Technical and financial innovations have led to the introduction of complicated financial instruments and trading strategies with a global reach. As a result of some of these developments, transparency, procedures, and control are prone to be compromised. Preventing illegal activity is increasingly a challenge for regulators, and options, being complicated instruments, add many more layers to the required regulations, with their varying brokerage charges with complex structures and allowed leverage levels with high-risk exposure. In this article, we discuss the basic regulations, governing bodies, and their activities for the options market in the U.S.
The primary aim of a regulated financial market is to protect the rights and interest of the common investor by enforcing the required set of protocols. Options regulators in the U.S. establish, register, standardize, amend, or revise (as necessary) the rules for options trading in the U.S., involving:
- Option chains for given strike price and expiry dates
- Trading units
- Lot size
- Position holding limits
- Exemptions in limits for hedged positions
- Exercise mechanisms
- Rules for order reporting and exception handling
- Rules for off exchange options transactions
- Setting leverage and margin limits
- Short selling rules
In addition, regulators establish requirements on trade reporting, dispute handling mechanisms, and disciplinary actions against the non-compliant individuals and businesses. Most of these rules and regulations are imposed via brokerage firms.
An option contract can be traded on a stock/index or on forex/commodity/futures as an underlying. Different US organizations regulate these categories. All option contracts traded over stock/index are overseen by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA); while options contracts over forex/commodity/futures are watched over by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).
The Securities and Exchange Commission
The SEC, founded in 1934, has a mission statement “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” It establishes regulations to ensure fair practices are followed in the markets with complete transparency. A complete list of SEC option trading rules is available here.
Financial Industry Regulatory Authority
Created in 2007, FINRA is a non-government body devoted to investor safety and market reliability through regulation. Its main focus is on the compliance by security firms and brokers of a set of rules and on ensuring market transparency. FINRA operations can be divided into four sections:
- Educating public about investment, money handling, frauds, and risk management through training modules available on its website.
- Mandatory broker-dealer registration: all companies in securities transaction business in US are obliged to register with FINRA and become a licensed broker-dealer. If they do not, they could be subjected to penalties, legal action, and even a shutdown.
- Securities licensure and exams.
- Record keeping of disciplinary actions.
FINRA’s option specific regulations are available in their detailed option regulation guide. Proposals by member exchanges are carefully verified for impact assessment, and if found suitable, rule changes are implemented in accordance with the SEC.
The Commodity Futures Trading Commission
Established in 1974, the CFTC is a government body that assists future trading for different sectors such as agriculture, global markets, energy, and environmental markets. Its regulation aims to fulfill its mission “to protect market participants and the public from fraud, manipulation, abusive practices, and systemic risk related to derivatives.” The CFTC also offers mechanisms for individual traders to file a complaint, as well as a whistleblower program. Below is the list of exchanges monitored by CFTC:
- Chicago Board Options Exchange
- Chicago Board of Trade
- Chicago Mercantile Exchange
- US Futures Exchange
- Kansas City Board of Trade
- Minneapolis Grain Exchange
- New York Mercantile Exchange
- New York Board of Trade
The National Futures Association (NFA)
The National Futures Association (NFA) is the “premier independent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets” (including options). A detailed regulatory guide (including options) is available on the official NFA website. All NFA members have the following obligations:
- To be a listed/registered member of NFA.
- Adhere to essential capital requirements.
- Record keeping and reporting which should be exhaustive for all transactions and related business activities.
Key US Options Regulations
Here are some of the key regulations in the U.S.:
- Option traders in the U.S. are required to trade within the prescribed limits set by the respective regulator.
- Because short trading on options can often lead to losing more than the traded amount, leverage limits, margin requirements, and short positions have the most regulations to protect investors and traders from unknown risks.
- Option traders are required to maintain the minimum margin amount as set by the broker, based on regulations.
- For short options on forex, the notional transaction value amount plus the option premium received should be maintained as a security deposit.
- For long options, the entire option premium is needed as deposit.
- First-in, first-out (FIFO) rule prevents holding similar option positions.
The Bottom Line
How well regulators ensure smooth functioning through established regulations, rules, and dispute resolution mechanisms exposes the real efficiency of a given market. While it is always exciting to trade on complex financial assets like options and other derivatives in hope of better profits, care should be taken to ensure the markets, participants, and facilitator firms are well regulated.