Out Of Options

Two ex-traders say unusual after-hours price changes stacked the deck against them

Going to bed a millionaire and waking up a pauper is a recurring nightmare for a lot of investors. But for Michael Vitanza, who traded options at the New York Futures Exchange (NYFE), it was no dream.

Vitanza had invested in options on Pacific Stock Exchange Technology Index (P-Tech) futures. But after the market closed, the values of his positions would suddenly change. Sometimes they were sliced in half; sometimes they were inflated. Those after-hours price cuts in what are called settlement prices kept setting off margin calls. Fearing he couldn't keep coming up with enough cash to meet the margin calls, Vitanza adopted trading tactics that eventually wiped him out.

Vitanza, a single father who's now broke and unemployed, claims that he was done in by the way that exchange insiders fiddled with settlement prices after the market closed. How can option prices be changed? When an option is actively traded, the settlement price is usually the price of the last trade. But if an option doesn't trade much, its price can shift out of line with the stock or index on which it's based. So after the close, it must be assigned a value--which firms and traders use to tally their books every night and calculate their net worth. The settlement price is crucial, because it determines the value of equity in margin accounts. If, at day's end, a trader's equity is inadequate, he'll get a margin call. And if he doesn't come up with more cash right away, his account can be liquidated.

A number of options experts feel that, though extreme, Vitanza's experience with settlement pricing reveals fundamental flaws in how many options are valued after the close. Those flaws appear to invite behind-the-scenes abuses and raise questions as to whether options exchanges can adequately police themselves.

Vitanza and fellow trader Frank Carmona are preparing a $24 million lawsuit that accuses Norman Eisler, the former chairman of the NYFE, of adjusting settlement prices on P-Tech options for his own benefit. Their clearing firm, New York's Klein & Co. Futures Inc., already filed a $100 million suit against Eisler in July for the same reason. And all three parties are suing the New York Board of Trade (NYBOT), the NYFE's parent exchange, for neglecting to supervise Eisler properly. The NYBOT and Eisler have yet to file a response to the Klein suit. And they declined to comment for this story.

The NYFE is a tiny exchange in the World Trade Center. A seat costs a mere $1,250. Vitanza, 42, and Carmona, 44, were small-time "locals," or self-employed traders who owned seats and traded for themselves. But their story could be that of any small investor who dabbles in options--and especially options on futures contracts, an area that's growing by leaps and bounds. Vitanza and Carmona say that they complained repeatedly for nearly three years about the weird settlement pricing, but that exchange officials ignored them. "That an exchange could not notice this for three years is unconscionable," says Carmona.

Eisler didn't just head the NYFE. He also headed its P-Tech Futures and Options Settlement Committee, the group that set the after-hours prices. And he traded P-Tech futures and options for his own account, an accepted industry practice. Vitanza and Carmona allege that for nearly three years, Eisler set settlement prices to hide huge trading losses of his own and prevent margin calls on his account. "Norman had 16 aces in his deck," Vitanza \says.

To support their allegations, Vitanza and Carmona argue that when the NYBOT finally took settlements out of Eisler's hands on May 15, his account came up $4.5 million short. Eisler failed to meet the margin call and immediately resigned from the exchange.

Carmona's suspicions were first raised in July, 1997, when he simultaneously bought puts for $6.90 and sold calls for $3.50. They were both settled after the close at much lower levels--$4.35 and $1.70, respectively. A call is an option to buy: Its price rises when the underlying index rises. A put, which is an option to sell, rises when the index falls. How could both calls and puts lose more than 35% of their value in the same day--when they're supposed to move in opposite directions?

Once Carmona and Vitanza figured out what was happening, they could have cashed out their positions, of course, and refused to play. But trading was their livelihood, and they couldn't afford the cost of a seat at other exchanges. They figured they could trade around the problem. But gradually the discrepancies got bigger.

Copies of Vitanza's and Carmona's trading statements show discrepancies growing greater as tech stocks heated up late last year. Puts that Vitanza bought at $13.30 on Oct. 5, for instance, were valued at the end of the day at a settlement price of $7. That made his position worth 47% less than he thought it was. Calls sold short at $5.50 on Oct. 18 were marked down, after the close, to only 5 cents--a nickel. But Vitanza couldn't buy or sell at that price. It was just an overnight valuation.

In the stock market, a stock's settlement price is the price of the last trade, even if that trade took place hours before the close. But options work differently. Their prices are based on some underlying commodity, security, or index. The options that Vitanza and Carmona traded are based on futures contracts for the P-Tech index of 100 tech stocks. The prices of those stocks, and thus the value of the index, keep changing up to the close. If an option doesn't trade frequently, its last price will probably be out of whack with the index.

