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I sold some in-the-money naked calls, and found out the next day that the broker bought the underlying shares to cover the calls. They claimed that the underlying is hard-to-borrow and since the option was in the money and could be assigned (even though the option still had significant time value and no sane person would exercise it), they needed to cover it in compliance with rule 204. I was shocked to hear this. Can a broker do this?

Some clarification: the calls were not assigned (I still have the position) and I had more than enough margin. The broker did not close my short calls, just bought the underlying.

Update: The broker has now walked back from their claim and attributed the buy-in order to some miscommunications.

  • which country ? – Raj Oct 24 '19 at 12:56
  • @Raj It is a big US brokerage firm. – xesxz Oct 24 '19 at 17:21
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As I understand it, Rule 204 has to do with selling stock short without having shares available to deliver shares at settlement. So if exercise would result in such a short sale, the position would then be subject to a close out.

Your broker closing your option position in anticipation of a possible fail to deliver also seems wrong to me. That's just my opinion but I'm no expert. The first thing that I would suggest would be to check to see if there's any such language in your option agreement. Brokers can impose more stringent requirements than Reg T, Reg SHO, etc. In lieu of that, contact the SEC to see if they can provide any clarification.

Not exactly the same situation but I have had a number of existing short positions called in. My broker notified me during trading hours and gave me until 4 PM EST to buy in the position which is something you always want to do yourself because the broker will close at 4 PM or later and that usually means a haircut since B/A spreads are wider during after hours. I'd be dismayed if this occurred without the courtesy of notification, as you experienced.

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The broker must exercise practice as required by rule that means to reduce their risk exposure.

Ironically, you may think it put you in the bad position as this may jack up the price of the stock (depends on the liquidity of the stock). However, this will also buffer the last minute purchase jack up the price.

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