Small £2500 Accounts Early assignment and margin call

[Shoptions]

smallfil wrote:
How will they make you pay? They will probably, sue and attach whatever assets you have to recoup the difference.

Okay, the original post identified the account using the GBP symbol, and I have absolutely no knowledge of how these things work in the UK. But here in the US, what smallfil said is a bit of hyperbole and panic.

If you sell a naked call and it gets exercised, then as the OP said, you will be short the stock. If your account does not have sufficient funds or equity available to support that short stock position, the broker will probably just execute an order to buy the stock back at the market price right after the exercise. And they can do this without any warning. This is commonly referred to as "buying to cover" the short position. It liquidates the short stock position.

Let's assume that you buy the stock back at a price that is higher than the strike price at which you sold it. That means you will sustain a loss. But it might be only a few hundred dollars, and there might be enough cash or equity in your account to handle that.

Under US rules, the broker could issue a margin call and give you up to five days to deposit additional funds to support the short stock position. On a new account with a very low balance, that's not likely. Most US brokers would immediately liquidate the position.

A naked short call certainly can generate a large loss, that could be much more than what you have in your account. And yes, that could lead to the closure of your account, and collection proceedings or a lawsuit to recover the negative balance. But that will not happen every time a naked call gets exercised and you don't have enough money to support the short stock. It depends on the individual circumstances each time.

If the short call is part of a spread, the outcome could be very different.

BMK

Thanks for the response. To clarify to some points:

"The broker will probably just execute an order to buy the stock back at the market price right after the exercise".
--Does the buy to cover involve the broker's money as my account can't afford to buy the stock back?

"Under US rules, the broker could issue a margin call and give you up to five days to deposit additional funds to support the short stock position. On a new account with a very low balance, that's not likely. Most US brokers would immediately liquidate the position."
--Additional funds would mean -£27500 in this case and I simply can't afford that. Whilst it is 'not likely' I need to know that it definately would not happen as I don't want to end up owing money.
--How would they liquidate the position?

Thanks again for the help.

 

[guru]

Bought a call @ $305.
Sold a call @ $300.

That's a little different scenario from what you originally posted, and looks even better/safer for you. Only a short option can be assigned, so you'd still have the long/purchased call that will protect you and cap your losses. So ending up with negative -100 shares and a long call will be just fine, but you'd probably want to close both positions at that time, rather than buying back shares and selling another call. Then start a new position/trade.
This situation isn't common and it's even less common to cause problems, except for possibly being concerning when it happens the first time. Don't panic

 

[Shoptions]

First, it is rare that a call would be exercised early except in limited circumstances (upcoming dividend or a hard to borrow stock). If you are assigned early on a naked call, it becomes a margin issue, not a risk issue.

If you are assigned early on a short call, you then become short stock. There is no more risk here then being short the call and has the opportunity to make more money for you (except if there is an upcoming dividend and if the stock is hard to borrow).

If this happens you will get a margin call and either add money or by back your short stock (or IB will do it for you).

Thanks for the response. Not sure I understand how I can be short stock if I don't have capital in my account (£2500) in the first place to buy the stock (£30000 (1 contract at 300 stock price)).

 

[FSU]

Thanks for the response. Not sure I understand how I can be short stock if I don't have capital in my account (£2500) in the first place to buy the stock (£30000 (1 contract at 300 stock price)).

Your capital has nothing to do with the assignment. If you are assigned on a short call, you will get short stock. If you don't have enough capital to hold the position, you get a margin call.

If we are talking about an early exercise, as others have said, you have your long call to protect you. You are not taking on any more risk here.

 

[BMK]

You've asked a lot of different questions. This will take some time.

If the short call is exercised (which in this context means the same thing as "assigned") then you have to sell the stock. If you don't own the stock, the broker will lend it to you. You will be charged interest on the present value of the stock until you buy the stock in order to return it to the broker. The broker will lend you the stock, and you will sell it to the guy who has exercised the call. You will sell it at the exercise price of 300.00 per share. The result will be that $30,000 will be deposited into your account.

Don't get too excited. You won't be allowed to withdraw it. (In theory, you will earn interest on this money. But interest rates are so low right now, and the amount of time so short, that the interest will not be meaningful. The interest rate you are paying for borrowing the stock is higher than the interest rate you are earning on the money from selling the stock short.)

