Rules and Risks

Rules and Risks

Avoiding the PDT rule via butterfly spreads and the risks of early assignment

The recent increase in free time and widespread availability of commission free trading have spurred an unprecedented influx of retail investors (speculators) into the financial markets. Many lack a complete understanding of the rules that govern the actions taken within the account they are using to make trades. This would imply a lack of awareness of various risk factors as well.

The Pattern Day Trader (PDT) Rule

Not created by brokers but simply enforced by brokers

The Pattern Day Trader Rule is one often misinterpreted as specific to a brokerage when in fact it was put in place by FINRA and applies to any and all brokerages whom in turn enforce the rule for margin accounts.

Pattern Day Trader
FINRA rules define a “pattern day trader” as any customer who executes four or more “day trades” within five business days, provided that the number of day trades represents more than six percent of the customer’s total trades in the margin account for that same five business day period.

The SEC has published info on this as well:

Does it really help?

Originally the rule was created to protect smaller investors from the risks that are inherent to day trading. The idea being that accounts with less than $25K were most likely non-sophisticated investors and additional restrictions should limit their ability to day trade since they are 'not fully aware' of the extent of risk associated with day trading.

I would argue that in the majority of cases this rule actually causes more harm than does good. Anyone who wants to day trade is still going to do it anyway to the extent possible. They will most likely lose more money by holding trades overnight so as to avoid the 90-day restriction than they otherwise would have had they closed the position the same day.

Here is an example of what I mean: Suppose gambler trader John has already made 3 round trips (day trades) in the past 3 days. He thinks markets are insanely overvalued and buys a put option on SPY that he plans to hold for a couple of days. An hour or so later the FED puts out a press release saying that they will soon be starting purchases of below investment grade corporate bonds. John laughs since this is old news and was already announced but markets rally anyway. The put position is already underwater.

Now John has 2 choices:

  1. Sell the put to close the position and minimize further losses. This means making a 4th round-trip and a subsequent 90-day timeout from trading.

  2. Hold the put overnight to avoid PDT designation and hope that the overnight ramp in /ES futures coupled with the theta decay do not substantially deepen the loss on the trade.

Looking at this another way, the choice John is facing is between being excluded from participating in the financial markets (which so far in 2020 are as close to a casino as could be) or take on greater risk by continuing to hold a losing position and incurring greater losses than a 'sophisticated investor' who would have sold shortly after the trade went against them since they aren't worried about round trips.

the PDT rule results in smaller traders taking on greater risk just to continue participating in financial markets

Excellent job regulators, thanks again for protecting the smaller investors.

Circumventing Restrictions

There is a difference between tax evasion and tax avoidance which is to say breaking the rules results in penalties but playing by and around the rules is only frowned upon at worst. On Wall St. it is par for the course.

John actually has a 3rd choice in the hypothetical (but highly probably and frequently occurring) situation above because John bought a put rather than sold shares short.

The mechanics of this third choice depends on whether John wants to maintain any exposure to the price movement of the underlying. If so he could sell a put with a different strike (higher or lower depending if he wants net positive or negative delta). The resulting position is now a vertical spread and a portion of the risk has been removed. But let's assume John just wants to get out of the position entirely.

  1. Convert the position to a butterfly.

This is accomplished by selling 2 puts at the nearest strike and buying 1 put at the next nearest strike. The trades executed in a single order (back spread or back ratio) or each leg individually (buy the 1 put then sell the 2 puts). Once complete, the butterfly neutralizes the exposure of the position (close to 0 but not 100%).

Before the age of zero commission trades this is something that would not be as feasible.

Although, in the age of Regulation NMS, I'd recommend John open the 2 additional legs individually lest he enjoy getting the short end of the spread stick (or risk not getting the order filled).

You can read more about why commission free trades are not really free and how exploiting retail investors is standard practice

As an added bonus, John can now use a portion of the original funds to buy calls. Especially now that he realizes that another jobs report comes out tomorrow. Because in this 2020 stock market casino a bad jobs report is good since it means more money printing and good jobs report is even better since the data is never fudged and it would mean the economy is running on all 2 cylinders again.

Early Assignment Risk

Ex-Dividend Date

SPY has an ex-dividend date tomorrow (6/19/2020) and I am curious about the following:

  • How many people have short call positions either naked (hopefully not) or as part of a call spread.
  • How many of those people plan on exercising their long calls to capture the dividend or how many would be able to do so.
  • And finally, how many people are holding short calls likely to be assigned and have no idea about this particular risk.

