In response to the low interest rate environment that has prevailed for a decade, many brokerage firms — including well-known wirehouses such as Merrill Lynch, Morgan Stanley, and UBS — have reportedly recommended various options strategies to their customers as supposedly safe and efficient mechanisms to enhance income. However, when stock markets turn volatile, these strategies can quickly spiral into unexpected investment losses for retail investors — as recently occurred during a spike in stock market volatility that peaked on February 5, 2018.
Despite the risks embedded in options, particularly naked options, brokerage firms like Merrill Lynch, Morgan Stanley and UBS have reportedly presented some retail investors with opportunities to engage in sophisticated, highly complex options strategies, often fraught with risk. One such options strategy, marketed in some instances as a yield enhancement strategy (or “YES”), involves writing so-called iron condors through S&P 500 derived options. In some instances, investors are steered into such strategies seeking the option premium income, without actually understanding the risks associated with options trading strategies.
When it comes to yield enhancement options strategies, perhaps the most commonly used financial instrument is the extremely well-known S&P 500 Index (“SPX”), a stock index based on the 500 largest companies whose stock is listed for trading on the NYSE or NASDAQ. The Chicago Board Options Exchange (“CBOE”) is the exclusive provider of SPX options. In this regard, CBOE provides a range of SPX options with varying settlement ranges and dates, including A.M. and P.M. settlement, weekly options and end-of-month options. Significantly, because SPX is a theoretical index, an investor who engages in options trading using SPX will necessarily be engaging in uncovered, or naked, options trading.
An iron condor is an options strategy that entails writing a series of options, typically all at once or around the same time. The iron condor structure entails writing two near money options that are short, in addition to purchasing two deeper out-of-the money options that are long. The first component of an iron condor involves selling an out-of-the money put (short put), while simultaneously selling an out-of-the money call (short call). When implementing this first component of an iron condor — the options trader is essentially hoping that between now and expiration, SPX’s trading will remain range-bound between the two strike prices — thereby ensuring that the naked options will expire worthless and the investor will profit from the option premium earned.
In recognition of the extreme risk associated with short naked options, the iron condor has a second component for purposes of risk mitigation. Specifically, the second part of an iron condor involves buying a further out-of-the money put, as well as buying a further out-of-the money call. Thus, while the first two legs of the iron condor involve two extremely risky short naked options, the third and fourth legs of the iron condor seek to mitigate that risk with less risky long SPX options. Collectively, these four options trades, or legs, make up an iron condor.
Ultimately, options strategies like the iron condor amount to bets in favor of time decay versus volatility. On the one hand, an investor can pocket options premium income in those instances where the option — which has a finite lifespan and fixed expiration and, therefore, is properly viewed as a decaying asset — goes to zero and expires worthless. However, on the other hand, periods of pronounced market volatility can quickly lead to scenarios where the option premium is dwarfed by losses due to market volatility. Recently, a volatility spike in the stock markets in early February 2018 reportedly caused substantial losses to some investors placed in so-called “yield enhancement” and other strategies premised on low market volatility.
Unfortunately, some investors have been steered into unsuitable and risky options strategies without receiving full disclosure from their financial advisor concerning the significant risks embedded in options investing and/or hedging. Investors who have sustained losses in connection with options investing may be able to recover their losses in FINRA arbitration, if the recommendation by a broker lacked a reasonable basis in the first instance, or if the nature of the investment — including its risk components — was misrepresented.
The attorneys at Law Office of Christopher J. Gray, P.C. have significant experience in representing investors who have sustained losses due to the negligence or misconduct of their broker and/or brokerage firm, including cases involving managed futures, options, and leveraged and/or inverse ETFs. Investors may contact Law Office of Christopher J. Gray, P.C. at (866) 966-9598 or firstname.lastname@example.org for a no-cost, confidential consultation.