TD Ameritrade Sued by Customer Over Failure To Exercise In-The-Money Options

March 1, 2012

In a Financial Industry Regulatory Authority ("FINRA") ArbitrationStatement of Claim filed in July 2011, public customer Claimant McCarthy, appearing pro se,sought $2,250 in damages. TheDecision does not indicate whether Respondent TD Ameritrade denied the allegations and/or asserted affirmative defenses, although such is likely. In the Matter of the FINRA Arbitration Between Daniel J. McCarthy,Claimant, vs. TD Ameritrade, Inc., Respondent (FINRA Arbitration 11-02896, February 24, 2012 ).

The sole FINRA Arbitrator hearing this dispute dismissed Claimant's claim in its entirety.

Ready, Fire, Aim?

Hey, what can I tell you?  This is how the Decisionpresented this case to us.  McCarthy came, he saw, and he was conquered. As to how he got there and why he lost, it wasn't set forth up to the point where we're told the Claimant lost.  For whatever reason, after dismissing the claims, the Arbitrator then added a section to the Decision titled: "Arbitrator's Report."  Not the way I would have done it but, oddly enough, notwithstanding the unorthodox ordering of things, the subsequent explanation was quite enlightening and compelling:

Claimant contends that he should have received a call before his in-the-money option position was sold at market and that there were several strategies Respondent should have taken to maximize his return. He asks for damages in the amount of $2,250.00. Respondent contends that Claimant's in-the-money position was required by standard industry policy to be automatically exercised before expiration, and that because Claimant's margin account did not have the required buying power to cover purchase of the underlying shares. Respondent was forced to liquidate the position. Claimant correctly points to steps he himself could have taken to improve his return, but he took none of them, despite having been notified by email three times in the days before this transaction occurred that his in-the-money position would be automatically exercised absent instructions, and that it was his responsibility to ensure that his account had the necessary funds to cover that transaction. Respondent had no responsibility to trade this self-directed account on its own initiative to maximize return in this situation, and in fact is forbidden to do so. Respondent had authority to take the action it did; Claimant had been notified of impending action; and Respondent was not required additionally to call him before taking that action.

Bill Singer's Comment

Like I said, the Arbitrator gives us a succinct rendering of the facts and his rationale for dismissing the claim, albeit in an unorthodox cart-before-the-horse fashion. Although I'm not crazy about that editorial decision, I do applaud the cogency of the content in the report.

So - what's going on here?  Well, there are a lot of folks who trade options.  For some, it's a leverage play whereby a smaller amount of dollars gains more exposure than the cost of buying the actual underlying shares. For others, options are a way to control portfolio risk through hedging or reducing the net cost of a position.

An options contract is quoted per share but your actual purchase is for 100 shares, so you should always remember that you need to multiply the quoted price by 100. Similarly, keep in mind that although you can buy a single share of stock, the typical round-lot is for 100 shares.  Consequently, when you look at your trading screen, you may see a quote of $550 for one share of Apple but for $11 you can purchase an Apple $550 Call contract for near-term expiration (remember: that's actually $1,100 per the 100 shares covered in each options contract).  One-hundred shares of the exchange traded fund S&P 500 Index will run you about $13,700 but one contract for that same index could be about $50 per 100 shares covered for a few days' of remaining play.  Of course, the risks of options are considerable and the cheaper price does not necessarily mean that you're getting in at a relatively lower price - quite the contrary.

One of the problems with options is that unlike shares of stock, they have a shelf life - they expire.  A very common source of friction between options players and their brokerage firm is what happens when an option expires in-the-money.  On that magical moment when your 550 Apple Call is tied to a closing price of the stock at, say, 551, now what?  You may have paid $20 per share for the option when you first bought the call - the stock would have needed to go to $570 for you to break even on your position. On the other hand, failing to have sold the Call before it expired, you're now sitting with the right to force someone to sell to you 100 shares of Apple at $550 when the shares closed at $551 - and who knows, maybe some huge news is scheduled to come out before the market's open on Monday; or perhaps you'd just as soon realize a loss on the option but now own the 100 shares.

You wouldn't think that an expiring option barely in the money would cause a lot of customer litigation but you'd be wrong. The garbage that you took a bath on as of Friday's closing could be worth a fortune Monday or by the end of the following week.  Similarly, you may not have had the bucks last month to buy 500 shares of XYZ but your 5 Calls were set to expire and you figured that, what the hell, I'd like to own the stock and may as well exercise my right to call the shares.

Except there's often this one problem.

On Friday, when you need to make the decision to exercise, you had left work early or the shares were underwater about an hour before the close and you stopped watching them - not realizing that they made a strong move higher on some rumors.  Unfortunately, there just wasn't sufficient funds in your account to permit you to buy the shares pursuant to the exercise of your call.  Now, sure, that shortfall may have been a lousy couple of hundred bucks that you could have easilty and quickly come up with but for the fact that no one from the brokerage firm called you.  Then of course, maybe they did call you but you didn't listen to your voicemail until Monday morning. If the stocks drops the next week, no big deal.  On the other hand, if the damn shares skyrocket, oh boy, are you gonna blow a gasket.

I went online and found TD Ameritrade's "Margin Handbook," and read page 14: "OPTIONS EXERCISE AND ASSIGNMENT."  Frankly, it's pretty straightforward and clear but for the fact that few, if any, customers bother to read such disclaimers until they learn that the in-the-money options weren't exercised because of insufficient cash or margin. My suggestion is that you make it a point to read TD Ameritrade's disclaimer below and to also make sure that you have a copy of your firm's similar policy.  You'll see that it's pretty much the same rules at E*TRADE, Schwab, and the rest of the industry.

TD Ameritrade Margin Handbook


On options expiration day (the Saturday immediately following the third Friday of each month), it is our firm's policy to automatically exercise all long equity options contracts that are at least $0.01 in-the-money, and all long index options contracts that are at least $0.01 in-the-money. 33 To exercise options outside of these parameters, or to decline the automatic exercise of options within these parameters, options owners must notify a Client Services representative of their instructions.  This notification must occur by 4:30 p.m. ET on the last trading day for the options contracts.  It is the responsibility of the investor to have sufficient buying power in the account to exercise a long call options contract, and to have the stock in the account to exercise long put options.  TD Ameritrade Inc. reserves the right to close out options positions that pose risk if exercised or assigned if you do not have sufficient buying power to cover any possible exercise or assignments, please deposit funds or close out your positions before the close of market on the Friday prior to expiration.  Please contact a broker or refer to your account's position page to confirm options assignments for your account.

TD Ameritrade, Inc. receives assignment instructions from the Options Clearing Corporation (OCC) and uses a lottery system to randomly assign individual brokerage accounts that are short the options positions.  A more detailed description of the random allocation procedure is available on request or online in the Help Center.

33 If trading in an underlying security has been halted and trading does not resume before expiration, the option may not be automatically exercised.  Exercise settlement values for index options are determined in a variety of ways.  The settlement value may be determined by the closing prices of the index securities on the last trading day before expiration or by the opening prices of the index securities on expiration day.  Please contact a Client Services representative for more information.