U.S. Options Market Regulations

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, and options, 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 the options market in the U.S.

Key Takeaways

In the U.S., regulators like the SEC, FINRA, CFTC, and NFA oversee options trading to ensure transparency, fairness, and investor protection.
Due to its complexity, options trading is highly regulated, with rules on position limits, leverage, margin requirements, and reporting standards.
FINRA enforces compliance on broker-dealers, requiring mandatory registration, securities licensing, and record-keeping of disciplinary actions.
The CFTC and NFA regulate futures and forex options, seeking to prevent fraud, enforce capital requirements, and maintain the market's integrity.

Options Regulation

The primary aim of a regulated financial market is to protect the rights and interests 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:

Options 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 non-compliant individuals and businesses. Most of these rules and regulations are imposed via brokerage firms.

An option contract can be traded on a stock/index or on forex/commodity/futures as an underlying. Different U.S. organizations regulate these categories.

All option contracts traded over stock/index are overseen by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA); while options contracts over forex/commodity/futures are watched over by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

The Securities and Exchange Commission (SEC)

The SEC, founded in 1934, has a mission statement “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” It establishes 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 (FINRA)

Created in 2007, FINRA is a non-government body devoted to investor safety and market reliability through regulation. Its main focus is on compliance by security firms and brokers with a set of rules and on ensuring market transparency.

FINRA operations can be divided into four sections:

Educating the public about investment, money handling, fraud, and risk management through training modules available on its website.
Mandatory broker-dealer registration: all companies in the securities transaction business in the U.S. are obliged to register with FINRA and become licensed broker-dealers. 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 detailed option regulation guide. Proposals by member exchanges are carefully verified for impact assessment, and if found suitable, rule changes are implemented in accordance with the SEC.

Fast Fact

SPXW options are the most heavily traded options. SPXW are weekly options on the S&P 500.

The Commodity Futures Trading Commission (CFTC)

Established in 1974, the CFTC is 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 traders to file a complaint, as well as a whistleblower program. Below is the list of exchanges monitored by the CFTC:

Chicago Board Options Exchange
Chicago Board of Trade
Chicago Mercantile Exchange
Nadex
Minneapolis Grain Exchange
New York Mercantile Exchange
ICE Futures U.S.

The National Futures Association (NFA)

The National Futures Association (NFA) provides regulatory programs to ensure the derivatives markets function with integrity. A detailed 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 U.S. Options Regulations

Here are some of the key regulations in the U.S.:

Options 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 a deposit.
First-in, first-out (FIFO) rule prevents holding similar option positions.

Who Regulates Options in the U.S.?

The main regulators of options in the U.S. are the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC oversees options on stocks while the CFTC oversees options on commodities and options on futures. In addition, the Financial Industry Regulatory Authority (FINRA) enforces regulations on broker-dealers and trading practices. The Chicago Board Options Exchange (CBOE) also has its own rules and regulations to oversee options trading.

What Is the Difference Between the SEC and the CFTC?

While both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are financial regulatory bodies in the U.S., they focus on different areas of the financial markets. The SEC oversees securities such as stocks, bonds, and mutual funds, while the CFTC oversees commodities and derivatives, such as options and futures. Both seek to ensure fair trading and protect investors.

Who Issues U.S. Options?

Options exchanges issue U.S. options. These include the Cboe Options Exchange, the Nasdaq PHLX, NYSE Arca Options, NYSE American Options, the MIAX Options Exchange, and the BOX Options Exchange. The Options Clearing Corporation (OCC) clears and guarantees options that are standardized and listed by these exchanges.

The Bottom Line

How well regulators ensure smooth functioning through established regulations, rules, and dispute resolution mechanisms 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 the hope of better profits, care should be taken to ensure the markets, participants, and facilitator firms are well-regulated.