Suitability Part 1: Suitability
As a securities industry professional you have a responsibility to ensure that the strategies you recommend are suited to the goals and objectives and risk tolerance of your clients. Guidelines regarding suitability are published by the exchanges, which are self-regulatory organizations (SROs). Your firm, however, may have practices that differ slightly from these guidelines. Therefore, you should always check with your firm’s option principal or the appropriate SRO to ensure your compliance. As you will see, a firm understanding of procedures and requirements related to suitability will enable you to assist the public more efficiently.
Like many people new to options, you may be feeling a little trepidation. In some circles the word “options” conveys the notions of high risk and speculation. While it is true that options can be used to speculate, the same can be said for other investment products. Day trading or short-term trading with stocks is a popular method of speculating, but, as you undoubtedly are aware, stocks do not have to be traded in this fashion. The same is true of options. Options can be used in a variety of ways from conservative to speculative.
Prior to recommending any strategy to a customer you must have a reasonable basis for believing that the recommended transaction is suitable for your customer. The determination of suitability is based upon information obtained from your customer relating to his or her investment objectives, financial situation, and other relevant information. Typically, suitability rules also provide that no recommendation of an option strategy may be made unless you have a logical basis for believing that your customer has sufficient knowledge and experience in investing and trading that he or she can reasonably be capable of evaluating the risks of the recommended option strategy. Moreover, your customer must be financially able to bear the risks of the recommended option position.
A common misconception is that options strategies are “all speculation”. Nothing could be further from the truth. Whether a strategy is conservative or speculative depends on the goal of the strategy and how it is implemented. Accordingly, the goal of a recommended strategy should be known, and it should be explained to the customer at the time that a recommendation is made. SROs require that recommendations of brokers be judged on the basis of whether or not it can be reasonably said to present fair treatment for the person to whom it is directed. Profitable results are not a basis for determining that a strategy was suitable.
Since options provide a wide range of ways to implement conservative strategies as well as speculative strategies, the determination of suitability of a particular option strategy for a client requires knowledge on the part of the broker as to how options work and what the goal of using them is.
Evaluating a client’s suitability for options is not an automatic exercise. Forms, questionnaires, and computer programs are useful tools to help evaluate a client’s goals, needs, and tolerance for risk. Only after a client’s financial status and objectives are known can a determination be made as to what type of option strategies are suitable. Moreover, there might be times when an option recommendation could be more suitable than a stock recommendation, and the broker has to know the difference.
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