SEC: OptionsXpress Traded Naked (and Other Problems)

Econintersect: The SEC (Securities and Exchange Commission) has charged a subsidiaries of Charles Schwab Corp (NYSE:SCHW), optionsXpress and OX Trading, along with current OX Trading CFO and former optionsXpress CFO Thomas E. Stern, with registration violations and with violating naked short selling rules. Two separate sets of charges were filed by the SEC on Monday, 16 April 2012 and on 19 April 2012.

Here is a summary of the naked short selling charges from Reuters:

The SEC said optionsXpress engaged in a series of sham transactions that violated “Regulation SHO” a rule that requires equity securities to be delivered generally three days after the date of a trade.

OptionsXpress, former Chief Financial Officer Thomas Stern and Jonathan Feldman, a customer, were charged in the SEC’s proceeding, which will be heard by an administrative law judge.

Three other company officials, head of trading Peter Bottini and compliance officers Phillip Hoeh and Kevin Strine, settled related charges in separate administrative proceedings without admitting or denying the regulator’s findings.

Tom Steinert-Threlkeld, at Science Technology Monitor, has a cleverly illustrated slide show that describes the essential elements of the naked short selling case. Here’s a summary:

SEC Contention:

1. Customers simultaneously enter into the sale of a put and purchase of call with identical strike prices and expiration dates. This, the SEC contends, created a synthetic long position.
2. Customers sold a deep-in-the-money call at the same strike price, thus creating a hedged position that had no directional risk for stock price movement.
3. Deep-in-the-money calls have little open interest, neither optionsXpress nor the customer delivered shares to cover those sold short positions and therefore they were “creating a failure-to-deliver position,” according to the SEC.

OptionsXpress Contention:

1. The simultaneous purchase of the call and sale of a put at the same strike does create a long position (bet that stock will go up) and this position must be covered (offset with an equal short position).
2. Selling a deep-in-the-money call is a bet that the market will go down and therefore covers (offsets) the synthetic long. This removes unlimited risk whether the stock goes up or down. (This seems to agree with SEC contention #2.)
3. Then the customer would buy the number of shares on the open market necessary to cover their option position and hold them with limited risk if the price went down.
4. The position was re-hedged with new deep-in-the-money calls. (The SEC says that this required exercize to be on the same day and that was not always done.)
5. There is no failure (or ‘perpetual failure’ as the SEC stated) to deliver because shares were always bought to cover assignment of calls.

On April 19 the SEC announced they were pursuing a second set of charges related to optionsXpress with an administrative proceeding against Thomas E. Stern, formerly CFO of optionsXpress, and a firm with which he is now the CFO, OX Express. OX Trading is also a subsidiary of Schwab, having been acquired at the same time as optionsXpress.

This new proceeding involves charges that OX Trading continued to trade at optionsXpress as a firm after it had delisted itself from the Chicago Board Options Exchange (CBOE) and “de-registered” itself from SEC supervision. The SEC claims this move was made “apparently to avoid an audit” and covers the time from March 2, 2009 to November 16, 2010. Effective November 16, 2010 OX Trading again acquired a CBOE trading permit and again registered with the SEC. The SEC complaint applies to the 20+ month period of no registration.

Here are statements from representatives of OX Trading, from Securities Technology Monitor:

“There is no clear guidance suggesting that a firm such as OX trading, which is a proprietary trading firm that offered price improvement for optionsXpress customers should be registered as a broker dealer,” said Trace Schmeltz, a partner in the Chicago office of Barnes & Thornburg, who represents Stern.

OX Trading had no customers and was not a broker, however, said Stephen Senderowitz, a Chicago lawyer representing OptionsXpress.

“The issue that will be presented to the Administrative Law Judge is whether a trading entity whose principal function was to provide price improvement for its affiliate’s customers acted as a dealer, which required registration, or as a proprietary trading firm, which did not,’’ Senderowitz said.

This new case has nothing to do with optionsXpress, according to Senderowitz.

The SEC case includes a cease and desist order. Securities Technology Monitor has the following summary:

According to the SEC’s order, Stern terminated OX Trading’s membership with the CBOE and ended the firm’s broker-dealer registration with the SEC. Meanwhile, OX Trading quietly continued to conduct trading through a customer account at optionsXpress. Stern, who also was OX Trading’s chief compliance officer, later fabricated and backdated an allegedly exculpatory letter purporting to demonstrate that he had properly informed CBOE that OX Trading would deregister and become a customer of optionsXpress.

Stern was terminated by optionsXpress in January this year.

Notes:

1. OptionXpress advertises naked put selling. This is not the process that is being addressed by the SEC. The advertised strategy is one which is well accepted as a procedure for acquiring stock at a below current market price if it declines in price sufficiently to go below the strike price before the put expires. Although referred to as “naked” the process requires the account to maintain a margin position sufficient to cover the purchase should it occur. If the price does not decline sufficiently the stock is never purchased and the premium received is retained by the seller. Example:

Current stock price $50.

Current $45 put price is $0.50.

If the sold put is exercised (happens if the price reaches $45 or less), the stock is put to the seller at a cost of $45 per share, or a net of $44.50 plus transaction costs.

If the stock never drops to $45 the put seller pockets the $0.50.

2. OptionsXpress advertises naked call selling, although they advise against it because of high risk. They do suggest that it generally should only be used very near to expiration to mitigate risk. They also advise that “naked calls” should be offset by the prudent with a “bear spread.” Of course, if a sold option is in an appropriate spread it is covered and no longer actually naked. Example (extended from information at the optionsXpress site):

Current stock price $83.10

Current $90 call price is $1.35

If price goes above $90 by expiration to call will be exercised and the stock must be sold to the call buyer for $90. If the price goes to $100 the call seller loses $10 (difference between what he has to pay for the stock he sells for $90) minus $1.35 premium received for option plus transaction costs.

If the price goes to $110 or $120 the loss mounts. There is no limit.

To avoid this risk the seller of the $90 call can buy a $95 call at the same expiration. If this can be purchased for $0.45 the net option position is $1.35 – $0.45 = $0.90. The potential gain on the spread is $0.90 per share (minus transaction costs) if the stock stays below $90 until after expiration. The maximum loss is now limited to $4.10 if the stock rises above $95 per share ($90 sell price – $95 buy price) plus $0.90 net gain on option spread premiums.

The max loss/gain ratio here is 4.56 ($4.10/$0.90). Many option traders have more favorable ratios above which they will not go, say 2/1 or 2.5/1. Using such ratios can still be profitable because more than 75% stock options expire worthless.

John Lounsbury

Sources:

SEC charges optionsXpress over naked short selling (Sarah N. Lynch and Aruna Viswanatha, Reuters, 16 April 2012)

SEC Charges Ox Trading, optionsXpress, and Former CFO With Registration Violations (SEC Press Release, 19 April 2012)

SEC Charges optionsXpress and Five Individuals Involved in Abusive Short Selling Scheme (SEC Press Release, 16 April 2012)

Naked Short Selling Case Ensnares Ex-optionsXpress CFO, Customer (Tom Steinert-Threlkeld, Securities Technology Monitor, 16 April 2012)

Naked or Not? optionsXpress’s Short Selling, Step by Step (Tom Steinert-Threlkeld, Securities Technology Monitor, 18 April 2012)

SEC Initiates 2^nd Case Against ex-optionsXpress CFO (Tom Steinert-Threlkeld, Securities Technology Monitor, 19 April 2012)