Account opening process

As you’ve learned, options are risky, short-term securities. Because of that risk, opening an options account requires the registered representative and the firm to use extra care and sound judgment.

Consider what could happen if an inexperienced investor is approved for options trading and then sells a short naked call, which has unlimited risk. If the position moves against them, the account could lose substantial value and the investor could end up owing money.

Registered representatives must help customers understand both the benefits and the risks of options. Much of that happens during the account-opening process. FINRA Rule 2360 requires the following protocols to be followed when an options account is opened:

1. Customer completes a new account form
2. The ODD is delivered
3. An options principal approves the account
4. First trade “opens” the account
5. Customer returns signed options agreement within 15 days

Let’s break down each step.

Customer completes a new account form

Opening any new account starts with completing a new account form. Today, most firms collect this information online.

The customer provides personal information (name, DOB, SSN, address, etc.) and suitability-related information, including:

• Investment objective
• Employment status
• Estimated annual income
• Estimated net worth
• Estimated liquid (easy to access) net worth
• Marital status*
• Number of dependents*
• Investment experience and knowledge

*You might wonder why marital status or number of dependents matters. Many investors have financial obligations to a spouse, children, or other dependents. If the investor takes on high-risk option positions with significant loss potential, those obligations can make the consequences more severe. In general, the more financial responsibilities a customer has, the more cautious a firm should be when deciding whether to approve an options account.

A customer isn’t technically required to answer suitability questions, but refusing to provide information increases the chance the firm will disapprove the account. The approving supervisor (discussed below) uses this information to decide:

• Whether the account should be approved
• What types of options strategies the customer may trade (if approved)

The investor also isn’t technically required to sign the new account form. In practice, most firms require a signature on a customer agreement, which often includes an arbitration agreement and other terms of doing business with the firm. A future chapter covers arbitration agreements.

Once the new account form is completed, it’s forwarded to a Registered Options Principal (ROP - Series 4) or a General Securities Sales Supervisor (Series 9/10). This principal reviews the information and decides whether to approve the account.

If the account is approved, the firm must send the investor a summary of the background and financial information on file (for example, investment experience/knowledge and net worth) within 15 calendar days. This gives the customer a chance to confirm the information is accurate.

This confirmation is done through negative confirmation (affirmation). That means the customer only needs to respond if the information is incorrect. If the customer doesn’t respond, the firm assumes the information is correct.

The ODD is delivered

After the new account form is completed, the registered representative must provide the Options Disclosure Document (ODD). The ODD is a booklet that explains the characteristics, risks, and benefits of options. If you want to see the actual ODD, use the link above to download the PDF.

The ODD is created by the Options Clearing Corporation (OCC). Regulators want investors to have access to clear, standardized information about options before trading them. The ODD provides that resource, even though the investor still has to choose to read it.

The ODD must be delivered to each customer at or prior to account approval. If the ODD is amended, the amendment must be delivered to existing customers by the time an options transaction related to the amendment is confirmed.

For example, suppose the ODD section on spread strategies is updated. By the time an existing customer’s spread trade is confirmed (by trade confirmation*), the customer must receive the relevant ODD amendment(s).

*A trade confirmation is an official document that summarizes a securities transaction’s details, costs, and results. This is covered further in the brokerage accounts unit.

Options principal approves account

After the new account form is completed, it’s forwarded to the appropriate principal/supervisor (Series 4 or 9/10) who oversees options-related activity. The supervisor:

• Confirms the customer provided all required information
• Evaluates whether options trading is suitable for the customer

The suitability information (such as net worth and investment experience) helps the principal decide what securities and strategies are appropriate given the customer’s financial situation and background. Based on that review, the principal determines what level of options trading the investor is eligible for.

For example:

• If an investor has limited experience or limited financial resources, the supervisor may disapprove the account or restrict the customer to lower-risk strategies such as covered calls and/or long options (both have limited loss potential).
• If an investor has substantial experience and significant financial resources, the supervisor may allow higher-risk strategies such as short naked calls or short straddles (both have unlimited loss potential).

If the principal decides to approve the account, they sign the new account form. Once signed, the account is approved and the investor may enter options transactions (subject to any strategy or level restrictions).

First trade “opens” the account

After approval, the customer can place trades. Technically, the account is considered “opened” when the first trade is placed. Whether it’s an opening purchase or sale, the account becomes active after that first transaction.

Customer returns signed options agreement within 15 days

During the account-opening process, the financial representative provides the customer with an options agreement. When signed, it confirms the investor:

• Received the ODD
• Understands and will follow OCC rules, including position and exercise limits (covered later in this unit)

The customer has 15 calendar days from account approval to return the signed options agreement. If it isn’t returned on time, the account is restricted to closing transactions only.

For example, the customer could close out a short put by entering a closing purchase. In other words, the customer may reduce or eliminate existing options positions, but can’t establish new positions (opening transactions) until the signed options agreement is returned.