At some point after you sell the stock short, you will have to buy it back in order to close out the position. The broker can do this for you automatically under certain circumstances. Or you can place an order to achieve this. You will have to buy it back at whatever the current market value is, which will probably be more than 300.00 per share (because that is why the short call was exercised, because it was in the money). If the stock is at 305.01 or above at expiration, the broker will automatically exercise your long call. That will allow you to buy the stock for 305. 100 shares will cost you 30,500.00. But you already have 30,000 sitting in your account. So you have to come up with 500.00, which hopefully you actually have available in your account. So you buy the stock, and then you give it back to the broker. Because the broker lent you the stock, so that you could sell it when the short call was exercised, remember?

So you have lost $500, less whatever you got when you sold the spread. That is theoretically your maximum loss on the position.

That is one way this could play out. However, if the stock is sitting at 303.50 at expiration, the broker should not exercise your 305 call to buy the stock. When you get to the point where it is early afternoon on the day of expiration, and it appears that the long call will not be in the money, the broker can choose to simply make you buy the stock at whatever the current market price is, presumably less than 305. The result is the same. You buy back the stock and then return it to the broker. But your loss is not as great. In this example, you buy it back for 303.50 instead of 305.

What happens to your long call? Either it expires worthless, or you can sell it for a few bucks as expiration approaches because you don't need it anymore to protect you from extreme loss on the short stock, because you bought the stock back at 303.50.

Okay, here's the absolute worst case scenario:

You are short the stock, having sold it for 300. So you have 30,000 sitting in your account (plus your own money) and you get to expiration. The stock is at 304.71. The broker, in theory, could choose to do nothing. They don't have to protect your ass. If the broker does nothing, and you do nothing, then the long call expires worthless, and you remain short the stock at the end of the day.

Then you wake up the next morning (or Monday morning) short the stock, without a long call to limit your potential losses. And as the market opens, the stock rockets up to 370 on some sort of unexpected news. Now your broker freaks out, and immediately forces you to buy back the stock at the market price, which costs you 37,000. You have 30,000 from when you sold the stock, plus your own money. But it's not enough. Your account now has a negative balance, and you owe your broker several thousand dollars.

That's not going to happen to you. Your broker will not take that risk. If the stock is between 300 and 305 on expiration, your broker will force you to buy it back at the market price. You will not be allowed to remain "naked short" the stock overnight. For a customer with only 2500 pounds in his account, the broker will not allow that kind of risk.

If you had a lot more money in your account, the broker might allow you to just stay short the stock, and then you would be exposing yourself to a lot more risk.

Does any of this make sense?

BMK

 

[Shoptions]

You've asked a lot of different questions. This will take some time.

If the short call is exercised (which in this context means the same thing as "assigned") then you have to sell the stock. If you don't own the stock, the broker will lend it to you. You will be charged interest on the present value of the stock until you buy the stock in order to return it to the broker. The broker will lend you the stock, and you will sell it to the guy who has exercised the call. You will sell it at the exercise price of 300.00 per share. The result will be that $30,000 will be deposited into your account.

Don't get too excited. You won't be allowed to withdraw it. (In theory, you will earn interest on this money. But interest rates are so low right now, and the amount of time so short, that the interest will not be meaningful. The interest rate you are paying for borrowing the stock is higher than the interest rate you are earning on the money from selling the stock short.)

At some point after you sell the stock short, you will have to buy it back in order to close out the position. The broker can do this for you automatically under certain circumstances. Or you can place an order to achieve this. You will have to buy it back at whatever the current market value is, which will probably be more than 300.00 per share (because that is why the short call was exercised, because it was in the money). If the stock is at 305.01 or above at expiration, the broker will automatically exercise your long call. That will allow you to buy the stock for 305. 100 shares will cost you 30,500.00. But you already have 30,000 sitting in your account. So you have to come up with 500.00, which hopefully you actually have available in your account. So you buy the stock, and then you give it back to the broker. Because the broker lent you the stock, so that you could sell it when the short call was exercised, remember?

So you have lost $500, less whatever you got when you sold the spread. That is theoretically your maximum loss on the position.

That is one way this could play out. However, if the stock is sitting at 303.50 at expiration, the broker should not exercise your 305 call to buy the stock. When you get to the point where it is early afternoon on the day of expiration, and it appears that the long call will not be in the money, the broker can choose to simply make you buy the stock at whatever the current market price is, presumably less than 305. The result is the same. You buy back the stock and then return it to the broker. But your loss is not as great. In this example, you buy it back for 303.50 instead of 305.

