By Katie Johnson

Self-directed brokerage accounts are on the rise. In Q1 of 2020 alone, online brokerage firms Charles Schwab, TD Ameritrade, Etrade, and Robinhood all reported astronomical growth of as much as 170% in new account openings compared to Q1 2019. TD Ameritrade noted that its new investors generally “skew younger.” This corresponds to the increase in intakes we have seen in the Clinic: many potential clients are in their 20’s and 30’s with complaints against their online brokerage as opposed to a particular broker.

There is abundant fuel for this investment fire. Record breaking unemployment, a volatile stock market, and job insecurity have all driven people to seek low-cost investments to protect and grow their savings. In the midst of working from home, apps are easily accessible and let people avoid the face-to-face interaction with brokers. Similarly, many online platforms advertise commission-free trading. Often times, the advertising emphasizes the benefits of option and margin accounts (which are riskier) without giving equal airtime to the risks. The biggest issue with this is that when investors apply for these accounts, they sign account documents that were written largely to insulate brokerages from liability.

The Clinic’s recent intakes regarding self-directed accounts have two significant themes: investors who feel like brokerages should have noticed inflated income or investment experience through background checks or investigation; and investors who thought they calculated the risks but somehow lost more money than their calculated loss.

I inflated a number or two on my application to get approved for a higher level of options trading, but shouldn’t the firm have caught that when they did their due diligence?

The short answer to this is no. While FINRA requires that brokerages obtain certain customer information in order to approve them for an options account, investors are the ones filling out their information when applying for self-directed accounts. Theoretically, the investors are the most reliable source of that information. What’s more, the account contracts include a provision that says you the investor affirm that what you put down is true because you understand the brokerage is going to rely on that information.

How could I have lost so much more than the maximum loss that I calculated?

While many investors feel confident in their calculated losses, they are usually calculating how much they stand to lose if the stock price moves unfavorably to their position. However, investors don’t always realize that every disclosure says investors may stand to lose their entire investment. For example, the options disclosure on Charles Schwab’s website says that option customers “should clearly understand that there is no guarantee that option positions may be offset by either a closing purchase or closing sale transaction […]. In this circumstance, option grantors could be subject to the full risk of their positions until the position expires.” In other words, while you think you have done everything right, there is still the risk that everything could still go wrong. This is further detailed in the example below.

But I didn’t know what I was getting myself into.

Options are an iceberg of complexity and self-directed investors are the Titanic, full steam ahead. Many account opening documents include things like “By signing, you acknowledge you have reviewed X, Y, and Z disclosures and understand their terms and conditions.” Every account contract includes the same incorporation of the Options Clearing Committee’s (OCC) “Characteristics and Risks of Standardized Options”—a 188-page document outlining, as it says, the characteristics and risks of options. One, it’s jarring that it takes 188 pages to outline the characteristics and risks. Two, while it’s unlikely that investors read every page, they still sign the account documents saying they did in fact read the hefty document and that they understood what it told them. While this does not absolve brokerages of liability when they improperly approve investors for higher levels of risk and/or margin trading, it certainly adds a hiccup to the dispute resolution process.

The Clinic’s options-related intakes center around the issue of truly understanding the nature of options. If the 188-page disclosure didn’t make it clear, options are complicated and even the risks are difficult to understand. For example, the OCC Disclosure says that implementing a spread strategy may reduce your risk exposure, but then later says spreads are complex and “complexity not well understood is, in itself, a risk factor.” The Disclosure goes on to suggest consulting with someone who is “experienced and knowledgeable with respect to the risks.”

Here is an illustration of how quickly things can go wrong, some common misconceptions about options, and some suggestions for protecting yourself as an investor.

Let’s say you execute a call spread—a commonly used two-part strategy where you buy and sell a call option on a particular stock.

The call you sell means, if the buyer exercises their option, you have to sell 100 shares of the stock at the agreed upon price per share (the strike price). In general, a buyer only exercises their option if the strike price is lower than the stock’s market price (the option is “in the money”) because the option lets them buy the shares for a bargain. When you sell an option, you collect a premium, the price paid for the option itself. If the buyer exercises, then in addition to the premium you collected, you earn the strike price multiplied by the 100 shares you are obligated to sell. Many investors sell options to collect premiums.

The call option you buy gives you the right to buy 100 shares at the strike price. The spread lets you avoid buying the stock up front because the option you sold acts as an “offsetting position.” In other words, if the option you sold is exercised and the shares get called away from you, you can use the option you bought to call away the stock from someone else in order to satisfy your obligation to sell. Alternatively, you could purchase the shares if the market price is in between the strike prices of the options you bought and sold.

The benefits of a spread are that you don’t have to buy the stock up front and you collect the difference in the premium you collected vs the premium you paid. If the market price goes above the two strike prices, you still buy the stock for a bargain, but you sell it for an even bigger bargain – therefore, you only lose out on the difference of those two prices. This is the “maximum loss” that you calculate.

But the mechanics of options and the options exchange are not widely known and misunderstanding them can get newer investors into significant trouble.

