Non-Equity Options and Option Account Rules

Index options

An index option is written on a market index rather than on a security, and it settles in cash. There is nothing to deliver, so exercise produces a payment equal to the in-the-money amount times a multiplier, conventionally $100.

Worked example: an investor holds an S&P index 4400 call and the index settles at 4450. The in-the-money amount is 50 points; times the $100 multiplier, the writer pays $5,000. Everything you know about intrinsic value carries over; only the settlement changes.

Broad-based index options track the market as a whole, and most of them are European-style — exercisable only at expiration, which means their writers cannot be assigned early. Some are not: the S&P 100 index option is the standing exception the exam likes, being American-style. Narrow-based or industry index options track a sector.

Cash settlement is delivered on the business day following exercise, and settlement values for many broad-based contracts are computed from opening prices on the last trading day rather than from closing prices — which is why a position that looked in the money at Thursday's close can settle otherwise.

The main institutional use is hedging a diversified portfolio. A manager holding a broad equity portfolio buys index puts rather than puts on each holding, sizing the hedge by the portfolio's value relative to the index level and adjusting for the portfolio's beta. That is a systematic-risk hedge and it protects against a market decline; it does not protect against a single holding falling while the market rises, which is unsystematic risk and requires options on that holding.

Foreign currency and yield-based options

Foreign currency options are written on a foreign currency with premiums and strikes quoted in US cents per unit, and they settle in cash. The contracts are on the foreign currency, so the direction question is always resolved by asking what the customer needs to buy or sell.

A US importer who must pay a foreign supplier in that supplier's currency at a future date is exposed to that currency strengthening. They need the right to buy it at a fixed rate, so they buy calls on the foreign currency.

A US exporter who will receive a foreign currency at a future date is exposed to it weakening. They need the right to sell it at a fixed rate, so they buy puts on the foreign currency.

Both reduce to the same instruction: identify which currency the customer will need to acquire or dispose of, and buy the option that gives the right to do it at a fixed price. Questions in this area are almost always solvable by that one step.

Yield-based interest rate options are written on the yield of a Treasury security rather than on its price, are cash-settled, and are European-style. Because they are on yield, the direction reverses from what bond intuition suggests: buying a call on a yield is a bet that yields will rise — which is a bet that bond prices will fall. A customer expecting rates to rise buys yield-based calls; a customer expecting rates to fall buys yield-based puts. Candidates who reason from bond prices get this backwards, which is exactly why the exam includes it.

Opening an options account

The sequence and its deadlines are specific, and the exam asks for the order.

The firm exercises due diligence to learn the essential facts about the customer — investment objectives, employment status, estimated annual income, estimated net worth and liquid net worth, marital status and dependents, age, and investment experience and knowledge. A customer's refusal to provide any of it must be noted on the record at the time the account is opened.

The options disclosure document must be furnished at or prior to the time the account is approved. Delivery of the ODD comes before approval, not after; that ordering is a frequent question.

A Registered Options Principal approves the account in writing, and the approval specifies the types of transactions permitted — buying, covered writing, uncovered writing, spreading, discretionary transactions. A branch manager who is not an ROP may approve, with confirmation by an ROP within a reasonable time.

Within fifteen days after approval, the firm sends the background and financial information on which it approved the account to the customer for verification, and obtains from the customer a written options agreement in which the customer agrees to abide by exchange and OCC rules and not to violate position or exercise limits. If the signed agreement does not come back, the customer may generally continue to close positions but not to open new ones.

Trading may begin once the account is approved. The signed agreement is a fifteen-day follow-up, not a precondition — which is the distinction the exam is testing when it asks what a customer may do on day three.

Uncovered writing carries additional requirements under Cboe Rule 9.1(f): written procedures stating the firm's suitability criteria, ROP approval of such accounts, a designated principal for accounts approved outside the criteria, minimum net equity requirements, and a special written description of uncovered writing risk delivered before the first uncovered transaction.

Position and exercise limits

Position limits cap how many contracts one customer, acting alone or in concert with others, may control on the same side of the market in one underlying. Cboe Rule 8.30 sets the standard tiers at 25,000, 50,000, 75,000, 200,000 and 250,000 contracts, with the higher tiers available to underlying securities meeting specified six-month trading volume and shares-outstanding thresholds.

What 'the same side of the market' means is the part that gets tested. Bullish positions aggregate together, and bearish positions aggregate together. Long calls and short puts are both bullish, so they count against one limit. Short calls and long puts are both bearish, and count against the other. Long calls and long puts do not aggregate, because they are opposite sides; nor do long calls and short calls.

The rule's own examples make the arithmetic concrete. Under a 25,000-contract limit, a customer long 25,000 calls may simultaneously be long 25,000 puts, because those are opposite sides. But a customer long 20,000 calls may not be short more than 5,000 puts, because those aggregate.

Exercise limits, under Cboe Rule 8.42, use the same numbers and cap how many contracts of a class may be exercised within any five consecutive business days.

Both limits exist to prevent one participant accumulating a position large enough to manipulate the underlying, and both are the exchange's rules, not the customer's firm's — which is why the customer signs an agreement not to violate them.

Communications and taxation

Options communications are separately regulated. FINRA Rule 2220 and Cboe Rule 9.15 require that communications about options be preceded or accompanied by the options disclosure document, be approved by a Registered Options Principal, and not contain projections of performance or unwarranted claims. Educational material that does not refer to specific securities can be distributed without the ODD, provided it meets the rule's conditions.

Taxation divides on the type of contract.

For equity options, nothing is taxed at the time the position is opened. If the option expires, the holder has a capital loss equal to the premium and the writer a short-term capital gain. If it is closed by an offsetting trade, the difference is a capital gain or loss. If it is exercised, the premium is folded into the stock transaction: a call buyer adds the premium to the cost basis of the shares acquired, a call writer adds it to the proceeds of the shares delivered, a put buyer subtracts it from the proceeds of the shares sold, and a put writer subtracts it from the cost basis of the shares acquired.

For non-equity options, Internal Revenue Code section 1256 applies. A section 1256 contract includes any non-equity option — broad-based index options and foreign currency contracts among them — and is marked to market at year end, with the gain or loss treated as 60 percent long-term and 40 percent short-term regardless of the actual holding period. That 60/40 split is the point the exam tests, and it applies even to a contract held for a week.