New York Securities Fraud Lawyers Blog
It is usually a bad sign when a retiree or the typical conservative investor suffers investment losses and brings a case to us where their broker was trading options. In such instances, it at least bodes well for a customer’s legal case when the investor has limited investing knowledge yet has somehow been approved by their brokerage firm for options trading. It is a sign that the investor may have been misled by a broker who was not properly supervised by the firm, as firms have a duty to know their customers and recommend investment strategies that are suitable to each investor’s risk tolerance and objectives. Very generally, options are not considered safe for conservative investors, but there are circumstances where they could be.
Options are considered high risk because they are derivatives of an underlying stock price, which gives investors a completely separate asset class of investment to speculate in. The speculation is a bet that not only tries to predict whether the stock price will go up or down to a particular price (known as a “strike price”), but whether it will reach or exceed that level within a specified timeframe (i.e., by the option contract’s expiration date). As the time frame gets closer and closer to expiration, the value of the options contract decays and becomes worth less and less over time, until it expires worthless, which is what happens with most options contracts. Moreover, when buying a stock, you simply pay the price of the stock. When buying an option contract, you pay a premium in addition to the price of the stock (should you decide or have the ability to later exercise that option). Therefore, buying shares in a specific stock is almost always a safer strategy than buying options for that same security.
Options differ from other asset classes in that they give the buyer (or seller) the right, but not the obligation, to buy (or sell) an underlying stock at a specific price on or before a specific date. It is the premium paid on an option that gives the purchaser the right (but not obligation) to later buy or sell, no different than placing a down payment on a home that you intend to later purchase at the agreed upon price. You could walk away from the purchase later and you only lose the premium. So by granting an investor a right, rather than an obligation, to transact in a certain security, options provide investors with the opportunity to speculate on the future price movement of that security. Although options allow investors to hedge, add cash flow, and leverage returns, options are inherently risky product because they are complex products that are wholly based on price speculation. It is, therefore, highly critical that your broker discuss all applicable risks with you before having an options trading strategy deployed in your account.
Considering the risks associated with trading in options, in April 2021 the Financial Industry Regulatory Authority (FINRA) released Regulatory Notice 21-15, which provided guidance to members regarding options account approval, options account supervision, and margin requirements for options accounts. This notice first reminds brokers that customers who wish to trade in options must be carefully approved prior to trading. Brokers must obtain and analyze several characteristics about an investor, such as personal information, investment knowledge/experience, financial situation, and investment objectives. Once a broker has decerned this information from an investor, the firm can then authorize the investor for approval in options trading, assuming options are suitable for the investor’s characteristics. Notice 21-15 also dictates that, when an investor applies for option trading capabilities in their account, FINRA members must supply that investor with a document entitled, “Characteristics and Risks of Standardized Options.” This disclosure document outlines basic information about options as well as the risks associated with the asset class.
Determining which options trading strategy is appropriate for a given investor primarily relies on the risk tolerance of that investor. Though atypical, a broker could in theory deploy an options strategy for a conservative investor that is utilized as either a hedge or insurance against future price movement, or to be used as a way to generate guaranteed premium payments. Additionally, the safest options trades for investors are “covered,” meaning that the investor owns the underlying stock that he/she is speculating on. Since the investor already owns the underlying stock, the investor’s risk is capped since he/she will not have to purchase the stock on the open market should the option get exercised.
Among the strategies in this category are holding put options and writing covered call options. For example, by buying puts, an investor can protect against the price of a stock dropping considerably at sometime in the future. Rather than having to sell a stock for an undetermined price in the future, buying covered put options allows an investor to lock in a specified price for the stock at a decided date in the future. Conversely, selling covered calls to other investors in the market who are betting that the underlying stock price will go up is considered one of the “safer” ways to trade options and to generate regular income from the premium payments received. If the house always wins in a casino, selling options on stocks you already own in your portfolio is one of the ways that trading options lets you be “the house.” However, such a strategy would only be considered conservative if the underlying stock was not volatile or expected to become so on the happening of a future event – i.e., volatility introduces risk that the options contract does not expire worthless; thus, even a “safe” options strategy is not without risk. Overall, such conservative options strategies should still limit an investor’s downside risk while providing relatively assured premium payments.
Contrarily, investors with higher risk tolerances will deploy strategies involving buying or selling “naked,” or uncovered, options. In these transactions, investors do not own the underlying stocks that they are speculating on, and as a result, are exposed to much more risk in the event of a large price swing in the stock which could force the investor to later purchase those shares. Aggressive options approaches can include leverage (i.e., money loaned to your account on margin) and highly complicated products as well as intricate strategies, so it is extremely important to discuss all the applicable risks with your broker prior to engaging in these types of trades.
If you are a conservative investor or retiree who has suffered unexpected investment losses due to options trading at the recommendation of your broker, the experienced, New York securities attorneys at Malecki Law can help determine whether those losses are recoverable. We provide free consultations and typically work on a contingency basis, meaning we do not get paid unless you recover.