Twenty-Six Thousand Calls for Margaret Chen
Your firm's position limit for XYZ common stock options is 25,000 contracts on the same side of the market. Margaret Chen holds, at Monday's close: 14,000 XYZ calls in her individual account; 4,000 XYZ calls in her IRA; 5,000 XYZ calls in an account titled to Chen Holdings LLC, which she wholly owns and controls; and 3,000 XYZ calls in an account for her father, over which she holds a power of attorney and places every trade. All are long calls with 12 days to expiration. On Tuesday morning she instructs the desk to exercise 12,000 of the calls over the next three business days. Separately, she asks whether the Chen Holdings position can be excluded because the LLC also holds 30,000 shares of XYZ common purchased "as a hedge."
1. Compute the aggregated position and determine whether a limit violation exists. What should the desk do before accepting Tuesday's exercise instruction?
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Aggregate the accounts that must be combined: the individual account (14,000), the IRA (4,000), and the LLC she wholly owns and controls (5,000) total 23,000. The father's account adds 3,000 because she holds a power of attorney and places every trade - control, not ownership, drives aggregation. Aggregate long-call position: 26,000 contracts, 1,000 over the 25,000 limit.
The violation exists as of Monday's close and should be treated that way. Before accepting the exercise instruction, the desk should:
- Confirm the aggregation analysis in writing and notify the ROP immediately.
- Recognize that exercising 12,000 long calls reduces the long-call position, so the exercise does not worsen the problem - it cures it. The desk may accept the exercise, but should not accept any new opening purchase of XYZ calls on the same side until the position is back under the limit and the ROP has reviewed the file.
- Document the timeline: the overage existed for at least one business day, and the firm's written procedures should specify prompt reduction. A violation that is cured within a day is still a reportable supervisory event internally; whether it is externally reportable depends on the firm's Rule 4530 analysis.
2. Does exercising cure the problem? Analyze how the position is measured and whether the exercise limit is separately breached.
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Two distinct limits, measured differently.
Position limit is measured at a point in time - typically end of day - on the same side of the market. Monday's close showed 26,000, which is the violation. Tuesday's exercise of 12,000 cuts the aggregate to 14,000, so by Tuesday's close the account is compliant. Curing after the fact does not erase Monday, but it does mean the exposure is short-lived and the supervisory response should reflect that.
Exercise limit applies to the number of contracts that may be exercised on the same side of the market within any five consecutive business days. Here the applicable limit is 25,000, and Chen proposes 12,000 over three days - comfortably inside the exercise limit. Had she wanted to exercise 27,000, the desk would have to spread the exercises across more than five business days.
One more step the desk owes her: exercising 12,000 calls creates a 1,200,000-share long position. Confirm the account can meet the resulting payment and margin obligation, and warn her in writing about assignment/exercise mechanics and the automatic exercise threshold on any remaining in-the-money contracts at expiration.
3. Evaluate the hedge claim on the Chen Holdings shares.
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The claim fails on its face. Chen Holdings is long 30,000 shares and long 5,000 calls. Long stock plus long calls is not a hedge - it is compounded long exposure in the same direction. A hedge against long calls would require a short stock position (or an offsetting short call, which would itself be on the other side of the market and measured separately).
Even if the economics had worked, the procedural point stands: a hedge exemption is not self-executing. It must be applied for and granted by the regulator in advance, it covers only the specific offsetting quantity, and the firm must maintain records of the exempted positions. You cannot retroactively re-label a position after a limit has been breached.
What to tell her: the 5,000 LLC contracts stay in the aggregation. The legitimate route to relief is a prospective application, with the position documented and the exemption reflected in the firm's limit-monitoring system so the next overage is caught automatically. Also correct the record in the file - a customer's (or a rep's) mistaken hedge assertion, left unchallenged, becomes the firm's problem in an arbitration.