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
  • Suitability
  • 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 running
  • 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.

LARGE OPTION POSITION REPORTING REQUIREMENTS

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