From the April 01, 2009 issue of Futures Magazine • Subscribe!

Bad fill or bad rule?

Oct. 10, 2008 was an extremely volatile day in equity markets. Glenn Pafumi, however, was enjoying a vacation in Australia. Unfortunately he had not kept an eye on the numerous options positions in his Interactive Brokers (IB) account and his margin fell below the required amount. IB has instituted an automatic system when customer margin levels fall below requirements. It does not issue margin calls but will automatically and almost immediately liquidate customer positions systematically until the account is above the proper levels.

They tout this as a way to protect customers and the brokerage. It also is part of the agreement customers sign when opening an account. It obviously eliminates delays and protects the account and brokerage from a worsening margin situation.

However, in the case of Mr. Pafumi, it may have exacerbated what could have been a minor problem. One of the positions liquidated was 86 short January $10 calls in biopharmaceutical company Telik (TELK).

The calls did not trade the day prior and were quoted at zero bid/10¢ ask when the underlying stock traded in a range from 45¢ to 57¢. The stock actually traded lower (35¢ to 47¢) the following day (Oct. 10), when his account dropped below its required margin, though overall volatility was much higher as the Chicago Board Options Exchange’s (CBOE) volatility index reached an all-time high (at the time) of 76.94.

On that day, Pafumi’s position in Zulab (the options symbol), and others were liquidated after market makers put out a zero bid/45¢ offer quote sometime before noon on Oct. 10. According to Pafumi, this quote required the IB to price the options at 22.5¢, which may have triggered the margin call and forced liquidation. When automatically executing a margin call situation, you usually are getting the worst possible price.

“At each execution, the market makers maintained a zero bid and kept increasing the price that I had to pay to cover in a liquidation situation,” Pafumi says. His position was liquidated in about six minutes from 45¢ up to $1.90. The trade cost him approximately $5,000 on options that were worth less than a penny (based on standard pricing models) and would have surely expired worthless if not for the margin call. “All on something that has a theoretical value of less than a penny. This is not an orderly market,” he adds.

Pafumi claims that the increasing offers triggered other liquidations in a snowballing effect.

Pafumi filed a complaint with the Market Regulation Department of the Financial Industry Regulatory Authority (FINRA) on Oct. 13. On Oct. 31, IB sent Pafumi a letter noting that they had received the complaint, and stated, “The executions which you received for the liquidation trades in your account on trade date Oct.10, 2008 were within the NBBO (National best bid and best offer) and compliant with the Market Maker obligation rules. As such, the trades will stand and IB will not offer to compensate your account in any form for the liquidation executions.” IB referred to CBOE rule 8.7(iv)(c).

FINRA referred him to the CBOE Department of Market Regulation, because IB is under CBOE jurisdiction. Some of the liquidation was executed on CBOE, but orders were also filled at other options exchanges.

After an investigation, CBOE determined that the executions were proper and cited CBOE rule 8.7(iv)(c), which states, “options classes trading on the Hybrid Trading System may be quoted electronically with a difference not to exceed $5 between the bid and offer regardless of the price of the bid.”

The rule is identical to rules at the other options exchanges. And there lies the rub. The CBOE has a rule that limits the bid-ask spread to 25¢ on options strikes trading below $2 (though this could be expanded in fast market conditions). These were executed electronically, however, so the $5 spread requirement applied.

Pafumi would like to see the rule changed.

The reason that the various exchanges have rules allowing for wider options spreads for electronic trading is to protect market makers from being hit on all their bids or offers across multiple options and multiple strikes. A floor trader can take the other side of a particular order but “electronic market makers are making markets for thousands of strikes across dozens of equities” says Mark Longo, founder of the

It is a reason often cited for why options on futures are still mainly traded in open outcry.

“A lot of it harkens back to the early days of electronic trading,” Longo says. “In those early days, most traders didn’t have the sophisticated algorithms that they have today. There was a genuine fear that electronic market makers could be hit on all of their markets simultaneously before they had a chance to react. If that happened, particularly in a volatile market, it could be disastrous. So wider limits were implemented for electronic exchanges.”

