Quote from jimrockford:
Let me first explain it with cash-settled options, and then with physically settled options.
If you are trading a spread on American style, cash-settled options, then you face the following risk of extreme uncontrolled loss:
A strong market move puts the spread deep in the money at the close of trading. The short option leg is exercised, generating a huge loss. You take comfort in your long option leg, which will limit that loss, with profit left over to spare. It is, however, too late to exercise your long option leg on the same day, because you didn't receive notice of assignment on the short leg until after it was already too late for you to issue early exercise instructions (note this will always be the case). So you resolve to exercise the long option leg as soon as possible, which would be the following trading day. So you are perfectly safe, right? Wrong.
You wake up and learn that the market has gapped open violently in the opposite direction from yesterday's big move. It keeps going and never looks back. Your long option leg becomes worthless by the close. You issue exercise instructions, but you get no cash because your long option leg is now worthless. You are now stuck with the entire loss generated by the short leg.
But there is another thing that can go wrong. Suppose the loss generated by the short leg so severely reduces your account equity, that you are in violation of margin rules. The long option leg counterbalanced this loss by becoming extremely valuable, but because it is an option, its value DOES NOT count toward measuring your account equity or satisfying your margin obligations. The broker now has the right to liquidate your long option leg by selling it before you have a chance to exercise it. The broker wishes to do this in order to generate some cash, which would count toward your account equity and reduce your margin obligations. What if there is no reasonable bid at the time of sale? What if the bid is near zero? This scenario also sticks you with most or all of the loss generated by the short leg.
Here is another nightmare scenario, which applies to physically settled, American style options. You have incurred a massive loss on the short option leg, and you have been stuck with a long or short equity position by assignment of your short option leg, and you resolve to exercise your long option leg in 24 hours, so as to reverse your massive loss. But - oh no! This massive loss triggers a margin violation! Your long option leg is extremely valuable, but because it is an option, its value does not count toward measuring your account equity or satisfying your margin obligations. So, the broker has the right to liquidate your account, and your long option leg is sold at an unreasonably low price before you get a chance to exercise it, and once again, you are stuck with most or all of the loss generated by the short option leg.
A variation on that nightmare scenario might occur where your long option leg is not liquidated, but the long or short equity position resulting from your short leg's assignment is liquidated instead, because you don't have enough margin to carry that equity position. You are confident you will be OK, though, because you plan to exercise your long option leg in 24 hours. But oh no! By the time you get the proceeds from exercising your long option leg, they have dwindled to near zero, because the market moved hard and fast against your long option leg! And once again, you are stuck with most or all of the massive loss generated by the short option leg!
Here is another variation on that nightmare scenario, which can occur when you are using options in order to get a great deal of leverage, to benefit from price movements on notional underlying quantities so large you could never afford to swing them around as underlyings. Your long or short equity position is liquidated, but your long option leg is left intact, and the market does NOT move against your long leg before you can exercise it. This successful exercise results in a new long or short equity position. You resolve to play it safe by closing that equity position at tomorrow morning's open. But oh no! The market gaps hard and far against you, and because you were excessively leveraged, the gap wipes out your entire account!
so give it up...you ARE talking to a wall. No one who trades options gives a flying F what the guy thinks.
