At brokerage firms,
the options division is one of the most difficult to manage.

Registered representatives who trade options are usually aggressive, as their client base employs leverage and trades frequently. But even though this is good for commission revenue, it’s not so good if firms want to avoid client complaints and — more important — litigation.

In an effort to deal with these issues, many brokerage firms have limited the type of option strategies they will allow registered reps to recommend. Some firms don’t allow the sale of naked put options; others will not allow puts inside RRSPs, despite recent legislation allowing this.

It’s understandable why firms have gone to these lengths. The fact is that investors who litigate against brokers on the basis of options trading have done quite well in the courts. Clients claim losses on the basis that they did not understand the risks and, often, we find that brokers have recommended strategies that the clients did not fully understand.

I raise this because I have been involved as an expert witness in a number of matters involving options since 1983. The cases have all had something in common: investors were using strategies that employed leverage. And, in some cases, the strategies exposed those investors to unlimited risk.

Uncovered call writing is an example of unlimited risk. Naked put writing also exposes the investor to unreasonable risks when leverage is employed, although you cannot say the risk is unlimited. In a worst-case scenario, the underlying security can only drop to zero.

Rarely have I seen a case in which the investor was harmed by purchasing call or put options. And that speaks to something I have talked about in previous columns: that you should always employ option strategies for situations in which the clients’ risk is predefined and limited.

It is also important that the registered rep documents how he or she arrived at a specific recommendation.

Although this may seem straightforward — you bought calls because you were bullish, for example — in the options business, a recommendation involves two steps:

> a view about the underlying security; and

> an opinion as to whether options are expensive or cheap.

Rarely have I seen any documentation about the second step, which I find interesting because the second step is probably the most important.

In this business, any position you can take with a long option can also be taken from the short side.

For example, if you are bullish on XYZ, you could buy calls or you could buy the stock and sell a covered call. Both strategies are bullish, and the one to use depends on the cost of the option. If options are cheap, buy the call; if options are expensive, implement the covered call write.

Step 2 does not require the registered rep to use a complex option pricing model. Rather, the rep should simply look to the Chicago Board Options Exchange’s volatility index (symbol: VIX) as a first step in establishing whether options, in general, are expensive or cheap. The registered rep could overlay a 200-day moving average on the VIX daily chart.

If the daily data are above the 200-day moving average, options are generally expensive, so lean toward writing strategies. If the daily data are below the 200-day moving average, then lean toward buying the option.

At the very least, if the registered rep has developed a two-step process, he or she will have laid out the logic as to why a specific strategy was recommended.

If advisors document the reasons for the decisions they have made with their clients, it may help clients better understand the strategy. And it can keep advisors out of court. IE