The Violative Trading
21. Six customer accounts at optionsXpress, including Feldman (“the Customers”), engaged in reverse conversions and similar options trading strategies starting no later than October 2008.
22. To execute these strategies, the Customers simultaneously entered into the sale of a put and purchase of call with identical strike prices and expiration dates creating a synthetic long position. The Customers would also create a short position to hedge their synthetic long position. They generally did this by selling deep-in-the-money calls. The synthetic long position and the short position were for an equal number of shares/contracts. Through this set of transactions, the Customers eliminated directional risk in the stock price.
23. An option that is “deep in-the-money” has a strike price that is far below (in the case of a call option) or far above (in the case of a put) the market price for the given security.
24. The deep-in-the-money calls sold to create the short position referenced hard-to-borrow securities and were frequently exercised. After the options were exercised and assigned to the Customers, the Customers had a synthetic long position and a short stock position for which they (and optionsXpress) were required to deliver shares by T+3.
25. However, neither optionsXpress nor the Customers delivered the shares by T+3 thus creating a failure-to-deliver position.
26. Instead of delivering the shares, optionsXpress and the Customers would give the appearance of closing out their fails by entering into a “buy-write,” i.e., they would simultaneously buy the shares they needed to cover the failure-to-deliver position and write (sell) deep-in-the-money calls representing an equivalent number of shares.
27. optionsXpress, Stern, and the Customers knew, or were reckless in not knowing, that most, if not all, the calls that were sold as part of the buy-writes would be exercised and assigned on the same day they were sold, resulting in shares not being delivered on settlement. Thus, optionsXpress, Stern, and the Customers knew, or were reckless in not knowing, that these transactions would result in failures-to-deliver.
28. Selling deep-in-the-money calls is essentially the economic equivalent of selling shares unless the stock price drops precipitously and therefore approaches the strike price.
29. To enter into the buy-write, the Customers paid a certain amount, generally between 1 and 2 pennies per share.
30. The newly written deep-in-the-money calls were generally exercised the same day they were sold (and thus were assigned to the Customers later the same day) putting the Customers back in their original short position, continuing the fails, and causing them to enter into another buy-write the following day. As a result, optionsXpress maintained a net short position at the end of each day.
31. The buy-writes continued on a daily basis until the original synthetic long position was unwound or expired. As a result, optionsXpress had a negative position in the National Securities Clearing Corporation’s (“NSCC”) continuous net settlement (“CNS”) system for extended periods of time.
32. While the daily use of buy-writes gave the impression that optionsXpress was closing out the failures to deliver as required, optionsXpress and the Customers were simply kiting stock to maintain the naked short position.
33. Put another way, the buy-write was a matched order entered for the improper purpose of appearing to close out delivery fails without actually delivering the shares.
34. The transactions were profitable for the Customers because they: (i) sold the initial position “for a credit”; (ii) took no risk with respect to the change in the price of the stock and options that occurred over the life of the position; and (iii) did not incur the costs associated with borrowing or purchasing sufficient shares to make delivery on the short sale. optionsXpress received Commissions on the transactions.
35. The Customers received a net credit for their initial position because of a difference in the relative value of the put and the call. Normally, the price of the put and the call will be in parity; however, the stock associated with the options traded by the Customers was generally hard-to-borrow and therefore expensive to borrow. Because of this, the cost of borrowing the stock was incorporated into the price of the put. Thus, the value of the put was higher relative to the value of the call.
36. Due to the cost of borrowing such hard-to-borrow stocks, the increased price the Customers received for selling the put would have been completely offset by the cost of instituting and maintaining the stock position, had optionsXpress and the Customers complied with their delivery obligations. In order to comply with those obligations, they would have had to borrow or purchase shares of the underlying stock in order to close-out the failure-to-deliver position.
37. By engaging in the buy-writes and thus having a constant unsettled stock position, optionsXpress and the Customers were able to evade the requirements of Reg. SHO at a relatively minimal cost, thereby maintaining the profitability of the trade.
38. By not delivering shares, optionsXpress and its Customers were extracting a profit at the expense of the true purchasers of the shares. There was no legitimate economic purpose to the buy-write transactions.
39. Indeed, the buy-writes standing alone were economically nonsensical because they cost the Customers money. Their purpose was to perpetuate a failure to deliver. This is not a legitimate economic purpose.
40. optionsXpress’ website notes that under normal circumstances the chance to execute profitable reverse conversions is extremely limited: “Individual investors and most other off-the-floor traders don’t have an opportunity to do conversions and reversals because price discrepancies typically only exist for a matter of moments. Professional option traders, on the other hand, are constantly on the lookout for these opportunities. As a result, the market quickly returns to equilibrium.”
41. From at least October 7, 2008 to March 18, 2010, the Customers conducted the trading strategy described above in the following securities and time periods....
and there's a list of trades in the PDF file.