What happens to your long call? Either it expires worthless, or you can sell it for a few bucks as expiration approaches because you don't need it anymore to protect you from extreme loss on the short stock, because you bought the stock back at 303.50.

Okay, here's the absolute worst case scenario:

You are short the stock, having sold it for 300. So you have 30,000 sitting in your account (plus your own money) and you get to expiration. The stock is at 304.71. The broker, in theory, could choose to do nothing. They don't have to protect your ass. If the broker does nothing, and you do nothing, then the long call expires worthless, and you remain short the stock at the end of the day.

Then you wake up the next morning (or Monday morning) short the stock, without a long call to limit your potential losses. And as the market opens, the stock rockets up to 370 on some sort of unexpected news. Now your broker freaks out, and immediately forces you to buy back the stock at the market price, which costs you 37,000. You have 30,000 from when you sold the stock, plus your own money. But it's not enough. Your account now has a negative balance, and you owe your broker several thousand dollars.

That's not going to happen to you. Your broker will not take that risk. If the stock is between 300 and 305 on expiration, your broker will force you to buy it back at the market price. You will not be allowed to remain "naked short" the stock overnight. For a customer with only 2500 pounds in his account, the broker will not allow that kind of risk.

If you had a lot more money in your account, the broker might allow you to just stay short the stock, and then you would be exposing yourself to a lot more risk.

Does any of this make sense?

BMK

Hi thanks for the in depth explanation. Yes this makes sense to me. I think where I was not grasping the concept was that in my head the broker would not be lending the short stock to customers because in reality this short stock would cost them £30000 and to do this for thousands of customers would potentially put them in a large deficit if no one paid on time.

Now I know that this short stock is lent to me then the rest of the explanation makes sense. Above the short strike there is loss and the loss is capped at a max loss due to the long strike, so £500 + cost of the spread.

I was just believing that they would not lend £30000 out with a £2500 account and assumed they would then try to recoup the money (lawsuits, courts etc) as some people have suggested!

Just 2 questions...You said that "At some point after you sell the stock short, you will have to buy it back in order to close out the position". If this is not done automatically by the broker then I assume I will be short 100 stock at £300 and long call at £305 (expiring at original expiry date). In which case I then have to choose when to close these individual legs?
Also is this with all brokers that 'lend you' the short stock? I am with Interactive Brokers.

I am grateful that you have explained in detail and very clearly...thank you.

 

[Shoptions]

Your capital has nothing to do with the assignment. If you are assigned on a short call, you will get short stock. If you don't have enough capital to hold the position, you get a margin call.

If we are talking about an early exercise, as others have said, you have your long call to protect you. You are not taking on any more risk here.

Thanks for the response I am very grateful.

 

[Shoptions]

That's a little different scenario from what you originally posted, and looks even better/safer for you. Only a short option can be assigned, so you'd still have the long/purchased call that will protect you and cap your losses. So ending up with negative -100 shares and a long call will be just fine, but you'd probably want to close both positions at that time, rather than buying back shares and selling another call. Then start a new position/trade.
This situation isn't common and it's even less common to cause problems, except for possibly being concerning when it happens the first time. Don't panic

Thanks for taking time to reply.

 

[BMK]

Shoptions wrote:

I think where I was not grasping the concept was that in my head the broker would not be lending the short stock to customers because in reality this short stock would cost them £30000 and to do this for thousands of customers would potentially put them in a large deficit if no one paid on time.

When you sell stock short (regardless of whether you do it by placing a direct order to sell short or through the assignment of a short call), you are not borrowing money. You are borrowing stock. You borrow the stock just like you can rent a car, or borrow your neighbor's lawnmower. These analogies are imperfect. But they illustrate the point that you are borrowing a piece of property--not money. Then, immediately after you borrow it, you turn around and sell it.

And although I said "the broker will lend it to you," in most cases you are not borrowing the stock from the broker. You are borrowing it from another stockholder--usually another customer of your broker. The broker facilitates and guarantees the loan (so the guy lending you the stock doesn't have to worry about whether you will give it back). You are charged interest on the value of the stock, which changes from day to day. And the loan is secured. You put up $30,000 in cash as collateral in order to borrow the stock. Where do you get that kind of money? From selling the stock. When you sell the stock, there will be $30,000 sitting in your account that you cannot withdraw, because it is collateral for the loan. That money comes from the guy who bought the stock--not from the broker.

