With the market’s wild fluctuations in 2020, many novice investors were lured into the stock market with dreams of hitting it big in the stock market. The rise of discount brokerage firms has given many inexperienced investors easy access to the financial markets including the ability to trade options, sometimes exposing them to unlimited risk. Investors with little cash to invest are being educated by discount firms that they may be able to “leverage” their investment in stock by trading options. While some options strategies such as covered calls are relatively safe in that losses are limited, other options strategies can not only wipe out an investor’s account, but can expose that investor to a large debit balance in their account that they cannot afford to repay. Many have suffered investment losses in speculative options trading that they should not have been approved for.

While brokerage firms require a customer to fill out questionnaires in order to be approved for options trading, there has recently been criticism of brokerage firms in allowing and approving inexperienced customers to trade options. The online platform Robinhood has committed to beef up its options eligibility requirements and investor education as a result of such criticism. Other firms, such as Fidelity Investments and Schwab have online investor education tools that attempt to inform investors who are trading options. Investors must meet certain criteria to be approved for specific levels of options trading. 

Movements in the market caused many options investors who were new to options trading or sophisticated options strategies to not only suffer investment losses but additionally caused them to be on the hook for large margin debits in their accounts. Many did not fully understand or appreciate the risks to which they were exposed.

The SEC Has Set Guidelines for Options Trading Approval

Before you can trade options, your broker must approve your account for trading. You will have to first fill out your broker’s options agreement by providing information that will assist your broker in determining your knowledge of options and trading strategies, as well as your general investing knowledge and your financial ability to bear the risks of options trading. Based on the information you provide, your broker will determine whether options trading is suitable for you and, if so, what level of options trading may occur in your account.

According to the Securities and Exchange Commission (“SEC”), the information you will need to provide in an options agreement generally includes:

1. Investment objectives such as capital preservation, income, growth, or speculation;
2. Trading experience such as the number of years you have been trading stocks and/or options, the number of trades you make per year, the average size of each trade, and information about your general knowledge of investing;
3.
Personal financial information such as liquid net worth (investments easily sold for cash), total net worth, annual income, and employment information; and
4.
An indication of what types of options you would like to trade.

You Need Approval for Options Trading Levels

The information you provide allows your brokerage firm to determine which option trading levels if any, you qualify for. These trading levels determine the types of options trades you can execute in your account. Broker-dealers generally offer 5 levels of option trading representing varying degrees of risk. Level 1 generally represents the lowest level of risk, while level 5 generally represents the highest level of risk. The types of options trading that occur at each level and even the number of levels may vary among brokerage firms. You may ask your brokerage firm to provide you with a list and description of each option trading level it has available for its customers.

Options Carry Risk

In addition to the options agreement, the SEC and FINRA rules require brokers to provide certain disclosures to all potential options investors. Your broker must provide you with a copy of a publication from the Options Clearing Corporation called the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD). It contains the basic information about the characteristics of options as well as detailed examples of the risks associated with various options and options trading strategies.  

The SEC has issued an alert that options, like other securities, carry no guarantees, and investors should be aware that it is possible to lose all of your initial investment, and sometimes more.  

Examples of options risks are:

Option holders risk the entire amount of the premium paid to purchase the option. If a holder’s option expires “out-of-the-money” the entire premium will be lost. 

Option writers may carry an even higher level of risk since certain types of options contracts can expose writers to unlimited potential losses.

Other risks associated with trading options include:

Market Risk – Extreme market volatility near an expiration date could cause price changes that result in the option expiring worthless.

Underlying Asset Risk – Since options derive their value from an underlying asset, which may be a stock or securities index, any risk factors that impact the price of the underlying asset will also indirectly impact the price and value of the option. 

Investing in options can be both complicated and risky. If you do not understand how options work or the risks of investing in them, you probably should not be trading options. Newbie investors must be particularly careful when using their self-directed account to trade-in options. When it comes to your investments, if you don’t understand it-just don’t do it.

CONTACT US TODAY FOR A FREE CONSULTATION

If you or a loved one have suffered investment losses as a result of options trading, or any other type of investment fraud or broker negligence, contact the offices of Investment Fraud lawyer Melanie Cherdack for a free consultation. Because she has been in the trenches as a former Wall Street attorney, Melanie Cherdack and her team of experienced attorneys have seen just about every type of investment fraud or investment scam. While almost every investment carries a degree of uncertainty and risk, you may have been unnecessarily exposed to such risk. Former Wall Street securities attorney Melanie S. Cherdack and her team of lawyers represent individual and institutional investors who are unwitting victims of investment fraud and broker negligence. She heads up a group of attorneys who represent investors across the United States. Contact us by filling out our online contact form, or calling 888-768-2499.