So, you implemented a spread strategy earlier in the week. On Expiration Friday at 4pm ET (market close), the market price is below the strike price, so you think that the options have both expired out of the money. This demonstrates Misunderstanding #1: the options exchange does not close when the stock market closes at 4pm ET. The options exchange closes 5:30pm ET, 90 minutes after the stock market.

At 4:30pm, good news breaks and the stock price goes up. The option you sold is exercised because it’s a bargain. To exercise their option, the option-buyer tells their brokerage to exercise it, who then tells the OCC about the exercise order, then the OCC tells your brokerage, and your brokerage then tells you that you need to sell. Inherent in any game of telephone are delays in communicating vital information like “hey, you need to exercise the option you bought ASAP because the price is going up and you are obligated to sell.” Herein lies Misunderstanding #2: investors don’t get immediate notice of option assignment and you could find out once it’s too late to stop the bleeding.

So, you find out the following Monday morning that you were obligated to sell 100 shares that you didn’t own because you never exercised your option. Your brokerage stepped in and loaned you the shares to sell, but now you have to pay them back. You do this by buying the shares at market price. But, your right to buy at a bargain has since expired as of midnight ET on Friday. Now you’re stuck purchasing the stock at the much higher market price.

Time for some numbers:

Let’s say that the call option you sold had a strike price of $100. This means that your account gained $10,000 when you sold the shares your brokerage loaned you (100 shares for $100 each). Let’s also assume that after that sale, your account balance is $20,000.

Misunderstanding #3: If the market price of the shares is now $140, all you have to do is purchase the shares at $14,000, right? Unfortunately, it’s not that easy. Brokerages have equity and maintenance requirements. When the brokerage loaned you the shares to sell, you became required to keep 150% of the sale proceeds as the “equity requirement”—150% of $10,000 is $15,000. Even more, you have to keep 30% of the current market value of the shares, the “maintenance requirement”—30% of $14,000 is $4,200. [Note: Margin/maintenance requirements vary by broker and brokers can change them whenever they feel like it].

So, where your balance looks like you gained $10,000 on the sale of the options, you are actually required to maintain a minimum balance of $19,200 ($15,000 + $4,200). That means while you see $20,000 in your account, you only have $800 to spend. Purchasing the new shares for $14,000 requires dipping into your required minimum. Because you can’t afford the stock, your brokerage issues a margin/maintenance call. Unless you fund the account with additional money, your brokerage will liquidate your account positions to make sure the minimum $19,200 is there and/or purchase the shares in your account until they are paid back in full. Brokerages don’t have to tell you when or how they’re doing this, nor do they have to ask for permission; these are things you agree to in the account agreements.

Your obligation to sell as the option-seller is there regardless of whether you exercised your “offsetting” right to buy. So, while you chose a spread strategy to limit your risk and avoid up-front costs, you were effectively left with an uncovered option – a security with infinite risk that you would likely not have been approved for in the first place. Ways of limiting the “assignment risk” can be found on the OCC’s educational website mentioned below.

What can you do as an investor?

I am not going to tell you to not trade options. Options have undeniable advantages (e.g., letting investors avoid up-front costs of purchasing stocks outright). However, because the good always seems to follow the bad, here are some suggestions for things to keep in mind if you’re considering trading options with a self-directed account:

• Read the disclosures included in your account opening information. Some of them are only a page long. Know what the brokerage has the right to do—like liquidate your positions—in the event that you can’t afford to pay them back. Look for key words like risks, exercises, liquidation, and maintenance. This isn’t an exhaustive list, but those words will direct you towards finding information about what your rights and obligations are and what your brokerages rights are as well.
• Don’t inflate your numbers. Make honest representations about yourself so your brokerage doesn’t give you too much room to run. FINRA requires your brokerage to ask about your assets, net worth, and investment experience in order to protect investors. If you aren’t approved for the higher levels of risk, then theoretically the guardrails are working. If you aren’t approved for the higher levels of risk, you won’t be able to use riskier strategies. This could prevent you from getting into too deep of trouble. While brokerages aren’t necessarily off the hook if the risk level is still inappropriate, it’s almost always easier to argue “I did nothing wrong” as opposed to “I did something wrong, but the brokerage did something more wrong!”
• If the 188-page disclosure is too daunting, use the table of contents to find the risks that are relevant to you and read them. I wouldn’t direct you to a massive PDF if I didn’t think it was worth it. The OCC Disclosure is particularly helpful as it includes examples of how things often go wrong and ways to avoid those common mistakes.
• Similarly, the OCC—the ones that wrote the 188-page disclosure—created optionseducation.org, which details common strategies, risks, mistakes, ways to avoid those mistakes, and even has a chat function. Both the OCC Disclosure and Options Education website address the common misunderstandings I mentioned in earlier in the example.
• Lastly, sometimes things go wrong even when you do everything right. Maybe your broker gave you too much room to get yourself into trouble. Make sure to keep copies of account opening documents and communications with your brokerage in case you need someone to tell you whether there was any wrongdoing. Generally, the better kept your books are, the easier it is to advise you.