FINRA Rule 2360 Explained: Options

What Is FINRA Rule 2360?

FINRA Rule 2360 establishes a comprehensive regulatory framework for the conduct of member firms involved in options trading. It governs all aspects of options activity, including account approvals, supervision, position limits, reporting, disclosures, and settlement, ensuring market integrity and investor protection. 

The rule is particularly critical in mitigating systemic risks associated with high-volume or speculative options trading. It applies to standardized, conventional, index, and FLEX Equity Options, encompassing exchange-listed and over-the-counter (OTC) transactions.

Below, we provide a detailed analysis of FINRA Rule 2360’s key provisions, definitions, and requirements.

Critical Definitions Under Rule 2360

To establish a clear framework for compliance, Rule 2360 defines several critical terms, including but not limited to:

1. Call Option: A contract granting the holder the right to purchase the number of units of the underlying security or index at the stated exercise price.
   
   

2. Put Option: A contract granting the holder the right to sell the number of units of the underlying security or index at the stated exercise price.
   
   

3. Aggregate Exercise Price: The exercise price of an option multiplied by the number of units it covers.
   
   

4. Delta Neutral: A fully-hedged equity options position with a portfolio of instruments, including or relating to the same underlying security, offsetting the risk that the equity options position’s value will change with incremental changes in the security price underlying the options position.
   
   

5. FLEX Equity Options: Customized options contracts where the negotiated contract terms are consistent with the rules of the exchange where it is traded.
   
   

6. Premium: The aggregate price of the option contracts agreed upon between the buyer and the writer/seller for an options contract.
   
   

7. Series of Options: All option contracts of the same class, exercise price, and expiration date that cover the same number of underlying security or index units.
   
   

8. Options Disclosure Document (ODD): A comprehensive document outlining the mechanics, risks, and costs of options trading required to be delivered to all options customers before the account is approved for options trading.

Understanding these definitions is crucial for firms to properly apply the rule and avoid penalties associated with misinterpretation.

Account Opening and Approval

1. Diligence in Account Opening

Firms must exercise due diligence when opening options accounts to ensure suitability for the customer. This process is aligned with FINRA's overarching goals of protecting investors from inappropriate or high-risk transactions.

The due diligence process includes the following:

• Collect detailed customer information, including investment objectives, employment status, income, estimated net worth and liquid net worth, marital status, age, dependants, and trading experience.

• For customers who refuse to provide certain information, their refusal should be documented as part of their customer account records.

• Ensure the Options Disclosure Document (ODD) is delivered to each customer before the account is approved to trade options.

• Approve accounts for specific trading activities/levels (e.g., covered writing, spreads, uncovered writing).

2. Documentation Requirements

Proper documentation is essential to demonstrate compliance with FINRA Rule 2360 and protect both firms and their clients. Within 15 days of account approval, firms must:

• Obtain verification of the background and financial information from each customer.

• Obtain a signed agreement from the customer acknowledging and agreeing to be bound by FINRA rules applicable to the trading of options contracts and the rules of the Options Clearing Corporation, along with awareness and agreement not to violate the position and exercise limits established in the FINRA rules.

3. Supervision and Review

A Registered Options Principal (ROP) or a Limited Principal-General Securities Sales Supervisor can approve or disapprove accounts in writing and conduct ongoing reviews to confirm continued suitability, regulatory compliance, and alignment with customer objectives.  Notably, for accounts that write uncovered short option contracts, an ROP is required to approve these accounts.

Position and Exercise Limits

1. Limits Overview

Position and exercise limits ensure that no single entity holds an undue influence over the market:

• Position Limits: Vary by option type and underlying security, typically ranging from 25,000 to 250,000 contracts with some specific options exempt from the position limits (e.g., an equity options position of a Member or non-Member affiliate that is delta neutral under a Permitted Pricing Model).

• Exercise Limits: Linked to position limits, these restrict the number of contracts exercised within five consecutive business days.

