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Securities, Options and Futures Consultants

STOCK OPTIONS

OPTIONS ABUSE

Churning, or a broker in control of an account and trading primarily for the commission income he derives from it without proper regard for the profit potential of the client, is an offense within both securities and futures accounts. (See Churning in Stock Accounts). The offense extends into the world of options trading as well. However, the determination of when such options abuse is present is more difficult here. In part, this is true because of the failure of conventional measures such as the turnover ratio to assist in quantifying the offensive behavior when option trading is involved. It is also a consequence of the large number of different types of option positions that exist.

When the options utilized are securities options, it is appropriate to begin with whether the options trading is suitable for the client. If the options are futures options, the offense of suitability is inappropriate and should be replaced by an inquiry as to whether adequate risk disclosure occurred. Often a broker intent primarily on deriving commission income will place the client into trading positions which are not suitable as to his investment objectives, financial status, or risk profile. Alternately, a lack of adequate risk disclosure may prevail.

Should the result of the analysis be that the trading is unsuitable or inadequately disclosed as to risk as can occur, say, with an inexperienced investor of limited means who is subject to a large amount of rapid options trading, it may be useful to examine the commission-to-equity and cost-to-equity ratios in a manner similar to what would be done in a securities account with no options trading present. This may serve to document the excessive trading aspect of options abuse through the excessive depletion of account resources via commissions or other costs.

Beyond this it is usually necessary to examine the options trading in greater detail to determine the specific nature of the options abuse that may have occurred. Further abuse often is found through such a detailed examination as the following examples illustrate:

• In a commodity futures case the author was able to show through an analysis and subsequent expert witness report that in the broker's trading strategy it was mathematically impossible to earn a profit sufficient to overcome the commissions charged. In forcing a settlement of the matter at nearly 100% of the customer's losses (which were mostly commissions given the high efficiency at which the broker had worked to allow no profit or loss from the options trading itself), the clerk to Administrative Law Judge Bruce Levine was required to warn the firm that where the possibility of customer profit was mathematically $0, the firm faced an uphill battle in a pending Commodity Futures Trading Case (CFTC) reparations proceeding. Incidentally, Levine had himself failed to rule in favor of an investor in nearly 180 consecutive cases (Wall Street Journal 12/13/2000).
• In a securities situation involving options where almost all securities positions taken had CALL options sold against them, and where the securities positions that had losses were allowed to run while gains were automatically cut on the positions whose options had moved into the money, a large overall loss resulted even when accounting for the premium income on the options sold. Here the author was able to suggest that offensive behavior had occurred.
• In an account where only long option positions are taken if too many such long positions are taken without a fundamental grasp of the positions taken and the market, the account is almost certain to sustain losses. The reason for this is that those on the other side of such long positions (i.e., the option sellers) price their options to make money under most circumstances so that the expected profit of an opposing portfolio of long-only positions is usually negative. Therefore the use of long options must be both knowledgeable and selective to have a meaningful profit potential. Similarly, although protective action by buying a portfolio of PUT positions is often employed when a market downturn is expected and the closing of such underlying positions is ill-advised for tax or other reasons, its indiscriminate use is likely to result in an actual loss particularly as there is an overall upward bias in the markets.

The reader is cautioned not to conclude from the above examples that no useable mathematical measures of wide applicability exist for the detection of options abuse. In the literature a number of knowledgeable authors have opined on the possibility of such a measure often in the form of some new ratio. But often options abuse cases must be tried without the help of such mathematical measures and the analysis of a knowledgeable expert is almost always required.

It is possible to defend a broker in an options abuse case based on the fact that both options and futures are financial instruments of short duration. They expire quickly and are necessarily traded frequently. But clients must be knowledgeable and trading strategies carefully explained and agreed to and the client must be financially able to sustain losses. The defense of a broker or brokerage firm almost always involves adequate disclosure.

An example is a case in which only short option positions are taken for their income generating potential, which subjects the client to the possibility of almost unlimited losses. Such positions are suitable for only a very few clients who are deeply knowledgeable and for whom extensive risk disclosure has been made. Such trading can be very profitable but requires constant monitoring so as to be able to get out of the way of the train by rolling positions quickly when the market turns against the trader. The firm also needs to be sure that it does not adopt impediments to such necessary action.