Does IB take responsibility? An amazing story

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Option Trader

I mentioned on the link of "Danger of IB: True or False?" that liquidation in my partner's account had just occurred of over 200 box spreads due to the auto-liquidate software. The total net loss seems was $11k. IB had encouraged to file a complaint to enable them to review it. Although some people have thought IB could be unreasonable, we will see here what they will do in this case, where seemingly the fault is quite clear. Other people are welcome to share their comments and concerns.

Backround: Box spreads are hypothetically risk-free, and therefore do not require any margin. Yet, after opening the positions, my partner found out that IB had some type of restriction to not allow the Gross Position Value (GPV) to be exceed a certain size relative to net liquidation value. We had no idea that existing positions had to keep the right ratios in real time, otherwise there would be liquidation. After the liquidation occurred (which we believe was handled improperly by the auto-liquidate), someone in corporate IB pointed to somewhere in writing that mentions this can happen, while my partner's claim is that this information should have been shared by IB, because they were in constant communication, and IB was aware of the positions, and was aware my partner did not know of the liquidation concern.

Stay tuned, here is one of the two sections of the complaint (with a few minor changes). Next week, I may provide the second half.

REASONS THE MANNER OF LIQUIDATION WAS HANDLED IMPROPERLY:

1. Even when a broker has the right to protect himself by liquidating positions of a client, the broker is required to do it in a manner that will not unnecessarily damage the client.

2. Orderly liquidation would have reduced GPV by $100k, while the auto-liquidate reduced the positions by about $500k. The fact IB has software to handle liquidation of positions does not give IB more rights that a live broker handling the problem. A live broker would have liquidated two specific legs (totalling 100 options and 50 box spreads), while the auto-liquidate broke down 240 box spreads, and therefeore ultimately approximately 960 options.

3. The fact that $500k in GPV had to be liquidated to cover a cash shortage of $2k in the account indicates that auto-liquidation is not an effective method to handle GPV problems and does not replace a live broker--especially noting the results were marginal at best, because the system began again the next trading day.

4. The fact that a $2k cash shortage requires $100k in Gross Position Value ("GPV") to be liquidated (based upon 50:1 leverage), makes it doubly important for the broker to inform the client to give him the opportunity to wire in funds.

5. Since other or most brokers do not feel it risk to have this policy of limiting GPV, IB, who chose to apply this limit, should not also apply this limit in real time position value, and definitely not to auto-liquidate (and if to auto-liquidate, only if it were an effective means of handling the problem).

6. Although the purpose of the liquidation versus GPV limitation is to protect the broker, but the liquidations on February___ left loose legs and unhedged positions, which did not decrease, but increased the risk to both the client and broker.

7. Some of the options legs liquidated by the IB software did not decrease, but increased the problem of the ratio of net liquidation value versus GPV, by liquidating low priced out-of-the-money legs at market at below net liquidation value.
 
To paraphraase, here are some of key theme questions relevant to my partner's misunderstanding with IB. I would love to here feedback.

Caption 1: "How a $2k intraday cash shortage led to $500,000 in option positions being broken down."

Caption 2: "Does a broker's right to reduce a client's position size exempt him from responsibility to liquidate in an orderly manner?"

Caption 3: "Will your broker take responsibility for faulty liquidation software?"

Caption 4: "Is your money safe in the account of a broker who uses automated liquidation software?"

Caption 5: "Must a client personally verify with upper management that the representations reported over to him by a broker representative are complete and can be relied on?

Caption 6: "Is a securities attorney needed before you open an account with a discount broker?"
 
I direct your attention to the "View... Account..." window of IB's TWS software. 1. In the prominently featured "Margin Requirements and Trading Limits" panel, do investors with large box spreads get any indication that they are running close to the edge? 2. In the "Portfolio" panel, would using the "Liquidate Last" feature have protected your spread? Or are all your contracts "Liquidate Last"... (I'm prepared to be wrong about these above questions, I don't trade box spreads so I just don't know).

The above is just for the gallery. For the judge and jury, IB will show them the papers you signed which state that you read about and acknowledged these obscure restrictions, case closed. That said, its important that people air these matters out in this forum.

It may be that IB's technical support should have known that you were out of toilet paper and come over to your house to change it for you, but its unreasonable to expect any firm to live up to that standard. They can't have a staff of lawyers manning tech support. I don't mean to direct any of your anger away from IB and towards me, but as I watched your previous thread unfold, it seemed to me, and perhaps others, that you were heading for a fall.
 
Reply to Luh3417:

So we will "spill the beans" regarding the other section a little earlier than expected.

What would have been needed was liquidate first, not liquidate last. That was something that the auto-liquidate was supposed to handle.

When you mention about heading for a fall: your sense that something sensitive was at stake (which happened to be the box spread positions) was accurate, and was the reason for all the communication with IB directly (numerous e-mails) and via Elite Trader (on the other thread).
Specifically, there was an exchange of approximately 15-25 e-mails regarding why the system was stopping the positions from being made bigger! and if auto-liquidate was posing a threat to the existing box spreads--albeit the topic of the latter was assignments, it was obvious to IB that my partner was oblivious to the real-time liquidation threats, and also obvious to IB that my partner was extremely concerned to not have the delicate positions at the mercy of an automated liquidation system. My partner even made a specific request from IB to forward any information they have regarding box spread limitations!!

I am not sure if you are right about limitations to to IB's responsibility for their representative's communications in writing with customers, but regardless, he brought the issues to the attention of Proserve, and/or the Chief Man in the margin department.