When the short calls are assigned and the long calls not exercised it will be a bit of a shock but not the end of the world. Come tomorrow, Friday, one would exercise the long calls using the cash balance from having sold short shares via option assignment.

The max loss can be calculated by taking the difference in strike prices and multiplying by the number of contracts assigned. One assumption here is that the number of short contracts is <= the number of long contracts. Theoretically, one could have a gain instead depending on the strikes of the spread at when the long calls are exercised. Furthermore, should the price drop more than would be expected by the dividend payment, one could instead sell the long calls for premium and buy back the shares instead.

Ultimately, the dividend is what inflicts the bulk of the realized loss.

Payments in lieu of dividends

The reason for the early exercise by the call buyer and subsequent early assignment of the call seller is the result of the buyer capturing the dividend. Stocks or ETFs that pay dividends will to those holding shares acquired before the ex-dividend date. No dividends are paid to holders of options. Thus, in some cases like when SPY is going ex-dividend tomorrow, it is preferable to hold shares over call options which is why there tends to be a large portion of calls exercised the day before the ex-dividend date.

An investor/trader that wants to short sell shares (of SPY for examples) they must first borrow said shares to sell. This typically happens behind the scenes with the broker used to place the sell order. The broker typically has other customers with long positions in SPY and they loan the shares to the short seller for the duration of the position. Easy to borrow (ETB) and hard to borrow (HTB) are a measure indicating the availability of borrowable shares.

The person/entity that you sold short the SPY shares receives the dividend since they are long. The lender of the shares you sold is also entitled to the dividend since they are also long. Neither party would even be aware that you are involved except (at least until the lender receives payment in lieu of dividend in the amount of the expected dividend). They both are not able to receive the dividend for the (technically) same shares but are both entitled to the dividend. Therefore the short seller is obligated to pay one of the dividends and wherein the risk of early assignment culminates.

To be clear, the short call is not what results in being on the hook for the dividend but rather being short shares on the ex-dividend date whether it be from early assignment of a short call or simply selling shares short outright.

Fidelity sums this up surprisingly well in the 'Other considerations and risks' paragraph

If you are implementing a spread strategy that includes long contracts and short contracts, you need to remain particularly vigilant in regard to assignment risk. If both contracts are in the money and you are assigned on the short contracts, you will not be notified until the following business day. While you can exercise your long position on the ex-dividend date to eliminate the short stock position that was created, you will still owe the dividend because you were short the stock prior to the ex-dividend date.

Lessons Learned

Tuition at Wall St. University is extremely expensive. Many years ago, I was short calls going into an ex-dividend date for SPY. At the close of trading Thursday, the account was leveraged nearly 50x from having legged into the call spread gradually. I was not unaware of the ex-dividend issue but falsely assumed (just as is pointed out in the above excerpt from Fidelity) that I would be notified if assigned and have the opportunity to exercise the long calls. Wrong.

The next morning, I checked the balance of the account and saw that it was roughly $1,150,000. Since it had been only 4 digits the previous day, I knew there was a problem but I at least I knew exactly what the problem was: All 57 short calls had been assigned. This was around 8:45AM. I called the broker and they pulled up the account info.

I asked only one question: "How long do I have?".
The response: "15 minutes after cash markets open".
"Thank you". Click.

I knew the account was going to be liquidated programmatically but knowing I had a 15-minute window before that happened was quite useful (as well as generous on their part albeit standard procedures). I started putting together the best strategy possible given the circumstances and remaining long calls in the account. The price of SPY was lower than the drop expected from the dividend alone at market open which helped.

After exercising the long calls which were ITM, I was able to buy back most of the shares before 9:45. At that point, I watched the remaining positions liquidate.

I highly doubt that had I done nothing and let everything be liquidated automatically that it would have resulted in a much less favorable outcome. After everything was said and done the net gain/loss (ignoring the dividend) was about +$1500. Still not nearly enough to cover the 6K dividend owed. Needless to say, the account was more than wiped out and I did not trade for a long time after this episode.

I would be lying if I said that for the 30 minutes before markets opened, it was pretty amusing to have an account balance of more than a million dollars. Even if that account was also short 5700 shares of SPY.

For those watching intraday candles, these standard liquidations for overnight margin calls are part of the driving force behind the price action for the few minutes that follow 09:45:000 EST.

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