Options Regulations

Options Regulatory Framework

The regulation of options markets involves a multi-layered framework of rules and oversight from various regulatory bodies. As a Registered Options Principal (ROP), understanding this comprehensive regulatory structure is essential for maintaining compliance and supervising options activities effectively. The regulatory framework encompasses federal securities laws, rules promulgated by the Securities and Exchange Commission (SEC), self-regulatory organization (SRO) rules from FINRA and the options exchanges, and the rules and by-laws of the Options Clearing Corporation (OCC).

Unlike many other securities products that are primarily governed by a single regulatory body, options are subject to concurrent jurisdiction from multiple authorities. This creates a complex regulatory environment where the ROP must navigate overlapping rules and ensure compliance at every level. The foundation begins with the Securities Exchange Act of 1934, which grants the SEC authority over securities markets, including options. From there, the regulatory framework branches into exchange rules, OCC rules, and FINRA rules, each covering different aspects of options trading and supervision.

The ROP serves as the firm's primary compliance officer for options activities. This role requires not only knowledge of the rules but also the ability to implement effective supervisory systems, train personnel, and respond to regulatory inquiries. The consequences of regulatory failures in the options space can be severe, including fines, sanctions, customer restitution, and potential criminal liability in cases of fraud or willful violations.

Self-Regulatory Organization (SRO): A non-governmental entity that has the power to create and enforce industry regulations and standards. In the options context, FINRA and the options exchanges (CBOE, NYSE Arca, Nasdaq PHLX, etc.) serve as SROs with rule-making and enforcement authority delegated by the SEC.

OCC Rules and Role as Clearinghouse

The Options Clearing Corporation (OCC) is the world's largest equity derivatives clearing organization and serves as the central counterparty for all exchange-listed options transactions in the United States. The OCC is jointly owned by the options exchanges and operates under SEC oversight as a registered clearing agency under Section 17A of the Securities Exchange Act of 1934.

OCC's Role and Functions

The OCC performs several critical functions in the options market:

Issuer and Guarantor: The OCC is the issuer of all standardized options contracts and guarantees the performance of every options contract. When a buyer purchases an option, the OCC becomes the seller to the buyer. When a seller writes an option, the OCC becomes the buyer from the seller. This interposition eliminates counterparty risk.
Clearance and Settlement: The OCC clears and settles all options transactions, ensuring that exercise obligations are matched with assignment obligations and that funds and securities are transferred appropriately.
Exercise and Assignment: The OCC processes all exercise notices and randomly assigns exercise obligations to clearing members with short positions in the exercised series.
Risk Management: The OCC operates sophisticated risk management systems, including margin requirements for clearing members, collateral management, and stress testing to ensure financial stability.
Market Data and Information: The OCC publishes the Options Disclosure Document (ODD) and provides market data, including position limits, to market participants and regulators.

OCC By-Laws and Rules

The OCC's By-Laws and Rules govern the relationship between the OCC and its clearing members (broker-dealers). Key provisions include:

Clearing Member Requirements: Firms that wish to clear options transactions must become OCC clearing members and meet stringent capital and operational requirements.
Margin Requirements: OCC Rules establish the margin requirements that clearing members must meet on customer and proprietary positions. The OCC uses a sophisticated risk-based margin system called STANS (System for Theoretical Analysis and Numerical Simulations).
Position Reporting: Clearing members must report large options positions to the OCC, which monitors for manipulation and excessive risk concentration.
Contract Specifications: The OCC By-Laws define the terms of standardized options contracts, including strike price intervals, expiration dates, contract size, and settlement procedures.

For the Series 4 exam, remember that the OCC is both the issuer and guarantor of all standardized options. This means every listed options contract is issued by the OCC and guaranteed by the OCC, eliminating counterparty risk. The OCC is not a government entity but operates under SEC oversight as a registered clearing agency.

Exchange Rules and Requirements

Options are traded on multiple exchanges in the United States, including the Chicago Board Options Exchange (CBOE), NYSE Arca, Nasdaq PHLX, Nasdaq ISE, Nasdaq BX, Nasdaq GEMX, MIAX, and others. Each exchange operates as an SRO with its own rulebook, though many rules are substantially similar across exchanges due to coordination and standardization efforts.

