Options accounts

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. For example, imagine helping an inexperienced investor open an options account and then allowing them to sell a short naked call, which has unlimited risk. If the account later loses substantial value and the investor goes into debt, the firm and the representative will face serious consequences.

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 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, this is usually done online. The customer provides personal information (name, DOB, SSN, address, etc.) and also provides 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 how marital status or number of dependents relates to options trading. 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. 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 likelihood 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 is not technically required to sign the new account form. In practice, most firms require a signature on some form of customer agreement. This typically includes a pre-dispute arbitration agreement and other terms required to maintain the customer relationship. Arbitration agreements require unresolved disputes between customers and member firms to be handled through arbitration (rather than the U.S. court system). We’ll discuss arbitration further in a future chapter.

Once the new account form is completed, it’s forwarded to a Registered Options Principal (ROP - Series 4) or General Securities Sales Supervisor (Series 9/10). This supervisor 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 (e.g., investment experience/knowledge, net worth) within 15 calendar days. This gives the customer a chance to confirm the information is accurate. The customer verifies the information through negative confirmation (affirmation), meaning 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 produced by the Options Clearing Corporation (OCC). Regulators want investors to have access to clear 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, if the ODD section on spread strategies is updated, then by the time an existing customer’s spread trade is confirmed (by trade confirmation), the customer must receive the relevant ODD amendment(s).

Options principal approves account

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

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

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

For example:

• If an investor lacks investing experience or has limited financial resources, the supervisor may disapprove the account or limit the customer to covered calls and/or long options (both have limited loss potential).
• If an investor has years of investing experience and significant financial resources, the supervisor may consider allowing higher-risk strategies such as short naked calls or short straddles (both have unlimited loss potential).

When the principal determines that all required information has been provided and decides what options level is appropriate, the principal signs the new account form (if approving the account). Once signed, the account is officially approved and the investor may enter options transactions.

First trade “opens” the account

After approval, the customer may 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 trade.

Customer returns signed options agreement within 15 days

During the account-opening process, the financial representative provides the options agreement to the customer. If signed, this agreement confirms the investor:

• Has received the ODD
• Understands and will follow the rules of the options market (created by the OCC), including position and exercise limits (discussed in a future chapter)

The customer has 15 calendar days from account approval to return the signed options agreement. If it isn’t returned on time, the account must be restricted to closing transactions only. For example, the customer may close out a short put by making a closing purchase. In other words, the customer can reduce or eliminate existing options positions, but can’t establish new positions (opening transactions) until the signed options agreement is returned.