INFLATED PRICES. So after the close, a settlement value must be established, and how that's done varies by options exchange. But in the case of options on futures, it's done by a settlement committee--usually three or more people appointed by the exchange's board. "When you have an option that doesn't trade in the last few hours of the day and the underlying market shifts dramatically, yes, I've seen variations in price," says Maz Chadid, managing director of trading operations at the Chicago Mercantile Exchange, a far larger market than the NYFE. "But if the underlying market and volatility haven't changed, the settlement price would be close to the traded price."

Or should be. As Vitanza and Carmona see it, Eisler set hugely different settlement prices on P-Tech options to evade margin calls. When he bought options, they claim, he would inflate the settlement price to make his positions appear to be worth more. When he sold P-Tech options short, they allege, he did the reverse and reduced the settlement price. And whoever was on the opposite side of his trades--bought what Eisler sold and sold what Eisler bought--saw their accounts decline in value.

BUSINESS WEEK showed many of the settlement prices in question to options expert Lev Borodovsky, co-chairman of the Global Association of Risk Professionals. Borodovsky wasn't surprised that settlement prices varied from market prices, but he was surprised by the size of the price gaps. Among institutional investors, "no one really bothers with the settlement price," he says. "People don't trust it." That's because most exchanges, he contends, don't have enough surveillance to keep an eye on settlements. "Exchanges have hundreds and hundreds of options, and they're fairly understaffed to keep track of them," Borodovsky says. "With the less active contracts, they tend to look the other way."

An official at the Chicago Board Options Exchange (CBOE), the nation's largest options market, disagrees. "We have a market regulation department composed of at least 100 people. The CBOE takes surveillance very seriously."

Billion-dollar institutions, says Borodovsky, don't care about mispriced settlements: They have enough cash to meet overnight margin calls. "If they get screwed on the margin side, that's just a cost of doing business," he says.

But smaller investors usually can't treat margin calls as a cost of doing business. It was trying to avoid margin calls that trapped Vitanza. Last October, when tech stocks were becoming hugely volatile, he tried to hedge a position in P-Tech futures. The natural way to hedge would be to buy put options. But the settlement value of the puts was then marked down by 60%, making Vitanza vulnerable to margin calls. "Eisler made it impossible to invest in protection," Vitanza says. He wound up $263,000 in the hole and had to close out his account in March. Carmona blew out the next month with a $600,000 deficit.

Vitanza and Carmona weren't the only ones who complained about settlement prices to Eisler and to Klein & Co. President David E. Klein. Jeanette Young, another trader who cleared through Klein--and who is now on the P-Tech Settlement Committee--started complaining to Eisler and Klein in February. She also went over Eisler's head, talking to Joseph O'Neill, NYBOT's executive vice-president for strategic planning. Nothing was done. "The pricing on the options had absolutely nothing to do with reality," Young says. "So I got burned for about $30,000."

Says Michael Murray, a former NYFE trader who also lost a bundle in P-Tech options: "We were a very secondary exchange for NYBOT, so they went on the word of floor officials that everything was fine. They had no real oversight of the exchange."

Ultimately, the settlement game unraveled. As tech volatility increased, the NYBOT hiked its margin requirements. That meant Eisler had to put up more cash, which he apparently didn't have. According to Klein, Eisler got his first margin call, for $728,000, on May 11. The next day the sum grew to $1.3 million. When NYBOT intervened in the settlement valuation four days later, Eisler's loss turned out to be $4.5 million.

The aftermath was a mess. Since Klein & Co., the clearing firm, didn't have reserves to cover the $4.5 million, NYBOT confiscated the segregated accounts of all the firm's clients the following day, putting Klein out of business. The confiscation sparked a lawsuit from the New York Mercantile Exchange (NYMEX), which had traders who cleared through Klein. The suit was settled for an undisclosed sum.

NO GRUDGES. For Young, who was clearing through Klein and whose account was also confiscated, it was a terrifying experience. "I couldn't find a clearinghouse to carry my account for about a week after that," she says. "Nobody would take a NYFE trader." She and the NYMEX traders with confiscated accounts were forced to sign a waiver agreeing to forego any legal action against NYBOT before the exchange would return their money, she says. But Young holds no grudges. "I don't blame the exchange," she says. "I blame Norman."

In Carmona's and Vitanza's view, NYBOT's failure to uncover the settlement shenanigans was gross negligence. "You really don't want to put the job of settling prices in the hands of someone who has an economic interest," says Carmona. Besides, he adds, "settlement committees are fossils left over from a previous age. Computers could do the job much more objectively." And they are starting to: Roughly half of the options traded at the Chicago Merc, for example, are now settled by computer rather than committees.

But meantime, as a result of the debacle, Vitanza says he'll never trade again. And Carmona has taken a job teaching history at a Bronx junior high school. "I don't have my own classroom yet," he says. "So I have to wheel my books to each class." He used to be a millionaire. Now he makes $32,000 a year.

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