CBOE Rules

The Chicago Board Options Exchange is the largest options exchange by volume and has historically been the leader in establishing options market practices. Key CBOE rules include:

CBOE Rule 9.7 (Approval of Accounts): Requires member firms to establish procedures for opening and approving options accounts, including the requirement that a Registered Options Principal approve each account based on suitability factors.
CBOE Rule 9.8 (ODD Delivery): Mandates delivery of the current Options Disclosure Document to customers at or before account approval.
CBOE Rule 9.9 (Options Communications): Establishes requirements for communications with the public regarding options, including advertising, sales literature, and independently prepared reprints.
CBOE Rule 9.10 (Discretionary Accounts): Specifies requirements for discretionary options trading, including written authorization and principal approval of discretionary orders.

Cross-Exchange Coordination

To ensure market integrity and consistent regulation, the options exchanges coordinate on key regulatory matters through the Options Regulatory Surveillance Authority (ORSA) and direct coordination agreements. Areas of coordination include position limits, exercise limits, trading halts, and market manipulation surveillance.

When a regulatory issue arises, the exchange where the member firm's options principal is registered typically takes the lead in investigation and enforcement, though multiple exchanges may be involved if the activity spans multiple trading venues.

Firms must comply with the rules of every exchange where they are members and route customer orders. A violation of rules on any exchange can result in disciplinary action, even if the firm was primarily active on a different exchange. The ROP must ensure supervisory systems monitor compliance across all trading venues.

FINRA Options Rules

FINRA (Financial Industry Regulatory Authority) regulates broker-dealers and their registered representatives under authority delegated by the SEC. FINRA's options rules are found primarily in FINRA Rule 2360 (Options) and related communications rules.

FINRA Rule 2360 – Options

FINRA Rule 2360 is the comprehensive rule governing options activities by FINRA member firms. Key requirements include:

Account Approval (Rule 2360(b)(16)): Requires a Registered Options Principal to approve options accounts based on a suitability determination. The account must be approved for specific trading levels corresponding to different risk profiles.
Options Agreement (Rule 2360(b)(17)): Customers must sign and return an options agreement within 15 days of account approval. If not returned, the account is restricted to closing transactions only.
ODD Delivery (Rule 2360(b)(18)): The firm must deliver the current ODD at or before account approval and must deliver updates when supplements are issued by the OCC.
Position Limits (Rule 2360(b)(3)): Establishes position limit requirements and reporting obligations for large options positions. The specific limits vary by underlying security based on trading volume and market capitalization.
Supervision Requirements (Rule 2360(b)(21)): Requires firms to establish, maintain, and enforce written supervisory procedures reasonably designed to achieve compliance with options rules. A ROP must be designated to supervise options activities.

Suitability Obligations

Under FINRA Rule 2111 (Suitability) and Rule 2360, firms and registered representatives have specific suitability obligations for options recommendations:

Reasonable Basis Suitability: The firm must have a reasonable basis to believe the options strategy or product is suitable for at least some investors.
Customer-Specific Suitability: The registered representative must have a reasonable basis to believe the specific recommendation is suitable for the particular customer based on the customer's investment profile.
Quantitative Suitability: The firm must have a reasonable basis to believe that a series of recommended options transactions is not excessive in light of the customer's profile.

Options suitability is a multi-layered analysis. The ROP must ensure that the account approval level is appropriate for the customer's profile, that each specific options recommendation is suitable, and that the overall pattern of options trading is not excessive. Unsuitable options recommendations are one of the most common sources of customer complaints and regulatory actions.

Options Disclosure Document Requirements

The Options Disclosure Document (ODD), officially titled "Characteristics and Risks of Standardized Options," is the primary disclosure document for options trading. The ODD is published by the OCC and updated periodically through supplements. Understanding ODD delivery requirements is essential for ROPs and is heavily tested on the Series 4 exam.

