Options Trading

Strategies range from buying a single option, where the most you can lose is what you paid, to selling options without owning the stock, where losses can far exceed what you were paid. Options are often described as a way to generate income or limit risk, but a strategy that suits one investor can be a poor fit for another. Losing money in options is not, by itself, a claim. The key questions are whether the strategy fit the investor and whether the professional who recommended it fulfilled their duties.

This May Not Be Your Fault

If an options strategy was recommended to you, or placed in your account, and it cost you money you could not afford to lose, the responsibility may rest with your broker and the firm, not with you. Selling options for “income” can sound far safer than it is.

That is why the rules put duties on the professional. Under FINRA Rule 2360, a firm must learn about your finances, experience, age, and goals before approving your account for options, and must give you the options disclosure document. A broker who recommends an options trade must have reasonable grounds to believe it is suitable for you, and that you can understand the risks and afford a loss. Regulation Best Interest also requires brokers to put your interests ahead of their own.

How Options Strategies Work and Where the Risk Sits

According to the SEC’s investor bulletin An Introduction to Options, a call gives the buyer the right to buy a stock at a set price, called the strike price, and a put gives the buyer the right to sell at that price. The buyer pays a fee, called a premium, to the seller, who is called the writer. Where the risk sits depends on which side you are on:

• Buying calls or puts. You can lose the whole premium. The Options Clearing Corporation (OCC) describes an option as a “wasting asset” that becomes worthless if it is not sold or exercised before it expires. The SEC notes that it is possible to lose all of your initial investment.
• Covered calls. You own the shares and sell a call against them. The Options Industry Council explains that you collect the premium but give up much of the stock’s upside, while still bearing the loss if the stock falls. The premium is only a small cushion.
• Spreads. These combine options to limit some risk. The OCC cautions that a spread may not offset all of the risk of an uncovered position, and FINRA notes that almost all spreads require a margin account.
• Uncovered (“naked”) writing. You sell options without owning the stock behind them. The Options Industry Council says the loss on an uncovered call is unlimited while the most you can earn is the premium, and calls it the riskiest options strategy and unsuitable for most investors. An uncovered put writer must buy the stock at the strike price even if the market price is lower.

FINRA explains that for most stock options, a seller can be assigned on any day the markets are open, meaning the seller must deliver or buy the shares. A sharp move can also bring a margin call on short notice. For this reason, Rule 2360 requires firms that allow uncovered writing to set specific suitability standards, obtain a principal’s written approval, and give the customer a special written statement of the risks.

Example: a retiree who needs steady income may be told that selling options is a way to collect extra cash each month, without hearing that one sharp rise in the stock can produce losses many times larger than the income received.

Common Examples of Options Trading Claims

• Uncovered (“naked”) options recommended to investors with modest savings or little experience, without a plain explanation that losses can far exceed the premium collected — see Unsuitable Recommendations and our article The Truth Behind Selling Options
• Options strategies used in a retirement account or other money meant to last — learn more in Retirement Accounts Are Meant to Be Long-Term, Safe Money
• Covered call writing that capped gains and left a concentrated account exposed to a falling stock — see Overconcentration and When Covered Call Writing Backfires
• An account approved for options, or for a riskier strategy, based on inaccurate or incomplete information about the investor’s finances, experience, or goals — see Regulation Best Interest
• Options trades placed without permission, or beyond what the investor authorized in writing — see Unauthorized Trading
• Frequent options trading that produced commissions for the broker but little benefit for the investor — see Churning and How Options Losses Add Up Over Time
• Options income described as “safe” or low-risk without an honest account of what could cause losses — see Misrepresentation and Omission
• A firm that approved the account but never reviewed it for trade size and frequency, commissions, or concentration — see Failure to Supervise

How Can You Protect Yourself From Options Trading Losses?

Options are not off limits, but they call for more questions than a stock or a bond does. A few steps that help:

• Ask for the worst case in plain words. Ask how much you could lose on the strategy, and whether it could be more than you put in.
• Read the options disclosure document. Your firm must give you the OCC’s Characteristics and Risks of Standardized Options at or before approval. Read the sections on your strategy and ask about anything unclear.
• Check what the firm wrote down about you. Within 15 days of approving your account, the firm must send your financial information back to you for verification. If your income, net worth, or experience is overstated, say so in writing.
• Know what you authorized. If someone else places options trades for you, the firm needs your written permission that specifically covers options. Trading beyond it may be unauthorized.
• Look at the trading and the commissions. Ask why there are so many trades and what the broker earned on them.

Signs Your Options Trading May Have Been Unsuitable

• You were told that selling options was a way to earn extra income with little risk
• You do not know whether the options sold in your account were covered or uncovered
• You received demands to add money or securities after a stock moved against you
• Your statements show many options trades and high commissions compared with any gains
• Options were used in a retirement account you rely on for living expenses
• The income, net worth, or experience on your options application is higher than the truth
• No one walked you through the options disclosure document or the risks of your strategy
• There are options trades in your account that you do not remember approving