a long story about an arcane bit of option's past.
(For those of you too unfamiliar with some trading terms, there is a good financial dictionary here.)
I first saw an options exchange (PHLX) in 1979. The exchange was still upgrading from chalkboards to monitors (and we still called the screens “chalks” for years afterwards). Back then, back-office systems were slow and not computerized. Everything was paper, almost. Options expired on the Friday before the 3rd Saturday. The Saturday morning after Friday expiration all the clerks would work to do a final reconciliation. The rules were written so that options didn’t really expire until that last trade balancing occurred.. That way, the clerks wouldn’t be breaking any regulations by creating balance.
That rule was written lax.
Farmer’s Group Insurance was a stock whose options were listed on the PHLX throughout the late 80s. At the time relevant, the company had some news issues pending involving decisions to be made by a state regulator (I want to say in California, but I can’t really remember which state), in any case, the stock was trading big and funky, there was a lot of betting on what the regulator would do. (The exact issue is immaterial here, just assume one decision would be good for the stock price, the contrary decision bad.) The decision had been pending for some time, a few weeks, and that had been affecting the option pricing.
On that expiration, it was late in the day and the stock was trading a few points above strike (55, I think, but not certain). The expiring puts were trading with considerable value, as they had been all week, but they were STILL around 50 cents bid even though the stock was almost closed for the day (and more importantly, the near term options expired worthless, for good). Many different market makers had wandered by the pit that Thursday and Friday to get a sense what was happening. Quite a few of those sold a couple of puts, for the action. The market makers in the pit had been selling harder than others and were short plenty, they were much perplexed by the never ending bid. They were all short some type of risk, a lot of the talk that day was trying to figure out what that risk was and how to properly hedge it. One of them sold another 500 put contracts in the last hour, saying “well, if these puts are much in the money I’m bankrupt anyway, let the clearing firm worry about it.” (A very unethical and rare type of opinion, one which brought him much contempt.)
The market closed. The last trade in the stock was well above the strike price of that heavily bought put. The selling market makers went home feeling pretty good about their situation.
A few hours later, that state regulator issued the awaited decision. Probably he didn’t know anything about how his decision might affect option markets. Probably. Regardless, the news was bad for the stock price, even if the stock couldn‘t move during off-hours to reflect that. The holder of those puts exercised them, even though the stock was trading somewhat above the main strike price. He was willing to sell FGRP down about 5% from the last sale, so he used his puts.
But option expiration had already come and gone….hadn’t it?
People who price options are very careful to make sure they use the correct expiration date, that is very important to determining fair price. Sophisticated traders who work intraday will factor in, not merely the date, but the time of day. Back when FGRP happened, few knew to do this. Few knew exactly when options actually expired. The clearing firms of those couple of big long put exercisers were stuck in a tough place, sort of. On the one hand, option exercises had to be submitted by 4:30 Friday. That was their “rule. They enforced that “rule” on their clients every expiration. But here were a few big clients wanting to exercise “late”.
Of course, the clearing firms did what their big clients demanded. Let someone else sort it out.
The next morning, the clerks of the put-selling market makers had a very difficult time reconciling the trades and making them balance. Their bosses had told them (or they knew themselves) how much long FGRP stock to expect. Many of them were receiving more than thought.
On Monday morning, each of those put-selling market makers had all of that “extra” long stock in their accounts. The stock opened down, falling about 10%, well through the strike. It was painful for many of those floor traders.
The arbitration cases went on for years. I know, I did a lot of them.
Eventually, settlements were made and the rules were redrawn more clearly.
FGRP was an event that moved the exchanges more quickly to computerization and more forcefully to writing clearer and better known rules. This situation showed how important it was to know as much relevant information as can be known before risking huge blocks of money.
Hope that wasn’t too boring…smile
I first saw an options exchange (PHLX) in 1979. The exchange was still upgrading from chalkboards to monitors (and we still called the screens “chalks” for years afterwards). Back then, back-office systems were slow and not computerized. Everything was paper, almost. Options expired on the Friday before the 3rd Saturday. The Saturday morning after Friday expiration all the clerks would work to do a final reconciliation. The rules were written so that options didn’t really expire until that last trade balancing occurred.. That way, the clerks wouldn’t be breaking any regulations by creating balance.
That rule was written lax.
Farmer’s Group Insurance was a stock whose options were listed on the PHLX throughout the late 80s. At the time relevant, the company had some news issues pending involving decisions to be made by a state regulator (I want to say in California, but I can’t really remember which state), in any case, the stock was trading big and funky, there was a lot of betting on what the regulator would do. (The exact issue is immaterial here, just assume one decision would be good for the stock price, the contrary decision bad.) The decision had been pending for some time, a few weeks, and that had been affecting the option pricing.
On that expiration, it was late in the day and the stock was trading a few points above strike (55, I think, but not certain). The expiring puts were trading with considerable value, as they had been all week, but they were STILL around 50 cents bid even though the stock was almost closed for the day (and more importantly, the near term options expired worthless, for good). Many different market makers had wandered by the pit that Thursday and Friday to get a sense what was happening. Quite a few of those sold a couple of puts, for the action. The market makers in the pit had been selling harder than others and were short plenty, they were much perplexed by the never ending bid. They were all short some type of risk, a lot of the talk that day was trying to figure out what that risk was and how to properly hedge it. One of them sold another 500 put contracts in the last hour, saying “well, if these puts are much in the money I’m bankrupt anyway, let the clearing firm worry about it.” (A very unethical and rare type of opinion, one which brought him much contempt.)
The market closed. The last trade in the stock was well above the strike price of that heavily bought put. The selling market makers went home feeling pretty good about their situation.
A few hours later, that state regulator issued the awaited decision. Probably he didn’t know anything about how his decision might affect option markets. Probably. Regardless, the news was bad for the stock price, even if the stock couldn‘t move during off-hours to reflect that. The holder of those puts exercised them, even though the stock was trading somewhat above the main strike price. He was willing to sell FGRP down about 5% from the last sale, so he used his puts.
But option expiration had already come and gone….hadn’t it?
People who price options are very careful to make sure they use the correct expiration date, that is very important to determining fair price. Sophisticated traders who work intraday will factor in, not merely the date, but the time of day. Back when FGRP happened, few knew to do this. Few knew exactly when options actually expired. The clearing firms of those couple of big long put exercisers were stuck in a tough place, sort of. On the one hand, option exercises had to be submitted by 4:30 Friday. That was their “rule. They enforced that “rule” on their clients every expiration. But here were a few big clients wanting to exercise “late”.
Of course, the clearing firms did what their big clients demanded. Let someone else sort it out.
The next morning, the clerks of the put-selling market makers had a very difficult time reconciling the trades and making them balance. Their bosses had told them (or they knew themselves) how much long FGRP stock to expect. Many of them were receiving more than thought.
On Monday morning, each of those put-selling market makers had all of that “extra” long stock in their accounts. The stock opened down, falling about 10%, well through the strike. It was painful for many of those floor traders.
The arbitration cases went on for years. I know, I did a lot of them.
Eventually, settlements were made and the rules were redrawn more clearly.
FGRP was an event that moved the exchanges more quickly to computerization and more forcefully to writing clearer and better known rules. This situation showed how important it was to know as much relevant information as can be known before risking huge blocks of money.
Hope that wasn’t too boring…smile