ODD Content and Purpose

The ODD provides comprehensive disclosure about:

The nature and mechanics of options contracts (calls and puts)
The risks of various options strategies, including the potential for total loss and unlimited risk
How options are traded, exercised, and settled
The role of the OCC as issuer and guarantor
Margin requirements and their implications
Tax considerations for options transactions
Special characteristics of index options, LEAPS, and other specialized products

ODD Delivery Requirements

Situation	Timing Requirement	Consequences of Non-Delivery
New options account	At or before account approval	Cannot approve account; Rule violation
ODD supplement issued	Promptly to existing customers	Failure to disclose material information
Specialized products (index options)	Before first transaction in that product	Inadequate disclosure; unsuitability
Customer request for ODD	Within 3 business days	Customer service failure; potential complaint

Supplemental Disclosures

In addition to the standard ODD, firms must provide supplemental disclosure documents for certain specialized options products:

Index Options: Disclosure covering settlement in cash, the specific index methodology, and risks unique to index options.
LEAPS (Long-term Equity AnticiPation Securities): Disclosure about the longer time horizon and implications for time decay.
FLEX Options: Disclosure about the customizable terms and limited secondary market liquidity.
Binary Options: Extensive disclosure about the all-or-nothing payout structure and extremely high risk.

The ROP must ensure that the firm has systems in place to deliver the ODD and all required supplements in a timely manner and to maintain records demonstrating delivery to each customer.

Options Communications and Advertising Rules

Options communications are subject to heightened regulatory scrutiny due to the complexity and risk associated with options trading. FINRA Rule 2210 (Communications with the Public) establishes the framework for options-related communications, with additional requirements specific to options found in FINRA Rule 2360 and exchange rules.

Types of Communications

Communication Type	Definition	Approval Requirement
Retail Communication	Communication distributed to more than 25 retail investors within 30 days	ROP pre-use approval required
Correspondence	Written communication to 25 or fewer retail investors within 30 days	ROP or designee post-use review
Institutional Communication	Communication solely to institutional investors	Principal review (ROP recommended)
Internal Communication	Communication solely within the firm	No pre-approval required

Content Standards for Options Communications

Options communications must comply with strict content standards:

Fair and Balanced: Communications must provide a fair and balanced presentation of risks and benefits. Emphasizing profit potential without adequately disclosing risks is prohibited.
ODD Reference Required: All retail communications about options must include a statement that the ODD is available from the firm or from theocc.com. The communication should encourage customers to review the ODD before trading.
Risk Disclosure: Communications must clearly disclose the risks specific to the strategies discussed. For example, materials discussing uncovered call writing must prominently disclose the unlimited risk potential.
Prohibition on Recommendations: Communications cannot recommend options to customers who have not been approved for options trading or recommend strategies beyond the customer's approved trading level.
Performance Standards: If past performance is shown, it must include all required disclosures about hypothetical results, lack of guarantee, and potential for loss.
Testimonials and Endorsements: Use of testimonials is permitted but must comply with FINRA Rule 2210 requirements, including disclosure of material conflicts of interest and whether compensation was paid.

ROP Approval Responsibilities

The ROP must approve all retail communications about options before first use or publication. This pre-use approval obligation cannot be delegated to a non-ROP. During the review process, the ROP should:

Verify that all risk disclosures are prominent and adequate
Ensure the communication does not exaggerate potential benefits
Confirm that the ODD reference is included and meets regulatory requirements
Check that options strategies are accurately described and risks are not minimized
Verify that performance claims are substantiated and properly disclosed
Ensure compliance with recordkeeping requirements (must retain copy of approved communication for three years)

Remember the key elements for options communications with "FOUR": Fair and balanced, ODD reference included, Unlimited risk disclosed (where applicable), ROP pre-approval obtained. Every retail options communication needs all FOUR.

Supervisory Procedures for Options

Under FINRA Rule 3110 (Supervision) and Rule 2360, member firms must establish, maintain, and enforce written supervisory procedures (WSPs) reasonably designed to achieve compliance with applicable securities laws and regulations. For options activities, these procedures must be comprehensive and specifically tailored to the unique risks and regulatory requirements of options trading.