Finally, you mentioned anger; but that is not the word. As I mentioned on the other post, a company can have a problem, and the question is if they rectify it: a) compensation-wise, b) in IB's case, minimally, reprogramming auto-liquidate to find the leg(s) or spread(s) that cause the biggest problem to their ratio of liquidation value versus position value; also the lag time MUST be increased between liquidating legs, so that the system can update and recognize what the previous liquidation step had already achieved--as the main destruction occurred in 11 seconds, leg after leg till 448 of the wrong options were liquidated, and breaking up 172 box spreads.
 
Quote from Option Trader:

..... As I mentioned on the other post, a company can have a problem, and the question is if they rectify it: a) compensation-wise, b) in IB's case, minimally, reprogramming auto-liquidate to find the leg(s) or spread(s) that cause the biggest problem to their ratio of liquidation value versus position value; also the lag time MUST be increased between liquidating legs, so that the system can update and recognize what the previous liquidation step had already achieved--as the main destruction occurred in 11 seconds, leg after leg till 448 of the wrong options were liquidated, and breaking up 172 box spreads.
More...

I think that the behaviour in this case from your vendor is standard .... and I would say that your response is appropriate.

As a side note I have examined all of this and previously determined that I would not allow option trading through IB's platform until and if things are improved ....
 
"Liquidate First" would be a good improvement to TWS. I guess for now all one can do is set everything BUT the "Liquidate First" to Liquidate Last.
 
Hope you win. That sounds like a company who doesn't care what damage they cause, or how they hurt people. Imagine how the market-makers celebrated when they got a locked-in, instant, arbitrage profit of 11k as the box spread was unwound. Everybody recognizes IB has to protect themselves - but they've got this part of it wrong.
 
The setting 'Liquidate Last' still may be ignored - and probably will be ignored when needed most.

(Murphy´s Law)
 
Quote from Option Trader:

I mentioned on the link ... etc ... net liquidation value versus gpv, by liquidating low priced out-of-the-money legs at market at below net liquidation value.
More...

Without responding specifically to OptionTrader's statements (which would involve inappropriate disclosures in a public forum), I would like to address some of the issues in principle and to clarify IB's approach to risk management.
  • Box spreads are not risk free. They have interest risk, or in case of american style options, dividend and early assignment risk.
  • US option margins are based on an antiquated strategy/rule based model that does not correctly identify interest risk
  • IB's 50:1 gpv/netliq constraint is specifically designed to put a limit on the development of large positions in apparently risk-free strategies
  • the gpv requirement measures position size, not position risk. The two metrics can be related, but in the case of box spreads position size vs risk is reasonably orthogonal.
  • ANY portfolio that utilizes extreme leverage is risky.
  • IB's boundary for risk/position compliance is clearly defined and sharply delineated. We don't have a fuzzy gray area. when an account violates one of the risk conditions (margin, regt, gpv, commodity delivery, etc), we make the account compliant.
  • ANY liquidation is sub-optimal. We don't want to liquidate. It doesn't make for happy traders regardless of whether it is optimally handled or not. At the end of the day, people don't want others controlling their assets, positions, trades, etc. IB would far prefer that traders manage their own positions in an appropriately judicious way.
  • All risk management perspectives caution against the use of extreme leverage. All advise against large concentrated positions. It takes just a small change in market conditions to put a highly leveraged portfolio into risk non-compliance.
For example:
  1. lets consider an account with 46K in netliq and a gpv of 2.3M. The account holds short 1000 25-point boxes in some med-long dated european exercise US option. At a given (compliant) point in time, the box is worth (and is properly priced) at 23.
  2. It is within the gpv 50:1 limit by a smidgen and there is plenty of excess liquidity for margin purposes as the entire position is in a box.
  3. Now, due to marks on not-so-liquid contracts, the box gets a realtime value of 23.2. This doesn't take too much bad luck since there are 4 legs and the options have a bid-ask spread of 0.10-0.20 each leg.
  4. The account's net liq gets hit for 0.20 on 1000 boxes, -2000 USD. With a new net liq of 44K, the maximum position value would be 2.2M so IB starts a close out process by submitting orders (automatically) in each of the 4 legs for positions worth 100K. So far, undesired but still OK.
  5. The exchange market in each of the four options in the box get hit with market orders as liquidations are always market orders. This of course drives the prices even further against the position since closeouts always do. Quotes change and the new value of the box might be 23.4.
  6. The process starts again and will continue until the market pricing stabilizes and absorbs the liquidation orders without further fading.
    [/list=1]
    In the above example, had the account stayed at any leverage reasonably below the threshhold or was composed of a more diversified portfolio even at 50:1, the above scenario would have been largely avoided.

    IB has manually supervised but automation implemented risk management principles. We avoid the problems of human oversight in our risk mgmt approach by structuring algorithms to measure risk and implement reduction policies. We do not offer time intensive, account specific hand-holding for regular situations. When something truly unusual arises that requires the analytcal skills available more in people than in systems, our risk mgmt team takes over.

    IB has an autoliquidation model. We don't make margin calls and we don't let accounts promise to wire in money after the account is already in a deficit. This translates into lower losses to IB which in turn allows us to make the insurance component of our commission model minimal. People may not realize it, but there is an bad credit contribution implicit in all commission models and it is funded by clients on every trade. Indirectly, poor credit accounts are subsidized by quality accounts in the form of higher commissions. If we don't take the losses due to classics like "check's in the mail", we can continue to offer low commissions in a high-tech environment. Like driving a ferrari for VW prices.

    OptionsTrader made some statements about a more personalized post-problem support. While the statements may be appropriate in some environments, such support is not free, and that too translates into higher commissions. IB's approach is to give people the tools/data to manage their own risk and compliance with financial requirements before there is a problem.
 
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