How To Master Supervision Of Option Activity On The Series 4 Exam
and become a Registered Options Principal
This article will help you learn how to master the Supervision of Option Activity and get you ready to pass the Series 4 exam. As a Registered Options Principal a major part of your job function will be to supervise the how the firm and its employees transact business in options. Mastering these concepts is a must in order to pass your Series 4 exam.
What is the Option Agreement?
The option agreement is the OCC’s (Option Clearing Corporation) full disclosure document and it is titled “the Characteristics and Risks of Standardized Options”. All new option accounts must be approved by the registered option and security futures principal prior to the first option trade. An option investor must sign and return the option agreement within 15 days of the account’s approval to trade options. If the investor fails to return the option agreement within 15 days, no new option positions may be opened and the investor will be limited to closing transactions only until the option agreement is signed and returned. By signing the option agreement, the customer agrees to notify the firm of any significant change in their finances and the customer:
- Agrees to abide by all OCC and exchange rules
- Acknowledges that they have received and read the OCC risk disclosure document
- Understands any long options in the money by 1 cent or more at expiration will result in automatic exercise for the customer
- Understands payment, exercise and assignment terms
What are the keys to Option Account Supervision?
Customer option accounts require strict supervision to ensure compliance with all relevant rules and to ensure that customers only trade options within their approval limits. As customers and agents manage positions, it is quite possible for a customer’s account to end up with an option position that is not within the customer’s approval limit. ROSFPs must review customer accounts frequently to ensure customers stay within their approved guidelines. It would be quite possible for a customer whose account is approved for covered calls only to end up with a naked option position if they sold the underlying stock without covering the short options. If a customer’s account contains a position which is outside of its approval limit, written procedures must be in place detailing how to appeal to the ROSFP for an exception or the options must be covered promptly. ROSFPs must pay close attention to the relationship between customer approval limits and customer positions. When reviewing customer accounts, a ROSFP should also pay close attention to:
- Any churning or excessive commissions earned from the account
- The amount of options positions relative to the size of the account
- Frequent Reg. T extensions
- Profits and losses for option trades
- Any unauthorized transactions
- Any positions established that cannot result in a profit or are not economical
- Any suspicious activity i.e. trading on inside information and front runnings
- Ensure the customer does not exceed position limits
- Any manipulative activity such as capping or pegging
It is quite possible for an investor or trader to use options to profit unduly from the knowledge of a large order and to front run the block by entering an order to buy or sell options on the stock. Similarly, a trader or investor could use options to trade on inside information and to profit unduly from non-public material information. To guard against these situations, ROSFPs will look at the account’s option trading history and the time the option order is executed relative to the block transaction or relative to the release of material information. Orders executed just prior to a block transaction or just prior to the release of material information are more suspicious than orders executed much earlier. Additionally, transactions that are outside the account’s normal trading practices would raise a red flag as well. For example, if an account’s normal option trade is 10 contracts and the order being examined is for 100 contracts that would be a cause for concern.
An option trader who has a large option position may be tempted to try to manipulate the price of the underlying stock through capping or pegging. An investor who is long a large number of put contracts may be tempted to enter orders at the end of the day to sell the underlying security to keep the stock price down. This action would be an example of capping. If the same trader was short a large number of put contracts, the trader may be tempted to enter orders at the end of the day to buy the underlying security to keep the stock price up. This would be an example of pegging. Both capping and pegging activities should be guarded against by the ROSFP and are more likely to occur in the firm’s proprietary trading account or in the account of an institutional customer.
What are the Large Option Position Reporting Requirements?
Member firms are required to report certain large option positions to the OCC that are established for any account, or for any group of accounts acting in concert. Firms must file a large option position report (LOPR) once the position established exceeds the filing threshold on the same side of the market. For most securities the current filing threshold is 200 contracts on the same side of the market. Firms are required to file the initial LOPR data, as well as any changes in reportable positions to the OCC via the LOPR submission message. Once the data is collected by the OCC, the OCC will in turn provide the data to the self regulatory organizations. Firms are required to send their LOPR batch file to the OCC no later than 8:00 PM CST on or before T+1. The date that the firm establishes, modifies or closes an LOPR is know as the effective date. Firms are only required to send an LOPR submission to update a report when there is:
- An increase in a reported position
- A decrease in a reported position
- A reported position is closed
If a firm reports a large option position for an account it is required to report any changes to that position as long as the position remains above the threshold limit. If the previously reported position falls below the contract threshold the firm only needs file the reduction in the number of contracts in a single report. No subsequent reports are required for the position as long the position remains below the threshold limit.
The test may refer to the effective date of an LOPR submission as the trade date.
When Must Customer Confirmations and Account Statements be sent ?
All customers must be provided with a trade confirmation when an option order is executed. All confirmations must be sent to the customer no later than the option’s settlement date or T+1. Option trade confirmations must disclose:
- The type of option
- The type of transaction, buy or sell
- The underlying security
- The number of contracts
- The exercise price
- The expiration date
- If the transaction was to open or close
- The trade date
- The settlement date
- The premium and amount due or owed
- The commission charged
- If the firm acted as a principal or as an agent in the transaction
A customer must receive a statement every month in which there is activity in the account. All customers must receive account statements at least quarterly when there has been no activity in the account. Examples of activity include:
- Purchases and sales
- Dividend and interest received
- Interest charged
- Addition or withdrawal of cash or securities
Customer account statements must show:
- All positions in the account
- All activity since the last statement
- All credit and debit balances
Brokerage firms are required to disclose their financial condition to their clients by sending them a balance sheet every six months or on the request of a customer with cash or securities on deposit. Customer account statements must be maintained for six years and account statements must contain a notice requesting that the customer notify the firm of any material changes in their investment objectives or financial status.