Required Elements of Options WSPs

A firm's written supervisory procedures for options must address:

Designation of ROP: The firm must designate one or more Registered Options Principals to supervise options activities. The WSPs should specify the ROP's authority, responsibilities, and reporting relationships.
Account Opening and Approval: Procedures for reviewing options account applications, determining appropriate trading levels, approving accounts, delivering the ODD, and obtaining signed options agreements.
Suitability Determinations: Procedures for conducting suitability reviews at account opening, upon level upgrades, and on an ongoing basis to detect unsuitable trading patterns.
Order Review and Supervision: Procedures for reviewing options orders for suitability, accuracy, and compliance with position limits before execution. Special procedures for discretionary orders and complex strategies.
Communications Approval: Procedures for ROP pre-approval of retail communications about options and principal review of correspondence and institutional communications.
Trade Monitoring: Procedures for monitoring options trading activity to detect churning, unauthorized trading, position limit violations, and manipulative or fraudulent activity.
Exception Reports: Procedures for generating and reviewing exception reports identifying potential violations, such as trading beyond approved levels, unsettled trades, margin deficiencies, and aged fails.
Training: Procedures for ensuring that registered representatives who recommend options are properly trained and qualified. Documentation of training programs and competency assessments.

ROP Supervisory Responsibilities

The Registered Options Principal has specific supervisory obligations that cannot be delegated to non-registered or non-ROP personnel:

Approve options accounts and determine appropriate trading levels
Approve retail communications about options before first use
Approve discretionary options orders promptly (by the end of the day or next business day)
Review options trading activity for suitability and compliance
Investigate customer complaints involving options and respond appropriately
Respond to regulatory inquiries and examinations involving options activities
Review and update written supervisory procedures at least annually
Ensure adequate staffing and resources for options supervision

Testing and Verification

To ensure supervisory procedures are effective, firms should implement testing and verification mechanisms:

Periodic internal audits of options activities
Sampling of options accounts for suitability review
Mystery shopping or testing of account opening procedures
Review of exception reports and follow-up actions
Assessment of ROP workload and whether supervision is adequate given the volume of activity

The Series 4 exam will test your understanding of which supervisory functions must be performed by the ROP personally versus those that can be performed by other qualified personnel. Remember: account approval, communications pre-approval, and discretionary order approval must be done by a ROP and cannot be delegated.

Record Retention for Options Activities

Comprehensive recordkeeping is essential for demonstrating compliance with options regulations, responding to customer inquiries, and cooperating with regulatory examinations. FINRA Rule 4511 (General Requirements) and SEA Rule 17a-4 establish the foundation for recordkeeping requirements, with specific provisions for options activities.

Options-Specific Records

Firms must create and maintain records specific to options activities:

Options Account Records: The original options account application showing the customer's financial information, investment experience, and investment objectives. Retention: life of account plus six years after closing.
ODD Delivery Records: Documentation showing delivery of the ODD to each customer at account opening and delivery of supplements to existing customers. Retention: six years.
Options Agreements: Signed options agreements returned by customers. Retention: life of account plus six years.
ROP Approvals: Documentation of ROP approval of accounts, including the approved trading level and the date of approval. Retention: six years.
Communications: Copies of all retail communications about options, including the date of first use and evidence of ROP approval. Retention: three years.
Order Tickets: Options order tickets showing all required order information, time stamps, and principal approval (if required). Retention: six years.
Trade Confirmations: Confirmations sent to customers for each options transaction. Retention: six years.
Account Statements: Customer account statements showing options positions, transactions, and margin status. Retention: six years.
Position Limit Reports: Reports showing large options positions and submissions to exchanges/OCC. Retention: six years.
Exception Reports: Reports identifying trading violations, suitability concerns, or margin deficiencies, along with documentation of follow-up and resolution. Retention: six years.

Retention Periods

General retention rules for options records:

Six Years: Most options records must be retained for six years, with the first two years in an easily accessible place. This includes trade records, account documents (after account closing), and compliance records.
Three Years: Communications with the public about options (retail communications, correspondence) must be retained for three years from the date of last use or publication.
Life of Account: Certain foundational account records must be maintained for the life of the account and then retained for six additional years after closing. This includes the original account application and options agreement.

Format and Accessibility

Records may be maintained in electronic format, provided the firm complies with SEC and FINRA requirements for electronic storage:

Records must be in a format that prevents alteration
Records must be indexed and easily retrievable
The firm must be able to produce records promptly upon regulatory request
Records in the first two years of the retention period must be in an "easily accessible place" (generally interpreted to mean readily available rather than archived)

Inadequate recordkeeping is a frequent exam deficiency cited by FINRA and the SEC. The ROP must ensure that all required options records are being created, maintained in the proper format, retained for the required period, and are readily accessible. During a regulatory examination, the inability to produce required records can result in significant fines and sanctions.