 |
| By Nilus Mattive |
Something fundamental was lost in the debates about SVB Financial Group and Signature Bank of New York.
Some investors were right about them and still got screwed.
These investors didn’t need any bailouts. Yet they might have ended up without a penny to show for their foresight.
I’m not getting into the specifics of how depositors were backed, and investors were left to fend for themselves... that’s a topic for another day.
This is about a group of investors with some $292 million at stake that were locked in worry for two weeks despite doing nothing wrong.
You see, when news hit of the runs at those two banks, trading of their shares was halted. This is nothing new and can be crucial to minimize pariah speculators taking advantage.
What you likely haven’t seen on any news broadcast or read in any newspaper about this trading freeze was its subsequent effect on option holders.
Specifically, I’m talking about the $114 million in SVB Financial puts and $178 million of Signature puts that were also frozen.
Frozen Stocks,
Broken Options System
A put option gives the holder the right to sell shares of the underlying security at a set price at any time prior to that contract’s expiration. And that’s where the problem comes in.
Stocks don’t have this time element. If it takes weeks or even months to figure out who is owed what if anything at all, that’s all right. For an option holder or seller, they can’t wait.
Here’s the catch-22, however. When shares aren’t trading, the derivative options can’t trade or often even be executed. Meaning, despite the legal contractual right to sell shares — or buy them in the case of call options — there are no shares trading. Those shares still exist. But they are frozen.
This is a study of what happens to option buyers and sellers when something dumb happens in the market.
Investment Insurance
There are many reasons to buy or sell options, often not just for speculation.
Take the nearly $300 million in put options on those frozen banks’ stocks. Much of that money was locked in as hedges. Investors who owned shares of Silicon Valley Bank, for instance, might have seen shares sliding ahead of the run on deposits.
To hedge their long equity position, they bought puts. This allows them to theoretically sell some of their shares at a set price. That way, even if shares completely collapsed, they had some downside insurance.
Almost no one would blame them for this cautious decision. In fact, it proved the right move. But when the shares were halted, so were those options. In most cases, they were not able to execute their contractual right to sell shares.
The unfairness of this situation is not lost on people on all sides of the equation.
For example, angry SBNY put holders even set up a website: SBNYputs.com. You can read some true option horror stories there. And even though SBNY has since resumed trading, that did nothing to help people with options that expired in the interim.
Similar problems arise on the sell side of options, too. While selling cash secured puts is a conservative strategy, it can come with a major downside. They are on the hook to buy those shares at the prearranged strike price.
But what happens if shares are frozen? Do they get to keep the option premiums they collected even though their trade went about as bad as imaginable?
Fates Left up
to the Broker
Options Clearing, which is one entity in charge of settlements of option contracts, does have a long-standing position on all of this.
In a memo dated Jan. 3, 2012, the OCC has the discretion to apply exercise-by-exception procedures on affected options in the case of trading halts.
Ex by ex is simply automatic exercising of options that are expiring in the money. Unless trading begins before expiration, ex by ex does not apply. In other words, the OCC will simply let the option holder lose his or her money.
However, they do still have a contract with the option seller. So, they must go through their broker to manually execute their option contract. Here’s where the second problem comes in.
Brokers don’t handle this particularly well. A quick scan of the responses those SBNY option holders posted from their brokers shows that everyone was trying to pass the buck. In some cases, the brokers were encouraging put holders to just suck it up and take the loss.
If the option holder controls the shares of the underlying security, they have a pretty good chance of being able to execute their option, as long as their broker allows it.
If, however, a put option holder simply holds the option contract but not the underlying shares, they may very well be out of luck.
For the option seller, this could mean anything from legally playing a “Get Out of Jail Free” card and keeping their premium … to getting absolutely wiped out. It just depends on the luck of the draw.
This is why even the most conservative investment strategies should always be paired with analysis and understanding of the risks.
Bottom line: Even if you did the right thing regarding SVB or SBNY, you could have gotten screwed … and that should be a wake-up call to investors of all types.
Best wishes,
Nilus
P.S. My colleague and Startup Investing Specialist Chris Graebe announced a huge opportunity just last week. Equity crowdfunding, an alternative funding that allows regular, nonaccredited investors to invest in early, pre-IPO companies, is a rapidly growing space. And he’s found a company poised to disrupt a $100 billion industry. Click here to learn more about how to claim an early stake.
