Options Trading Supervision
Order Handling and Execution
The Registered Options Principal must supervise order handling to ensure that customer orders are executed promptly, accurately, and in accordance with applicable exchange rules. Options order handling has unique characteristics compared to equity orders, including the need to manage complex multi-leg strategies, time-sensitive expirations, and the interaction between options and underlying securities.
Options exchanges use a combination of electronic trading systems and market makers (also called specialists or designated primary market makers, depending on the exchange) to facilitate order execution. The ROP must understand how orders flow through these systems and where supervisory attention is most needed.
Order Types in Options Trading
The ROP must ensure that representatives and traders properly utilize the various order types available for options trading:
- Market Orders: Executed immediately at the best available price. In options, market orders can be risky because bid-ask spreads may be wide, especially for illiquid options. The ROP should monitor for excessive use of market orders in illiquid series.
- Limit Orders: Specify a maximum purchase price or minimum sale price. Most options orders are limit orders due to the wide spreads common in options markets.
- Stop Orders: Become market orders when a specified price is reached. Not all exchanges accept stop orders for options.
- Spread Orders: Simultaneous buy and sell of related options. Can be executed at a net debit or credit price. The ROP must ensure that spread orders are properly marked and meet the firm's criteria for the customer's trading level.
- Straddle and Strangle Orders: Multi-leg orders that combine calls and puts. Require higher trading level approval.
- Contingency Orders: Orders whose execution depends on another event or condition. These require careful supervision to ensure proper execution.
Definition
Spread Order: A multi-leg options order that involves simultaneously buying and selling options on the same underlying security. Spreads can be vertical (different strikes, same expiration), horizontal (same strike, different expirations), or diagonal (different strikes and expirations). The net premium paid or received is called the spread's debit or credit.
Best Execution Obligations
Under FINRA Rule 5310, broker-dealers have a best execution obligation: they must use reasonable diligence to determine the best market for a security and execute orders at the most favorable terms reasonably available. For options, this means considering:
- The quoted prices on multiple exchanges (many options are multiply listed)
- The size of the order relative to available liquidity
- Market conditions at the time of execution
- The speed of execution
- The likelihood of execution at the quoted price
Options are traded on multiple exchanges (CBOE, NYSE Arca, NASDAQ PHLX, ISE, MIAX, among others), and the same option may be quoted at different prices on different exchanges. The ROP must ensure the firm has procedures for order routing that seek the best available price across all venues.
Strategy Review and Monitoring
The ROP must monitor customer trading activity for appropriateness and compliance on an ongoing basis. This includes reviewing trading patterns, strategy usage, and potential violations of trading level restrictions.
Key Monitoring Areas
- Trading Level Compliance: Ensuring customers only execute strategies permitted at their approved level. A customer approved for Level 2 (long options only) must not execute uncovered writes.
- Pattern Analysis: Reviewing for excessive trading (churning), unsuitable strategies, or patterns that suggest the customer may not understand the risks of their activity.
- Concentrated Positions: Monitoring for situations where a customer has a disproportionately large position in a single underlying security or a single options series.
- Expiration Activity: Heightened supervision during expiration weeks, when customer communication about expiring positions, exercise decisions, and settlement obligations is critical.
- Complex Strategy Execution: Reviewing multi-leg orders and complex strategies to ensure they are properly constructed and within the customer's approved level.
Exam Tip
The Series 4 exam frequently tests the ROP's obligation regarding discretionary accounts. Every discretionary options order must be reviewed and approved by the ROP promptly -- typically defined as the same day the order is executed or by the next business day. Frequent options trading in discretionary accounts requires enhanced monitoring for suitability.
Record Retention for Options
The ROP must ensure that the firm maintains comprehensive records of all options-related activities. Under SEC Rule 17a-4 and exchange rules, key records include:
- Options account applications and approval documentation
- Evidence of ODD delivery
- Signed options agreements
- Order tickets with all required information (time received, time executed, strategy type, customer instructions)
- Customer confirmations
- Account statements showing options positions
- Customer correspondence related to options
- Exception reports and supervisory review documentation
| Record Type | Retention Period | Format |
|---|---|---|
| Account applications | 6 years after account closed | Electronic or physical |
| Order tickets | 6 years | Electronic or physical |
| Customer confirmations | 6 years | Electronic or physical |
| Customer correspondence | 3 years | Electronic or physical |
| Advertising materials | 3 years from last use | Electronic or physical |
Key Takeaway
The ROP's supervisory role extends beyond initial account approval. Ongoing monitoring of trading activity, execution quality, and compliance with trading level restrictions is essential. The ROP should use exception-based reports to identify accounts requiring heightened attention, including accounts with concentrated positions, frequent trading, or strategies that approach or exceed the customer's risk tolerance.
Mnemonic
ROP monitoring: "CLEPS" = Compliance with trading levels, Levels of activity (churning), Expiration activity, Position concentrations, Strategy appropriateness. Review CLEPS daily to stay on top of your supervisory obligations.
Check Your Understanding
Test your knowledge of options trading supervision. Select the best answer for each question.
1. Under best execution obligations, the ROP must ensure the firm considers:
2. A discretionary options order must be reviewed by the ROP:
3. Which order type is most commonly used for options transactions due to wide bid-ask spreads?
4. Customer correspondence related to options must be retained for:
5. Which of the following would require the MOST heightened supervision by the ROP?