Options Account Supervision
Account Approval Process
The options account approval process is one of the most critical supervisory functions for a Registered Options Principal (ROP). Unlike standard brokerage accounts, options accounts require a specific, multi-step approval process before customers can begin trading. The ROP must understand and supervise each step to ensure compliance with FINRA rules, exchange rules, and the firm's own internal policies.
Options trading carries unique risks that go beyond those associated with traditional equity or fixed-income investments. Customers who sell uncovered options face potentially unlimited losses. Even buyers of options can lose their entire investment within a short timeframe. Because of these risks, the securities industry has developed a rigorous account opening process specifically for options.
Under FINRA Rule 2360 and exchange rules (such as CBOE Rule 9.7), the account approval process for options trading involves several mandatory steps that must be completed in a specific sequence. The ROP is responsible for ensuring that each step is properly executed and documented.
Step-by-Step Approval Process
The options account opening process follows this sequence:
- Customer Application: The customer completes an options account application providing detailed financial and background information. This typically includes income, net worth, liquid net worth, investment experience (especially with options), investment objectives, employment status, and options knowledge level.
- Registered Representative Review: The registered representative reviews the application and makes an initial assessment of whether options trading is appropriate for the customer. The rep should discuss the risks of options trading with the customer.
- ODD Delivery: The Options Disclosure Document (ODD), officially titled "Characteristics and Risks of Standardized Options," must be delivered to the customer at or before the time the account is approved for options trading. This document is published by the Options Clearing Corporation (OCC) and explains the characteristics, risks, and mechanics of options trading.
- ROP Approval: The Registered Options Principal reviews the application and determines the appropriate level of options trading for the customer. The ROP must approve the account within a specific timeframe.
- Customer Agreement: The customer must sign and return an options agreement within 15 days of account approval. If the signed agreement is not received within 15 days, the account is restricted to closing transactions only.
Exam Tip
Critical timing rules for the Series 4 exam: The ODD must be delivered at or before account approval. The options agreement must be returned within 15 days of account approval. If the agreement is not returned within 15 days, the account is restricted to closing transactions only (the customer cannot open new positions).
Suitability and Trading Levels
Options suitability analysis is more granular than standard securities suitability. Most firms employ a tiered system of trading levels (also called approval levels or trading authorizations) that correspond to increasingly risky options strategies. The ROP must approve each customer for the appropriate level based on their financial situation, experience, and investment objectives.
Typical Trading Level Structure
| Level | Strategies Permitted | Risk Profile |
|---|---|---|
| Level 1 | Covered calls, protective puts | Lowest risk; requires stock ownership |
| Level 2 | Long calls, long puts | Limited to premium paid |
| Level 3 | Spreads (debit and credit) | Moderate; defined risk and reward |
| Level 4 | Uncovered (naked) puts | High; potential for substantial loss |
| Level 5 | Uncovered (naked) calls, straddles, strangles | Highest; potentially unlimited loss |
Suitability Factors for Options
When evaluating suitability for options trading, the ROP must consider:
- Financial Resources: Income, net worth, and liquid net worth must be sufficient to absorb potential losses at the approved trading level. Uncovered strategies require substantially greater financial resources than covered strategies.
- Investment Experience: Prior experience with options, equities, and other financial instruments. A customer with no investment experience should generally not be approved for complex strategies.
- Investment Objectives: The customer's goals must align with the strategies permitted at the approved level. Income-oriented customers may be appropriate for covered call writing; speculative customers may be appropriate for directional option purchases.
- Risk Tolerance: The customer must understand and be able to bear the specific risks of the strategies they will employ.
- Tax Status: Options can have complex tax implications that the customer should understand.
- Age and Employment: While not determinative, these factors contribute to the overall suitability assessment.
Warning
Approving a customer for uncovered options writing (Levels 4 or 5) without adequate financial resources and experience is one of the most common and serious supervisory violations in the options industry. The ROP must apply heightened scrutiny to high-level approvals and ensure that the customer truly understands the risks of unlimited or substantial loss potential.
Options Disclosure Document (ODD)
The Options Disclosure Document is a standardized document published by the OCC that every options customer must receive. The ODD serves as the primary disclosure tool in the options industry, analogous to a prospectus in the securities offering context.
Key ODD Contents
- Characteristics of standardized options (calls and puts)
- Risks of various options strategies
- How options are traded and settled
- Tax consequences of options transactions
- The role of the OCC as issuer and guarantor
- Exercise and assignment procedures
- Margin requirements (general overview)
Delivery Requirements
The ODD must be delivered at or before the time the account is approved for options trading. If the ODD is updated (supplements are issued regularly), existing options customers must receive the updated version. The firm must maintain records evidencing delivery of the ODD to each customer.
In addition to the ODD, the firm may also be required to deliver supplemental documents for specific types of options (e.g., index options, LEAPS, binary options) that have unique characteristics or risks not fully covered by the standard ODD.
Definition
Options Disclosure Document (ODD): A standardized document published by the Options Clearing Corporation titled "Characteristics and Risks of Standardized Options." It must be delivered to every customer at or before account approval. The ODD explains how options work, their risks, tax implications, and settlement procedures.
Options Account Types
The ROP must understand the unique requirements for different account types that may engage in options trading:
- Individual Accounts: Standard options accounts for individual investors. Suitability is based on the individual's profile.
- Joint Accounts: All account holders must sign the options agreement. Suitability should consider the most conservative participant.
- Corporate Accounts: Require a corporate resolution authorizing options trading, specifying who is authorized to place orders, and defining the scope of trading activities permitted.
- Partnership Accounts: Require a partnership agreement authorizing options trading, along with identification of authorized traders.
- Trust Accounts: The trust instrument must permit options trading. The trustee must be authorized, and the trading must be consistent with the trust's objectives and the trustee's fiduciary duties.
- Retirement Accounts (IRAs): Options trading in IRAs is subject to additional restrictions. Generally, uncovered writing is not permitted. Covered call writing and protective put purchases are typically allowed. Spread strategies may be permitted in some custodial arrangements.
- Discretionary Accounts: Require specific written authorization from the customer granting the representative discretion over options trading. Each discretionary order must be approved by the ROP promptly (the same day or the next business day).
Key Takeaway
The account approval process is the first line of defense in options supervision. A thorough, well-documented approval process prevents unsuitable trading, protects customers, and reduces the firm's regulatory and litigation risk. The ROP must view account approval not as a formality but as a critical supervisory function.
Mnemonic
Remember the options account opening sequence with "A-O-R-S": Application received, ODD delivered (at or before approval), ROP approves the account, Signed agreement returned within 15 days. If no S within 15 days, the account goes to "closing only."
Check Your Understanding
Test your knowledge of options account supervision. Select the best answer for each question.
1. The Options Disclosure Document (ODD) must be delivered to the customer:
2. If a customer fails to return the signed options agreement within the required timeframe, the account is:
3. Which trading level typically permits uncovered (naked) call writing?
4. Options trading in an IRA account is generally restricted from:
5. The signed options agreement must be returned within how many days of account approval?