March bank failures show tricky options even as traders pick winners

The sudden failures of Bank of Silicon Valley And Signature Bank last month created a nervous waiting game for options investors, showing that even winning trades can be risky in the derivatives market.

The shutdowns of SVB on March 10 and Signature on March 12 led to stops for the shares – at $106 per share for SVB and $70 per share for Signature.

This shutdown, and the way regulators and brokerage firms have handled open options contracts, has turned simple trades into a big headache for retail investors. In some cases, traders had to put in extra money and take potential risks or see their opportune bets expire worthless.

That was a problem for even more sophisticated retail traders such as Shaun William Davies, an associate professor of finance at the University of Colorado-Boulder, who had purchased Signature put options on the brokerage platform. Robin Hood with a strike price of $50 as a hedge against market volatility.

A put option gives its holder the right to sell the stock at the strike price and serves as a bet that the stock will go down. A sales contract is also attractive because it has limited disadvantages for the holder.

Logically, this trade should have been a big winner, but Davies’ options were technically out of the money, based on the last traded price – that is, the stock price at the time was above its strike price of $50 – and the shares were now illiquid. The put options were due to expire on March 17.

Davies said that generally he would sell his winning options trades before expiration, so he doesn’t have to deal with the settlement process. But the stop meant he had to convince Robinhood to open a short position to exercise his options, and then allow him to close out the short position whenever the stock started trading again.

The brokerage firm initially told Davies it would not allow him to open a short position, according to messages with customer support viewed by CNBC. He said there was no mention in the options agreement with Robinhood that highlighted this risk if the shares were stopped.

“In hindsight, I should have bought put options on First Republic or something…First Republic traded all day Monday [March 13]. I happened to trade the one that was closed – which should have been the best hedge, but it turned out to be the worst hedge,” Davies said on March 15, as he thought his options expire before they can be exercised.

Robinhood then allowed Davies to create the naked short position and thus exercise his option. A Robinhood spokesperson told CNBC the company is contacting customers one-on-one to help resolve issues.

However, there was still a tough waiting period for Davies and other traders in his position. Naked short positions showed a loss on paper in his account until the stock began trading over-the-counter on March 28. While he had enough money in his account to cover margin requirements, Davies said he was prohibited from making any further trades until the short position was covered.

While some of Davies’ confusion may have related to Robinhood, the broader issues weren’t limited to just one broker. The Options Clearing Corporation said the options are expected to close on broker-to-broker basissending investors digging into their options agreements to determine next steps.

Scott Sheridan, CEO of tastytrade, said the OCC’s decision meant the company had to work with customers individually to help close their positions.

“It’s unusual to see the OCC wash their hands of a situation. They are the judge, the jury and the execution for all matters related to options,” he said.

Likewise, in a post on RedditFidelity explained that investors who held put options would likely need to call a company representative in order to exercise the put option. Creating the necessary short position would require posting a cash margin of $10 per share, even if Fidelity had reduced the price of Signature and SVB to zero.

Trades with single put options were relatively easier to understand, but some accounts had put spread positions that include multiple options and were harder to unwind, Sheridan said. Some others had short sell positions, forcing them to buy the stock at the strike price, resulting in losses for traders.

Additionally, Sheridan said, there are regulatory minimums for margins that brokerages must impose on short positions and sometimes additional margin is needed for business risk management – ​​not a way to generate more profit. .

“Clients never want to hear about a risk margin department because it means something doesn’t look good for the business. But there’s a reason companies have a risk margin department. You just have to control the activity. We had a few accounts that were in debt, but from my perspective that was a minor injury to us compared to what was out there,” Sheridan said.

Another difficulty is that certain types of accounts, including retirement accounts, are not allowed to hold short positions, which created additional steps for traders and brokers to close the trade.

Even once Davies was able to take his short position against Signature Bank, the stress of the trade did not go away. He said there were concerns whether the stock would start trading higher as options traders rushed to close their positions, leaving him with only a small gain or even, in theory, a loss on the trade.

“I was super nervous about it, that they would close it at a ridiculously GameStop price,” Davies said, referring to the the meme stock craze that caught some retail brokerages off guard in 2021.