For the lender (and for the broker, who is guaranteeing the loan), the loan has almost no risk. The risk is that the stock will go way up, and you won't have enough money to buy the stock and return it to the lender. But the risk is limited by the long call. In your case, that risk is limited to $500, and you have that money in your account. So it is virtually impossible for the lender or the broker to get stiffed. And the broker is not putting up any cash. They are simply arranging for you to borrow the stock from another customer.

Shoptions wrote:

You said that "At some point after you sell the stock short, you will have to buy it back in order to close out the position". If this is not done automatically by the broker then I assume I will be short 100 stock at £300 and long call at £305 (expiring at original expiry date). In which case I then have to choose when to close these individual legs?

Yes, you can do that at any time. But the broker won't let you sell off the long call without buying the stock at the same time. If you did that, you would be short the stock without any upside protection, and your account doesn't have enough of your own money to support that kind of risk.

Buying the stock (to close the short position) while simultaneously selling off the long call can be done in a single order. It is actually the same thing as a covered call, or a "buy-write" order, except that both legs are closing transactions.

Shoptions wrote:

Also is this with all brokers that 'lend you' the short stock? I am with Interactive Brokers.

It is possible that in some cases the broker--IB or any other broker--might be unable or unwilling to arrange for you to borrow the stock when a short call is assigned. It might be because they can't find anyone who will lend the stock, or there might be some other reason. The broker has a lot of discretion, and they don't necessarily have to give you a reason. They can just say, "We're not doing this."

If that happens, when your short call is assigned, the broker can choose to force you to buy the stock immediately at the market price, in order to deliver on the assigned short call. It all happens at the same time, something like this:

1:15 PM Broker is notified your short call has been exercised and you are assigned
1:16 PM Broker places an order for you to buy the stock at the market price, which is 304
1:17 PM You deliver on the assigned call by selling the stock at 300

And your account balance goes down by $400. And the broker has the right to do this all without any warning to you. You get notified very quickly after it happens.

In this scenario, technically the broker is indeed lending you $30,400 for a couple days while these transactions settle. But there is no risk that you will fail to repay the "loan." Most of the money to repay the loan comes from the sale of the stock.

- - - - -

There is one other variable that you need to be aware of when you sell stock short: Dividends.

When you sell stock short, you have a situation where two people own the same 100 shares of stock. Imagine if you borrowed your neighbor's lawnmower and then sold it at a garage sale. Your neighbor still owns it. He didn't give it to you; he only let you borrow it. But the guy who bought it from you also owns it. And you are planning to buy another, identical lawnmower, hopefully at a lower price, so that you can return it to your neighbor and pocket the difference.

Likewise, when you short the stock, you have two people who own the same piece of property: the guy who lent you the stock, and the guy who bought it from you.

And now, while you are waiting for the stock price to go down before you buy the stock and return it to the lender, the company pays a dividend.

The company pays only one dividend. But both the lender and the guy who bought the stock have the right to receive that dividend. Two people own the same shares of stock, and you are not one of them. The company is only going to pay one dividend--to the guy who bought the stock from you.

Guess who has to pay the dividend to the guy who lent you the stock?

If you put on a spread, and the short leg goes into the money, and there is a dividend payment before expiration, this will often result in an early exercise and assignment. And you can end up having to pay the dividend to the lender of the stock. If you don't account for this when evaluating a spread, it can be a nasty surprise. It can turn a winning trade into a loser or a break-even trade.

You have to carefully look at ex-dividend dates to understand the potential consequences.

By the time you find out about an assignment, it may be too late to fix the situation by buying the stock. If you get assigned the day before the ex-dividend date, but you don't find out about it until the next morning, you are stuck holding the bag. You can buy the stock, but you won't get the dividend because you are buying on the ex date. But you have to pay the dividend to the lender, because you were short the stock on the ex date, and the company paid the dividend to the guy who bought the stock from you.

Hope this makes sense.

BMK

 

[Shoptions]

Shoptions wrote:



When you sell stock short (regardless of whether you do it by placing a direct order to sell short or through the assignment of a short call), you are not borrowing money. You are borrowing stock. You borrow the stock just like you can rent a car, or borrow your neighbor's lawnmower. These analogies are imperfect. But they illustrate the point that you are borrowing a piece of property--not money. Then, immediately after you borrow it, you turn around and sell it.