2. Exemptions

Specific hedging strategies, such as conversions, collars, and box spreads, may qualify for exemption from the position limits under FINRA guidelines. For example, if hedging criteria are met, a reverse collar strategy can be exempt from the position limits.

3. Large Position Reporting

Aggregate positions of 200 or more contracts in a single class on the same side of the market covering the same underlying security or index must be reported to FINRA, with details on the account holder and the total number of contracts.

Margin and Portfolio Margining

1. Margin Requirements

To mitigate risk, FINRA Rule 4210 establishes strict margin requirements for options:

• Uncovered Options: Higher margin requirements apply to offset the increased risk.

• Portfolio Margining: This allows for risk-based margining, providing flexibility for eligible customers. For instance, a well-diversified portfolio of ETFs may qualify for lower margin thresholds. A written disclosure must be delivered, and customers must acknowledge the risks.

Supervision and Compliance

1. Oversight and Designated Supervisors

Supervision of options activities is central to compliance. Firms must:

• Assign ROPs or Limited Principals to oversee trading.

• Ensure that the Principal supervisory office, with jurisdiction over offices servicing customer accounts, has access to information permitting the review of each customer’s options account on a timely basis.

2. Discretionary Accounts

Accounts where brokers execute options trades without prior customer approval require:

• Written authorization from the customer explicitly authorizing options trading.

• Enhanced oversight, including regular reviews of discretionary activity by a different ROP.

Customer Communications and Disclosures

1. Educational and Marketing Materials

All communication must be clear, balanced, and not misleading:

• Educational materials must include detailed explanations of risks, costs, and tax implications.

• Marketing must comply with FINRA’s general communication standards.

2. Transaction Confirmations

Each transaction confirmation must include the following:

• The type of option, the underlying security or index, expiration month, exercise price, number of options contracts, premium, commission, trade and settlement dates, buy or sell, whether the trade was opening or closing, effected on a principal or agency basis, and the date of expiration (other than options issued by the OCC).

• Distinctions between exchange-listed and other transactions in options contracts.

Tendering Procedures and Exercise

Rule 2360 establishes detailed procedures for exercising options:

1. Exercise by Exception (Ex-by-Ex): If an option is in-the-money, the holder automatically exercises it unless contrary instructions are given.

2. Contrary Exercise Advice: Customers may override automatic exercises by submitting contrary instructions before the cut-off time (5:30 p.m. ET) on the business day of expiration.

3. Assignment Methods: Firms must allocate assignments using a FINRA-approved method, such as FIFO or automated random selection, and notify customers in writing of their methodology.

Taxes and Settlement

Rule 2360 specifies the tax and settlement responsibilities associated with options exercises:

• Stock Transfer Taxes: Responsibility lies with the seller (writer) to whom the exercise notice is assigned for call option contracts and the exercising holder for put option contracts (with certain exceptions).

• Restricted Stock: This can only cover options if it complies with SEC resale rules.

Maintenance of Records and Complaint Handling

1. Recordkeeping

Firms must maintain:

• A central file for all written options-related complaints, including the complainant’s details and actions taken.

• Six months of customer account statements at both the branch and supervisory offices.

2. Complaint Tracking

Complaints about options must be sent to the office where the central file of options complaints is located within 30 days after receipt by a branch office subject to the complaint.

Restrictions on Transactions

FINRA may impose restrictions on options transactions or the exercise of options contracts to maintain market stability:

• Limit opening transactions during periods of volatility.

• Prohibit uncovered short positions exceeding established limits.

Penalties and Violations

Failure to comply with Rule 2360 may result in:

• Liquidation of excessive positions.

• Fines, suspensions, or loss of trading privileges.

• Violations deemed inconsistent with FINRA’s Rule 2010 on just and equitable trade principles.

Supplementary Material and Examples

To enhance clarity, Rule 2360 includes:

• Position Limit Examples: Illustrating how different combinations of calls and puts apply to position limits.

• Delta Hedging Conditions: Requirements for segregation of accounts, firewalls, and regulatory oversight to qualify for non-aggregation.