Options accounts

As you learned in the Options unit, options are risky short-term investments. Due to the risk involved, opening an options account requires extra care and diligence on behalf of the financial professional and firm.

Think about it - imagine you help an inexperienced investor open an options account, and then they sell a short naked call with unlimited risk. Later, the account loses thousands of dollars and the investor goes deep into debt. How would you feel?

As a financial professional, your job is to guide and help your customers understand the benefits and risks of investing. It’s important to ensure investors have a good grasp of the risks involved with options prior to opening an options account.

When an investor wants to open an options account, FINRA Rule 2360 requires a very specific process:

1. Customer fills out the new account form
2. Financial representative provides ODD
3. Account is approved by an options supervisor
4. First trade “opens” the account
5. Customer returns signed options agreement within 15 days

Let’s break down each step individually:

Customer fills out the new account form

The first step to opening any new account requires an account form to be filled out. In today’s digital age, almost every account form is completed online. The customer discloses their personal information (name, DOB, SSN, address, etc.), plus some options-related and suitability-related items, 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 be wondering how marital status or number of dependents relates to option trading. It’s not uncommon for an investor to support their family financially in one way or another. If they were to enter into risky option contracts that subjected them to significant loss potential, the situation would be much worse if dependents were involved. The more family obligations a customer has, the more restrictive a brokerage firm should be when deciding to whether or not to approve an options account.

The customer technically is not required to provide the requested suitability information but is at a higher risk of their account being disapproved if not enough information is provided. This information is used by the approving supervisor (discussed below) to determine if the account should be approved and/or what type of option contracts can be traded by the customer. Think about it - would it be a great idea to allow a novice to enter into an option contract that could result in them losing a significant amount of money? No - and that’s why this rule is in place.

Legally speaking, the investor is not required to sign the new account form. In practice, most financial firms require their customers to sign some form of a customer agreement, which typically includes an arbitration agreement. We discuss arbitration agreements in a separate chapter.

Once the new account form is filled out, it’s sent to a Registered Options Principal (ROP - Series 4) or General Securities Sales Supervisor (Series 9/10), who will analyze the data provided on the form and decide if the account should be approved. If the account is approved, the firm must send the investor a written copy of their background (e.g. investment experience) and financial (e.g. net worth) information within 15 calendar days. This allows the customer to affirm the documentation on file is correct. FINRA allows this type of affirmation to be performed by negative confirmation (affirmation), which means the investor only needs to respond if the information on file is incorrect. A lack of response essentially confirms the details are correct.

Financial representative provides ODD

After the new account form is completed, it’s the representative’s responsibility to provide the Options Disclosure Document (ODD), which is an options booklet of characteristics, risks, and benefits of options. If you want to see the real ODD, click the link above and download the PDF from the OCC’s website.

The ODD is a creation of the Options Clearing Corporation, which we learned about earlier in this chapter. The OCC regulates the activities and structure of the options markets. Part of their job is to ensure investors understand options before they trade them.

The ODD provides an opportunity for both the OCC and financial firm to verify the customer has enough access to information on options. While the investor must choose to spend the time reading the booklet, the resource is available.

Delivery of the ODD must occur prior to opening an options account or any options-related discussion. For example, financial firms must provide the ODD if mailing options marketing materials to a customer that has not yet received the ODD.

Account is approved by an options supervisor

After the new account form was filled out, it’s sent an appropriate supervisor (Series 4 or 9/10) with oversight concerning options-related activities. The supervisor confirms the customer provided all legally required information on the new account form and determines the suitability of the account.

The requested suitability information (e.g. net worth, investment experience, etc.) helps the supervisor determine what securities and actions are appropriate for the customer given their background and financial situation. With this information, the supervisor will determine what level of options trading the investor is eligible for.

If an investor lacks experience and/or doesn’t have the necessary financial resources, the supervisor may disapprove the account, or only allow investments in covered calls and/or long options (both have limited loss potential). If an investor has years of investing experience and high income/asset levels, the supervisor may consider allowing riskier option strategies like short naked calls (subject to unlimited loss potential).

When the supervisor concludes the required information has been disclosed and determines the level of options that can be traded, they sign the new account form (if they decide to approve it). Once signed, the account is officially approved and the investor can perform option trades.

First trade “opens” the account

Once the account is approved, the customer can place trades. Technically, the account is “open” when the first trade is placed. Whether it’s an opening purchase or sale, the account is officially active after the first trade is placed.

Customer returns signed options agreement within 15 days

At some point during the account opening process, the financial representative provides the options agreement to the customer. The investor confirms they’ve been provided the ODD, plus understands and will abide by the rules of the market (created by the OCC).

The customer has 15 calendar days from account opening to return the signed options agreement. If they do not return it in time, the account will be restricted to only closing transactions. For example, the customer can close out a short put by performing a closing purchase. Basically, they can put an end to current option positions, but can’t establish any new positions (opening transactions) until the options agreement is signed and returned.