock got delisted and trading is resumed at the OTCBB or Pink Sheets). Typically a stock opens about 2/3% down from the last price before the halt (read here) so that your put options serve their intended purpose.

The Options Clearing Corporation (OCC) / Options Industry Council also wrote in its FAQ (here) that even if a company goes bankrupt and its stock is halted, you can still exercise your options so long as the shares continue to exist.  The OCC also published info memos (see example here) that even though automatic exercise will be suspended (i.e. even if your option is in-the-money, it will not be automatically exercised as per normal), you can simply manually instruct the OCC to exercise the option (BTW, you can look up the latest info memos on your options by searching at theocc.com).

What’s The Problem?

All these sound great! So what’s the problem? The problem that I have not once seen mentioned in these sites is that your particular broker, cannot find the stock to deliver for the exercise of your put options, hence your broker does not allow you to exercise your puts, and your puts will expire worthless. This can happen with stocks that are already heavily shorted, or stocks with large put option open interest (relative to the float). And more often than not, if you are playing a situation where you are using puts, are you indeed in that particular situation.

From online forum postings where this scenario happened recently, TD Ameritrade allows you to put in a request for exercise before the expiration, which will be honoured when trading resumes (here , here, here), E*Trade allows for exercise only if you own the stock but not if it creates a short stock position (here), Interactive Brokers (here, here) is not allowing exercise if you don’t own the stock because there is no inventory (here, here, here, here). Note however that the situation can be dynamic from day-to-day, it is definitely possible that your broker managed to obtain shares for you to exercise your puts. Long story short, without owning the stock, you can be screwed.

From the point of view of the brokers, there are also issues they have to contend with

1. If they can find the stock to perform the assignment, they are taking a risk with the opening price of the stock once trading resumes. If they perform the exercise, give you a short stock position, and the stock opens with the price doubled, there is a risk you don’t have the funds to close the position. In this case they may require 100% margin for the position (either 100% on top of the money you get from exercise, or based on the latest stock price before halting). This is similar to brokers raising the margin requirement for companies with binomial events that are coming up (e.g. margin requirement for MELA, MNKD raised before FDA drug approval decisions)
2. If they take the stock from someone who has their holding already lent to a covered short (i.e. a put writer that is also short the stock), they cannot force a buy-in on that covered short because there is no market in the stock (trading halt). The lack of a market presents difficulties to brokers in reallocating already borrowed stock.

How Can It Play Out

How it can play out (the negative news scenario)

1. The exchange determines whether the company is seriously working to resolve the issues. If deemed not sufficient, the exchange gives notice to the company of its failure to meet listing compliance with a notice of de-listing, and a chance to appeal.
2. The company will decide whether or not to appeal, and may issue a press release on their decision.
3. The exchange replies in about a week, and either announces a date for trade resumption or de-listing.
4. If de-listed from the main exchange, the stock will resume trading on the OTC markets (e.g. OTCBB, Pink Sheets, Grey Sheets). Note that your broker may have certain restrictions on trading in OTCBB/Pink Sheets (some may only accept trades through the phone with high commission).

For the lucky ones that are able to find shares to hold a short position, from past similar situations, after the stock opens ~66% down when it resumes trading (this is the prime time to cover as people/institutions holding the stock are rushing for the exit at the bid), there could be a short squeeze where the stock can potentially go up 50%. After the squeeze, the stock will drop back down again. While that might cause you to think that its an opportunity to make a quick buck, don’t go there. If its already so hard to close an existing short position such that short sellers are buying into a squeeze, its even much harder to take two steps to initiate a fresh position then close it even higher. Of course if your company doesn’t recover from the halt and goes bankrupt (e.g. Chapter 11 or Chapter 7), your short stock position can be closed as though you buy-to-close at $0.

Can There Be a Massive Short Squeeze?

There is always some “debate” in the forums during that halt as to whether a massive short squeeze can be triggered after trading resumes.

What the Longs Say

1. The short interest is way high relative to the float (can even exceed the float). The shorts will need to cover their positions, which will cause a short squeeze.
2. SEC enforcement of Reg SHO will force the brokers to force cover short stock positions.
3. Massive short squeeze has occurred before in other stocks. Corus Bankshares jumped from $1 to $8 on a massive short squeeze  before being closed by the FDIC in 2009.
4. Shorts have to pay a high interest cost to maintain the short, such as a hard-to-borrow fee for stocks that are tough to find (this is dependent on each brokerage). Such interest can range from 7.5% p.a. to 200% p.a. on the dollar amount of shares shorted. China North East Petroleum (NEP) was halted from May 26, 2010 to Sep 08, 2010 (inclusive), i.e. 106 days, or 3 months 14 days. The interest to be paid could kill the shorts during the halt.

What the Shorts Say

1. Put writers that get stock assigned to them may not have enough equity in their margin account, especially when such risky stock requires 100% margin. This will trigger margin calls and pressurise them to dump.
2. Exercise of put options creates a short stock position (put holder) and an equal long stock position (put writer) at the same time. The person with the short stock position can essentially borrow from the equal long stock position, so the “short situation” has not worsened at all.
3. Most brokers will not ask clients to immediately cover their short stock position if they meet the margin requirements.
4. Institutions owning the stock will be forced to dump the stock to adhere to their internal rules.
5. All longs will rush for the exit, no one will be so naive to trust that all longs will cooperate with high limit orders. If there is any spike in the price, longs will rush to sell, effectively ensuring that the price stays down.
6. The longs’ trust in the company is already shattered, it will take good news and the stock price to rise for the shorts to lose.
7. The same situation happened with RINO and people were selling at the bid when the stock resumed trading on the pink sheets.

Case Study (RINO)

RINO was a China-based maker of water treatment / pollution control equipment.

Institutional Holders (below RINO blew up): UBS, Bank of America, Deutsche Bank, Barclays and Credit Suisse. Eric Jackson (TheStreet.com) reported that Deutsche Bank increased its RINO position by 38% in 3Q 2010.

What’s the Solution?

1. Don’t play such a situation in the first place.
2. If you are using puts for protection, own the stock (duh!), if you are worried about taking up too much of your capital, reduce your position, don’t risk it.
3. Buy put options with expiration some months (2-3 months) out if you expect a significant event around a certain time so that the stock would have resumed trading before your options expire.
4. Buy put options on other stocks that will drop significantly (but does not have an impending event that could get it halted) if this stock got halted. Note that the prior correlation does not matter. It is a case where when bad things happen, suddenly correlation increases towards 1. E.g. if a Chinese RTO stock got hammered, many other Chinese RTO stocks will get hammered as well.

SCENARIO #2

This scenario is a more typical scenario that people would usually think about. That is, the stock does not get halted, but it stays at a level above your strike price until option expiration. After option expiration, it can drift down or not. This would be a tough situation because you would have to make a determination based on the facts at that time whether or not to exercise your option, depending on whether you think the stock is heading down. If you don’t own the stock, the option to exercise your put may not be available to you if the stock is heavily shorted.

While buying puts with expiration further out does help, it naturally comes with a high cost. There is no easy way around this, the best way is to buy your protection when the stock is at a high so that you are buying protection cheap. If the stock fluctuates up and down with high volatility, the recommendation would be to buy more protection than you need when the stock is high, sell the extra protection for a profit when the stock is low, and repeat. If in the event that the stock goes further down, you have the minimum protection that you need. If the stock goes up, you just make less because of what you paid for the extra protection.