Technical and financial innovations have led to the introduction of complicated financial instruments and trading strategies with a global reach. As a result of some of these developments, transparency, procedures, and control are prone to be compromised. Preventing illegal activity is increasingly a challenge for regulators, andoptions, being complicated instruments, add many more layers to the required regulations, with their varying brokerage charges with complex structures and allowed leverage levels with high-risk exposure. In this article, we discuss the basic regulations,governing bodies, and their activities for theoptions market in the U.S.
The primary aim of a regulated financial market is to protect the rights and interest of the common investor by enforcing the required set of protocols.Options regulators in the U.S. establish, register, standardize, amend, or revise (as necessary) the rules for options trading in the U.S., involving:
- Option chains for given strike price and expiry dates
- Trading units
- Lot size
- Position holding limits
- Exemptions in limits for hedged positions
- Exercise mechanisms
- Rules for order reporting and exception handling
- Rules for off exchange options transactions
- Setting leverage and margin limits
- Short selling rules
In addition, regulators establish requirements on trade reporting, dispute handling mechanisms, and disciplinary actions against the non-compliant individuals and businesses.Most of these rules and regulations are imposed viabrokerage firms.
An option contract can be traded on astock/indexor onforex/commodity/futuresas anunderlying. Different US organizations regulate these categories. All option contracts traded over stock/index are overseen by theSecurities and Exchange Commission (SEC)and theFinancial Industry Regulatory Authority(FINRA); whileoptions contracts overforex/commodity/futures are watched over by theCommodity Futures Trading Commission(CFTC)and the National Futures Association(NFA).
The Securities and Exchange Commission
TheSEC, founded in 1934, has a mission statement “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”Itestablishes regulations to ensure fair practices are followed in the markets with complete transparency.A complete list of SEC option trading rules is available here.
Financial Industry Regulatory Authority
Created in 2007, FINRAis anon-government body devoted to investor safety and market reliability through regulation. Its main focus is on the compliance bysecurity firms and brokers ofa set of rules and on ensuring market transparency. FINRA operations can be divided into four sections:
- Educating public about investment, money handling, frauds, and risk management through training modules available on its website.
- Mandatory broker-dealer registration: all companies in securities transaction business in US are obligedto register with FINRA and become a licensed broker-dealer. If they do not, they could be subjected to penalties, legal action, and even a shutdown.
- Securities licensure and exams.
- Record keeping of disciplinary actions.
FINRA’s option specific regulations are available in their detailedoption regulation guide. Proposals by member exchanges are carefully verified for impact assessment, and if found suitable, rule changes are implemented in accordance with theSEC.
The Commodity Futures Trading Commission
Established in 1974, theCFTCis a government body that assists future trading for different sectors such as agriculture, global markets, energy, and environmental markets. Its regulation aims to fulfill its mission “to protect market participants and the public from fraud, manipulation, abusive practices, and systemic risk related to derivatives.”The CFTC also offers mechanisms for individual traderstofile a complaint, as well asawhistleblower program. Below is the list of exchangesmonitored by CFTC:
- Chicago Board Options Exchange
- Chicago Board of Trade
- Chicago Mercantile Exchange
- HedgeStreet
- US Futures Exchange
- Kansas City Board of Trade
- Minneapolis Grain Exchange
- New York Mercantile Exchange
- New York Board of Trade
- OneChicago
The National Futures Association (NFA)
The National Futures Association (NFA) is the“premier independent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets” (including options).Adetailed regulatory guide (including options) is available on the official NFA website. All NFA members have the following obligations:
- To be a listed/registered member of NFA.
- Adhere to essential capital requirements.
- Record keeping and reporting which should be exhaustive for all transactions and related business activities.
Key US Options Regulations
Here are some of the key regulations in the U.S.:
- Option traders in the U.S. are required to trade within the prescribed limits set by the respective regulator.
- Because short trading on options can often lead to losing more than the traded amount, leverage limits, margin requirements, and short positions have the most regulations to protect investors and traders from unknown risks.
- Option traders are required to maintain the minimum margin amount as set by the broker, based on regulations.
- For short options on forex,the notional transaction value amount plus the option premium received should be maintained as a security deposit.
- For long options, the entire option premium is needed as deposit.
- First-in, first-out (FIFO) ruleprevents holding similar option positions.
The Bottom Line
How wellregulators ensure smooth functioning through established regulations, rules, and dispute resolutionmechanisms exposes the real efficiency of a given market. While it is always exciting to trade on complex financial assets like options and other derivatives in hope of better profits, care should be taken to ensure the markets, participants, and facilitator firms are well regulated.
As an expert with a deep understanding of financial markets and regulatory frameworks, I bring a wealth of knowledge to shed light on the intricate world of options trading, particularly in the United States. My expertise spans both technical and financial aspects, allowing me to provide comprehensive insights into the complex landscape described in the provided article.
The article discusses the impact of technical and financial innovations on the evolution of financial instruments and trading strategies with a global reach. I recognize the significance of these developments in shaping the landscape and acknowledge the resulting challenges in maintaining transparency, procedures, and control. My extensive experience enables me to elucidate the complexities introduced by options trading and the associated regulatory measures in the U.S.
Let's delve into the various concepts covered in the article:
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Regulated Financial Market's Primary Aim:
- The primary objective of a regulated financial market is to protect the rights and interests of common investors by enforcing a set of protocols. This includes ensuring fairness, transparency, and efficiency in market operations.
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Options Regulations in the U.S.:
- Options regulators in the U.S. establish, register, standardize, and amend rules for options trading. This encompasses various aspects such as option chains, trading units, lot size, position holding limits, exemptions, exercise mechanisms, order reporting, exception handling, off-exchange transactions, leverage, margin limits, and short selling rules.
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Regulatory Bodies:
- Different regulatory bodies oversee options trading based on the underlying asset. For options contracts over stock/index, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) are the regulatory authorities. For options contracts over forex/commodity/futures, the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) are responsible.
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Regulatory Bodies Overview:
- The SEC, founded in 1934, focuses on protecting investors and maintaining fair markets. FINRA, established in 2007, ensures investor safety and market reliability through non-governmental regulation. The CFTC, established in 1974, oversees future trading across various sectors, protecting market participants from fraud and manipulation. The NFA is an independent provider of regulatory programs safeguarding the integrity of derivatives markets.
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Key Regulations for Options Traders:
- Options traders in the U.S. are required to adhere to prescribed limits set by regulators. Regulations cover leverage limits, margin requirements, short positions, and maintenance of minimum margin amounts. The First-in, first-out (FIFO) rule prevents holding similar option positions.
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Bottom Line:
- The efficiency of a market is demonstrated by how well regulators ensure smooth functioning through established regulations, rules, and dispute resolution mechanisms. While trading complex financial assets like options can be exciting, it is crucial to ensure that markets, participants, and facilitator firms are well-regulated to mitigate risks.
In summary, my in-depth knowledge allows me to provide a comprehensive overview of the concepts discussed in the article, offering clarity on the regulatory landscape and its implications for options trading in the U.S.
