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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The options approval form is designed to provide the brokerage firm with information about the customers experience, knowledge, and financial resourcesTHE OPTIONS ACCOUNT Believe it or not, one problem new traders sometimes face is not being able to obtain permission to trade options from a broker. Clients of brokerage firms who want to trade options are required to complete an options approval form when opening new accounts. The options approval form is designed to provide the brokerage firm with information about the customers experience, knowledge, and financial resources. According to the know your customer rule, options trading firms must ensure that clients are not taking inappropriate risks. Therefore, the new account form and the options approval document gather appropriate background information about each customer. Once the documents are submitted, the compliance officers within the brokerage firm determine which specific strategies are appropriate for the client. The process is designed to ensure that inexperienced traders do not take inappropriate risks. For example, if the option approval form reveals that the client has little or no options trading experience, and then the client goes on to lose large sums of money via complex high-risk trades, the brokerage firm could potentially face regulatory and legal troubles for not knowing its customer. So, each brokerage firm is required to understand the clients experience level and financial background to ensure that the customer is not trading outside of certain parameters of suitability. An individuals past options trading experience and financial resources will allow him or her to trade within certain strategy levels. For instance, level 1 strategies include relatively straightforward approaches like covered calls and protective puts. More complicated trades, however, require a higher level of approval. Table 12.1 shows a typical breakdown a brokerage firm might use to group strategies by levels. Traders with a great deal of experience and significant financial resources can generally receive approval for level 5 trading. This would allow them to implement any type of trading strategy, including high-risk trades like naked calls and uncovered straddles. Although the options approval levels can vary from one broker to the next, level 3 is enough for most readers following the strategies in this book. Since we do not recommend uncovered selling of options, approval beyond level 3 is unnecessary. At that point, traders can use a variety of simple strategies like straight calls and puts, as well as more complex trades such as spreads, straddles, and collars. In order to avoid the frustration of opening an account with a firm that will not allow trading in more advanced levels, new traders will want to find out the brokerage firms policy regarding options approval before funding an account. The best way to do this is to contact the firms options approval department by phone. If you have little or no experience, ask them what steps you need to take in order to trade the more complex options strategies (level 3). It sometimes helps to specify which trades (i.e., spreads, straddles, collars, etc.) you intend to trade. Often, the firm will ask you to write a letter or somehow demonstrate that you understand the risks of trading options. After that, most firms will allow you to fund the account and to begin implementing those options trading strategies that interest you. ROLES AND RESPONSIBILITIES OF ALL BROKERS Regardless of whether the broker charges high or low commissions, all brokers are regulated by the Securities and Exchange Commission (SEC) and are required to meet certain standards when dealing with customers. Specifically, the Securities Exchange Act of 1934 puts forth certain provisions that all brokers must adhere to. Duty of fair dealing. This includes the duty to execute orders promptly, disclosing material information (information that a brokers client would consider relevant as an investor), and charge prices that are in line with those of competitors. Duty of best execution. The broker has a responsibility to complete customer orders at the most favorable market prices possible. Customer confirmation rule. The broker must provide the investor with certain information at or before the execution of the order (i.e., date, time, price, number of shares, commission, and other information). Disclosure of credit terms. At the time an account is opened, a broker must provide the customer with the credit terms and, in addition, provide credit customers with account statements quarterly. Restriction of short sales. This rule bars an investor from selling an exchange-listed security that they do not own (in other words, sell a stock short) unless the sale is above the price of the last trade. Trading during offerings. Rule 101 prohibits the broker from buying a stock that is being offered during the quiet periodone to five days before and up to the offering. Restrictions on insider trading. Brokers have to establish written policies and procedures to ensure that employees do not misuse material nonpublic (or inside) information. WHY PAY HIGH COMMISSIONS? In a world of low-cost (in some cases, no-cost) trading and strict government regulation of brokers, does it ever make sense to pay the high commissions of a full-service broker? Sometimes it does. While investors are protected to an extent by federal securities laws, they are not protected from poor investment decisions. Investors often lose money in the stock market. There are risks and, in a world of do-it-yourself investing, the investor is ultimately responsible for ensuring that investment decisions are wise. The ultimate goal in investing is to preserve capital and improve your financial well-being. Investors are sometimes uncertain about the risks associated with an investment. If you are reading this book, you are probably not one of them. But, at times, a full-service firm can be helpful. For instance, firms like Merrill Lynch, Morgan Stanley Dean Witter, and Prudential have financial advisers or consultants who offer investment advice for a commission or fee. Sometimes paying a higher commission in exchange for objective financial advice is sensible. The important element in the equation, of course, is being confident that the information is objective and worthwhile. To find out, you can ask the perspective financial consultant a number of questions. The SEC has compiled a list of helpful questions to ask which can be accessed at its web site (www.sec.gov). Sometimes it makes sense to do boththat is, open an account with a brokerage firm to handle some of your retirement savings, money you have saved for an education, or other aspects of your portfolio, and then take a smaller percentage to trade options in a self-directed online account. For example, you might split your portfolio into 75 percent conservative investments and 25 percent with more aggressive options trades like long-term bull call spreads. CONCLUSION If you are motivated to the point that you want to invest in stocks, finding a broker and opening an account are relatively straightforward tasks. Over the long run, however, finding a broker to meet your particular investment needs can prove complicated. If you plan on doing one or two trades and are not seeking help with respect to your overall financial plan, a discount broker who simply executes your orders is appropriate. However, if you are not sure about whether the investment is a wise one, a fullservice broker, while charging higher commissions, may offer you objective and worthwhile information. Therefore, the first step in selecting a broker is determining the level of financial advice you need, if any. Regardless of whether you trade one or a hundred times a month, brokers have a duty to execute orders promptly and at the best possible price. While it is difficult to monitor the brokerage firm from the time your order is submitted until the time it is executed, there are some things you can do. If you trade actively, monitor the market in real time and watch your trade take place. In addition, consider submitting limit orders (priced between the bid and the offer). Finally, if you have a bad tradeor in Street parlance, a bad fillcontact your brokers customer service department and find out what happened. If the problem persists, remind them of their duty of best execution. If that doesnt work, change brokers. |
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