And although I said "the broker will lend it to you," in most cases you are not borrowing the stock from the broker. You are borrowing it from another stockholder--usually another customer of your broker. The broker facilitates and guarantees the loan (so the guy lending you the stock doesn't have to worry about whether you will give it back). You are charged interest on the value of the stock, which changes from day to day. And the loan is secured. You put up $30,000 in cash as collateral in order to borrow the stock. Where do you get that kind of money? From selling the stock. When you sell the stock, there will be $30,000 sitting in your account that you cannot withdraw, because it is collateral for the loan. That money comes from the guy who bought the stock--not from the broker.

For the lender (and for the broker, who is guaranteeing the loan), the loan has almost no risk. The risk is that the stock will go way up, and you won't have enough money to buy the stock and return it to the lender. But the risk is limited by the long call. In your case, that risk is limited to $500, and you have that money in your account. So it is virtually impossible for the lender or the broker to get stiffed. And the broker is not putting up any cash. They are simply arranging for you to borrow the stock from another customer.

Shoptions wrote:


Yes, you can do that at any time. But the broker won't let you sell off the long call without buying the stock at the same time. If you did that, you would be short the stock without any upside protection, and your account doesn't have enough of your own money to support that kind of risk.

Buying the stock (to close the short position) while simultaneously selling off the long call can be done in a single order. It is actually the same thing as a covered call, or a "buy-write" order, except that both legs are closing transactions.

Shoptions wrote:


It is possible that in some cases the broker--IB or any other broker--might be unable or unwilling to arrange for you to borrow the stock when a short call is assigned. It might be because they can't find anyone who will lend the stock, or there might be some other reason. The broker has a lot of discretion, and they don't necessarily have to give you a reason. They can just say, "We're not doing this."

If that happens, when your short call is assigned, the broker can choose to force you to buy the stock immediately at the market price, in order to deliver on the assigned short call. It all happens at the same time, something like this:

1:15 PM Broker is notified your short call has been exercised and you are assigned
1:16 PM Broker places an order for you to buy the stock at the market price, which is 304
1:17 PM You deliver on the assigned call by selling the stock at 300

And your account balance goes down by $400. And the broker has the right to do this all without any warning to you. You get notified very quickly after it happens.

In this scenario, technically the broker is indeed lending you $30,400 for a couple days while these transactions settle. But there is no risk that you will fail to repay the "loan." Most of the money to repay the loan comes from the sale of the stock.

- - - - -

There is one other variable that you need to be aware of when you sell stock short: Dividends.

When you sell stock short, you have a situation where two people own the same 100 shares of stock. Imagine if you borrowed your neighbor's lawnmower and then sold it at a garage sale. Your neighbor still owns it. He didn't give it to you; he only let you borrow it. But the guy who bought it from you also owns it. And you are planning to buy another, identical lawnmower, hopefully at a lower price, so that you can return it to your neighbor and pocket the difference.

Likewise, when you short the stock, you have two people who own the same piece of property: the guy who lent you the stock, and the guy who bought it from you.

And now, while you are waiting for the stock price to go down before you buy the stock and return it to the lender, the company pays a dividend.

The company pays only one dividend. But both the lender and the guy who bought the stock have the right to receive that dividend. Two people own the same shares of stock, and you are not one of them. The company is only going to pay one dividend--to the guy who bought the stock from you.

Guess who has to pay the dividend to the guy who lent you the stock?

If you put on a spread, and the short leg goes into the money, and there is a dividend payment before expiration, this will often result in an early exercise and assignment. And you can end up having to pay the dividend to the lender of the stock. If you don't account for this when evaluating a spread, it can be a nasty surprise. It can turn a winning trade into a loser or a break-even trade.

You have to carefully look at ex-dividend dates to understand the potential consequences.

By the time you find out about an assignment, it may be too late to fix the situation by buying the stock. If you get assigned the day before the ex-dividend date, but you don't find out about it until the next morning, you are stuck holding the bag. You can buy the stock, but you won't get the dividend because you are buying on the ex date. But you have to pay the dividend to the lender, because you were short the stock on the ex date, and the company paid the dividend to the guy who bought the stock from you.

Hope this makes sense.

BMK

Hi once again thank you for the in depth knowledge. I believe I understand the procedure with the expiration/early assignment. This has been a great help and I can ease my mind knowing I won't be in mountains if lifetime debt. I am sure that this has been a help to a lot of people who didn't understand the procedures. I hope I can use this knowledge to grow my small account now!!!! Many thanks once again.