Despite Picking Big Winners, March's Bank Failures Show Options Can Still Be Tricky

In the next few months, there are likely to be a lot of nervous wait games for options investors, as the failure of Silicon Valley Bank and Signature Bank must create a nervous wait game for options investors. This shows that even winning trades can be risky in the derivatives market. 

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After SVB's closure on March 10 and Signature's closure on March 12, the stocks of both companies were halted - the stock price for SVB was $106 per share and the stock price for Signature was $70 per share. 

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A halt in trading occurred as a result of this action, and the way the regulators and brokerage firms handled the outstanding options contracts, causing difficulty for retail investors. Traders found themselves having to set aside additional funds and take on additional risk in some cases, or they would lose their timely bets in value.

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As an example, even sophisticated retail traders like Shaun William Davies, an associate professor of finance at the University of Colorado-Boulder, whose signature put options had a $50 strike price in their portfolios as a hedge against market volatility on Robinhood, were faced with this problem as well.

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There are several advantages to owning a put option other than the ability to sell the stock at the strike price, as well as the ability to take a bet that the stock will go down. A put contract is also considered attractive due to the fact that it carries a limited downside risk.

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That trade should have been a big winner from a logical standpoint, but Davies' options were technically out of the money based on the stock price at the time, so the shares were now illiquid and the options were technically out of the money. As of March 17, the put options were due to expire, and they were expected to expire on March 17.

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His usual practice is to sell his winning options trades before expiration, so he is not concerned with the settlement process. He explained that he usually sells his winning options trades before expiration, so he doesn't have to deal with it. In order to exercise his options, Robinhood had to be convinced to open a short position for him, and then allow him to close it out whenever the stock returned to trading. 

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A message from Robinhood customer service viewed by Trade Algo indicates that he initially was told that the brokerage firm would not allow him to open a short position. Davies claimed there was no mention of this risk in their options agreement with Robinhood, which described the risk of a stock halt.

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On Monday [March 13], First Republic traded all day, so I should have bought puts on it... In hindsight, I should have done that. On March 15, when Davies thought his options would expire before he could exercise them, he said he had traded the one that had been shut down — which should have been the best hedge, but turned out to be the worst hedge,” because it was shut down. 

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An official spokesperson for Robinhood told Trade Algo that the firm has been reaching out to individuals to help customers resolve the issues with their naked short positions. Davies was later allowed to create the naked short position and, thus, exercised his option. 

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The naked short position, however, caused Davies and other traders in his position to experience an uneasy wait period until the stock started trading over the counter on March 28. Until the stock began trading over the counter, the naked short positions showed a loss on paper. Even though Davies said he had enough cash in his account to cover margin requirements, he was forbidden from continuing his trades until the short position was fully covered.

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Brokerages of other types

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Despite the fact that Davies' confusion was influenced by Robinhood, the broader issues were not only related to Robinhood. It was declared by the Options Clearing Corporation that options should be closed by brokers to brokers, sending investors to a deep dive into their options agreements in order to determine how they should proceed. 

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A tastyTrade CEO, Scott Sheridan, said that since the OCC made its decision, the firm would have to work individually with each customer to help them close out their positions.

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According to him, it is very unusual for the OCC to just dissolve its obligations after a situation has arisen, as they are responsible for all options-related matters, which they oversee. 

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The Fidelity Group also explained in a post on Reddit that investors with put options are more likely to need to contact the company's representatives to exercise their put options. It is important to note that, even though Fidelity had marked Signature and SVB down to zero, the need to create the necessary short position would require posting a cash margin of $10 per share in order to make the necessary short position possible. 

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Some accounts were more difficult to unwind than others due to the fact they had put-spread positions that include multiple options, Sheridan stated. It was easier for the traders to figure out the trades with simple put options. Those traders who had short put positions had to buy the stock at the strike price in order to get a profit, which resulted in losses for them.

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Further, Sheridan said that brokerages have to adhere to regulatory minimum margin levels on short positions which must be imposed by regulators, and that sometimes additional margin is required for firms to manage their risk - not just to facilitate more profits for the firm. 

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There is a reason firms have risk margin departments because that means they aren't making decisions that are in their best interest. In the end, customers don't want to hear from the risk margin department because it means something isn't looking good to the firm. You simply have to control the business and control the customers. There were a few accounts that were debited, but from a financial perspective, it was nothing more than a minor wound when compared to what was going on around us. 

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Furthermore, some types of accounts, such as retirement plans, are not permitted to hold short positions, which means that traders and brokers have to take further steps to close out short positions, which creates additional hassle for them as well. 

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Uncertainty lingers in the air

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After Davies had been able to enter his short position against Signature Bank, the stress of the trade did not go away even after he had entered into his short position. The options traders rushed to close out their positions, which left him with only a small gain or possibly even a loss on the trade since he was concerned about whether the stock would begin trading at a higher price as traders rushed to close out their positions. 

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In 2021, certain retail brokerages were caught off guard by the meme stock craze that caught many off guard in the retail industry at the time. I was somewhat nervous about that because I thought they would close it out at some ridiculously high price. 

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The ordeal made Davies reevaluate the basics he preaches to his college students about living a life of success and financial security. He was eventually able to cover his short position by paying just 20 cents per share - making a nice profit.

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As a professor of derivative securities at the University of Colorado Boulder, Davies admits, "I had my tail between my legs, since I teach my students how to refrain from trading derivatives and how to be passive investors," he says. 

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