Can a ( stupid ) client exercise a worthless option?
Hi WSO Trading forum,
You are a sell-side trader. Suppose your client bought an stock American option from you. He is long a call of stock XYZ strike 100.
Now XYZ is trading at 95. As he is a stupid investor, he decides to exercise the option to buy stock XYZ at price 100, which I know is a more expensive price than 95.
My question: do you have the ABILITY to LEGALLY execute the trade to sell him XYZ at 100, the strike of the option. The inference here is that the client is stupid and that you make a quick 5 as a result of this.
Please only answer if you're a trader in an IB. I emphasize - this is a question of the ABILITY, considering both ACCOUNTING and LEGAL aspects, to process the sale at 100.
Cheers,
Nijikon
I'd be happy to respond, although I am not a sell side trader... Would you like me to?
Hi Martinghoul, your experience and previous valuable comments make you an exception. Please respond.
Haha, now I feel all special...
The answer is this (to the best of my knowledge): whether or not to exercise an option is always the choice that belongs to the party which is long. If that party chooses to exercise in a manner which appears suboptimal, there is no reason a priori why they shouldn't be able to do so (after all, there are possibilities where what you perceive as suboptimal is actually perfectly sensible, given specific circumstances, as mentioned by another poster). The main thing here is that the option contract doesn't involve any decisions by the seller, who mechanically does whatever the buyer instructs.
I have encountered cases where some listed options were exercised in a genuinely suboptimal fashion to the tune of a few million USD. In that case it was due to a clerical error, but when people were asked by the exchange if they would return the money, they refused, as was their right.
Now the more ambiguous point here is that the above, which is based on the legal language of the contract, wouldn't preclude the client from suing the bank. While a lot of such recent lawsuits involve much more exotic products than simple options, the logic is very similar: the evil bank took advantage of a dumb unsophisticated client. That's something to be aware of.
Considering an option is a legal contract to buy/sell at a pre-specified price, why wouldn't you be able to excise? My understanding is this would be possible for exchange traded options considering you are not required to exercise an ITM option at maturity. I don't see a reason why OTC options would be different unless there is specific language excluding it in annex. Not quite sure how this would be handled for accounting purposes..
One thing I would like to touch on - unless this is a very vanilla trade don't assume the person excising is being stupid. It can make sense to exercise an option that is slightly out of the money for liquidity purposes if the security trades in a thin market. I can also think of other situations where this could make sense if the option is part of a larger option package of traded against the underlying asset. There could also be potential tax and accounting benefits to doing something like this, but I am no accountant.
Hope this helps..
Thank you jbuckets. What I've been hearing that is for an exchange traded option, the client can only exercise if the option was IN THE MONEY. Hence, my question of this ( stupid ) investor being able to exercise the option buying the underlying at a higher strike price (100) than the current price (95).
Yes, I thought this question might come down to the actual language of the option. This was what I was told.
The sell-side trader can only go to the client with the following:
Case: XYZ trading at 105. Strike at 100. "Sir. XYZ trading at 105. Would you like to exercise your option to buy at 100 and sell at 105 making a profit of 5?"
Case: XYZ trading at 95. Strike at 100. The sell-side trader is NOT allowed to say "Sir. XYZ trading at 95. Would you like to exercise your option to buy at 100 making your current mark to market of XYZ at -5".
Of course, the client hearing this will say "F*** off."
What I was really asking is the possibility of this scenario: Client: "Trader. I'm exercising my option to buy XYZ at 100." Trader: "Sir, you know you can buy XYZ at 95 right?" Client: "I don't give a F***. Just exercise my option. I'm buying XYZ at 100." Trader: (This client is f*** up) "Sure. Sold XYZ to you at 100." Client: "Thanks. Bye."
And the client has on his books long XYZ entered at 100.
For all legal and accounting purposes, is the above possible?
First off, you don't need to be in IB to understand what you're asking. It's a basic options question and it's really simple. Options are contracts. It's a contract between a two people where one has the right to execute and the other has the obligation to deliver. That's it. Classically speaking, an Options Contract is a promise between a promisee (the buyer and rights holder) and the promisor (the seller, who upon execution is obliged to deliver) which meets the requirements for the formation of a contract and limits the promisor's power to revoke an offer. It meets the classic definition of a contract because the execution price of the option contract (what price the option is bought/sold for) is treated as consideration for legal purposes. Since it fits the definition of a contract and is considered to be a unilateral contract, the rights holder can do what he wants regardless of the economic benefit or harm that the rights holder may incur.
Assuming that this is a standard options contract, if he owns the right to purchase/sell the underlying security, then yes, you have to execute the assignment whether it's for a gain or loss. It doesn't matter what the client is thinking, the client has a legal right to buy/sell his shares whether they option is in the money or out of the money. If he calls you up and says execute my options, you must execute. Even if he asks for your advice, he can disregard your opinion if he wants because your job is to execute whatever trade he gives you. There is no legal ramification for you by following his instructions exactly how he gives them.
As an aside, if I were you're client and you ran through any of those scenarios with me, I would call your boss and chew the two of you out because you are not in the job of telling a client how to trade and he shouldn't be letting trades who do that deal with clients. Even if it's simply telling me I can execute my contract and make money, as a client I would read that as you are questioning my judgment. As a client, I'm not interested in hearing you question my judgment or give me unsolicited advice because your advice, opinions and suggestions may be flat out wrong and counter to what I am trying to do. I'd make sure that I would limit my interaction with you as much as possible for questioning my judgment no matter how good of a trader you are because you spat in my face. Most importantly, I would severely limit my trading with your firm because of it. It's something to keep in the back of your mind when you deal with people, not everyone wants to hear your opinion on what they should do.
I am not at all sure I would agree with the last paragraph...
I may have been a little harsh there and should clarify. If this were unsolicited advice, which it sounds like the OP was implying, I would be pissed. I've had that happen to me where I've inadvertently made a comment about their position (sometimes warranted, sometimes unwarranted) and gotten told off by clients before over it. If I actively solicited the trader's opinion, whether I agree with his take or not, I wouldn't explode. I think that should have been made clearer, but the rest of my commentary on this still stands as true.
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