Longo, however, believes the rule is archaic and modern algorithms should allow market makers to dynamically adjust their positions to avoid getting hit across the board all at once. ”In this day and age, with so many safeguards in place to protect electronic options traders, it’s difficult to believe that electronic market makers need such large limits on their bid/ask spreads,” Longo says.

Peter Bottini, EVP-Trading, optionsXpress, would also like to see a change. “This is a common problem, but not a consistent problem in the option marketplace,” Bottini says. “You’ll have customers liquidating positions in volatile times and that’s where we’re most likely to encounter the situation. From our perspective, we worked diligently with the exchanges to change their rules. They haven’t been that responsive,” he says, though he adds, “They have been responsive case-by-case when they have problems. They’re very accommodative to make sure the customer doesn’t get gouged.”

Bottini says that optionsXpress has created their own routing system that will send orders to a broker to work manually if they see an unusually wide quote. “We did that to protect our customers. In this customer’s situation, there’s a conflict because market makers are selling these contracts at such inflated prices and profiting greatly from it and customers are getting the raw deal.”

Another possible mistake Pafumi may have made was to even have been holding onto the position. He acknowledges that the previous day the option was zero bid/10¢ offer and that the Black-Scholes value had dipped to about a penny. He had held the position for a long time, initiating them as LEAPS several years earlier, and had earned most of the profits in the options. But they were so far out of the money, he didn’t want to cover.

“Why cover them? Let worthless options expire worthless. I decided I didn’t want to pay 5¢. It made no sense to pay a nickel or a dime.”

Adding to his dismay is that he had several short positions on options far out of the money that were also liquidated in the margin call. Several of these options were also relatively illiquid and had a theoretically value slightly higher than the Telik options, but they were liquidated at 5¢ and 10¢.

Pafumi does not dispute that the executions were within the rules and does not seek an adjustment in price, but he would like the rule changed. “This particular rule is obsolete and it is not fair. I am not the only person to get [hurt] like this.”

While Pafumi is ultimately responsible for allowing his margin to dip below the appropriate levels while admittedly trading in extremely illiquid securities, something all our experts agree is a very bad combination, there is no getting around that this was a bad — though legitimate — fill.

And Pafumi was no neophyte. He worked as a consultant to an options broker dealer for years and started trading options when they first were listed on the CBOE in 1973. He has 35 years of experience in options.


The bottom line lesson is to avoid illiquid options and if you insist on trading them, do not allow your account to get close to a margin call situation, especially if you have an agreement that the broker will automatically liquidate them.

“When trading such a product, you should do everything possible to avoid a margin call,” Longo says. “When receiving a margin call in a product like ZULAB, the executions will be horrible. I can’t say exactly what a fair price would have been; however, $1.90 for such an out-of-the-money option seems extreme, even in such a volatile market.”

Mr. Pafumi was certainly careless to allow this to happen, But this is not only a cautionary tale for traders, but also for exchanges and brokers because the execution he received does not reflect well on the market.

Options expert Howard Tyllas calls it a sad situation and says that IB should have risk control safeguards built into its smart routing, so that it could have routed this to the floor. “The exchange has a good rule using the 25¢ between the bid/offer, but $5, no matter the price of the option, is like giving a thief a license to steal. In that regard, I hold the entity responsible for writing a rule that is screaming for wrongdoing like this to happen,” Tyllas says.

An IB spokesman says that all executions are routed electronically, so there was no floor option.

Bottini adds, “I don’t think this was handled well and reflects poorly on a very customer friendly marketplace. It happens infrequently and nine times out of 10 the exchanges step up and adjust the price.”

Electronic markets have made options trading much more efficient and accessible but this may lead to a false sense of security. People could start to look at markets like magic or a video game: The stock is here, the volatility is X, Black-Scholes says Y, so I should get filled here. It is not magic. Underlying it all are traders and market makers and if you are trading something obscure with less coverage, you are not likely to get a good price, but the worst legitimate price.

Christine Birkner contributed to this article.

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