Here is the scoop. If you had a stop triggered on this trade today you are the victim of a Fast Market/Maximum width. I made various phone calls today to get the story straight. Three different online brokers, a former options market maker, and an AMEX exchange representative. I heard a couple different stories. The first story was the funniest. A retail customer probably used a sell limit order at .70 for a size of 200 contracts. Since the bid ask size on this option is about 20 x 20, every available price was picked off all the way down to .70. We know that this cannot be the case since it is a violation of exchange law. If the stock price is at $13 and you have the right to buy at $10, this option is worth $3. By rule, I am fairly certain that the .25 rule comes into play. Correct me if I am wrong, but by rule this option cannot trade by more than .25 below parity (intrinsic value). Meaning $2.75 is the lowest it should trade.

Why did traders get kicked out then?

Second story is the non-existent "Manning Rule" in the options market. The Manning Rule prohibits an NASD member firm that is holding a customer limit order from trading for that member's market making proprietary account at a price that would satisfy the customer's limit order without executing that customer limit order. The rule is applicable in the extended hours session. So I was told that the market maker could have created this trade (being on both sides of the market) to flush out a few stops. However this would have created too much directional risk for this person, and not a tremendous amount of incentive.

So here is how it really happened...

The final story that made sense was that the exchange approved the spread to be widened due to a fast market/maximum width reached. This does not happen very often but will in circumstances where you are dealing with an illiquid market and a ton of orders come into play. When market-makers want relief in the bid/ask spread because of something unusual happening in the stock, they will call for floor officials, state their reasons, and if it's warranted the floor officials will declare a "fast market" for the stock (the term probably came from market conditions changing very quickly), which allows the market-maker to widen the bid/ask spread. The floor officials usually decide how wide they can make the spreads--2 or 3 times normal width, depending on how extreme the conditions are.

As many noticed, we created quite a racket in these options and caused the exchange to declare a fast market and open the spread to 3.60 x .70. This will cause traders to avoid trading this option until the spread narrows, and subsequently booted all kinds of stops.

The Good News:

Since you cannot trade an option this far below parity, the exchange approved price adjustments to be honored at 2.80. If this has not been reflected in your account, GET ON THE PHONE. This can turn a loser into a big winner.

In closing I hope this was a good learning experience, but it turned a good profit once your price is adjusted. Here is another risk of trading illiquid options. With such a cheap stock, it's worth it to just buy the stock outright...isn't it?

Posted by Option Addict on 1/29/2007 at 8:53 PM | Permalink