Supervising General Options Trading
Strategy and risk must be recognized on sight
A supervisor should be able to read an order ticket and immediately name the strategy and its risk profile: long call/put (maximum loss = premium paid), covered call (loss limited by stock decline, offset by premium), naked short call (theoretically unlimited loss), naked short put (loss to zero on the underlying), vertical and calendar spreads (risk defined by strikes, expirations, debit or credit), straddles and combinations (long = defined loss; short = substantial or unlimited), and ratio spreads (uncovered ratio carries the naked risk).
Mechanics that generate questions
- American vs. European style - equity and ETF options are generally American-style and exercisable any business day; most cash-settled index options are European-style and may be exercised only at expiration.
- Cash settlement vs. delivery - index options settle in cash; physical delivery applies to equity and ETF options.
- Expiration and automatic exercise - OCC exercises positions that are in the money by at least $0.01 unless the customer instructs otherwise; know the firm's cut-off for contrary instructions.
- Exercise and assignment - exercise notices are allocated by random process; assignment creates a delivery or cash obligation the customer must be able to meet.
- Adjustments - splits, mergers, and special dividends change the deliverable, not the contract's enforceability.
Traps
Treating a European-style contract as exercisable early; assuming a long option's loss can exceed premium; overlooking that a short uncovered position requires margin and a demonstrated ability to meet obligations.
Rule of thumb
If the maximum loss cannot be calculated from the customer's holdings, the position is uncovered and the account must be approved and margined for that level.