Stock options are a powerful tool for traders and investors to magnify returns, hedge risk or generate income. At their core, options are simply the right to buy or sell a stock at a pre-negotiated price by a certain date, but trading options is a lot more complicated than stocks. There are a lot more variables influencing price and the risks are often a lot higher.
Let’s take a look at how to get started with options trading, including how to open an options trading account, determine the right strategy and realize your goals over time.
Options trading has become a lot more accessible over the years. Once reserved for financial professionals, most traders and investors can start trading options these days with minimal education or experience. Long-term investors can use options to augment their existing portfolio and short-term traders can use them for greater leverage.
Before you get started, you must familiarize yourself with how options work and their unique terminology. Knowing terms like strike price and the difference between a call and a put option are critical to understanding option trades. It also helps to understand time, volatility and other factors that influence the price of an option to properly manage trades.
The three most important terms are:
- Premium: The amount paid to buy or received to write an option contract.
- Strike Price: The pre-negotiated price of the stock if it’s bought or sold under the terms of the option contract.
- Expiration Date: The date and time that the contract ends, and the buyer loses their right to exercise the option.
The two most basic types of options are:
- Call Options: Give the buyer the right to buy a stock at a pre-negotiated price by a certain date.
- Put Options: Give the buyer the right to sell a stock at a pre-negotiated price by a certain date.
Each option trade has a buyer and a seller. The buyer purchases the contract and associated rights whereas the seller writes the contract and agrees to deliver or receive the stock. For example, a covered call involves selling a call option against stock that the investor already owns, enabling them to deliver the stock if the option is exercised.
We will learn more about some common option strategies below, but the Option Industry Council (OIC) provides an excellent introduction to option basics. If you aren’t familiar with option basics, it’s a good idea to develop a core understanding of how options work before moving on in order to avoid making potentially costly mistakes.
Open an Account
There are many different brokers that support options. When choosing between different brokers, you should look at both the trading costs and the platform capabilities. Many sophisticated platforms have volume-based fees whereas simpler platforms charge a flat fee that typically consists of a commission and a per-contract fee.
We recommend Ally Invest because of its $0 commissions and low $0.50 per contract fees, which is lower than Schwab, TD Ameritrade, Merrill Edge and Fidelity. In addition, the trading platform includes option chains, profit/loss diagrams, profitability calculators and proprietary research, along with a convenient mobile application for trading on-the-go.
You may need to provide several pieces of information to the broker:
- Investment Objectives
- Trading Experience
- Financial Information
- Option Strategies
Based on your responses to these questions, the broker will assign an initial trading level that determines what strategies you can use. Low-risk Level 1 accounts may qualify for basic strategies, like covered calls, whereas high-risk Level 5 accounts may qualify for naked puts and other riskier option strategies with greater potential for gains and losses.
When opening an options account, you will need to sign an options agreement form and read the Characteristics and Risks of Standardized Options. While you cannot purchase options on margin, some brokerage firms may also require margin accounts for certain options transactions, such as writing uncovered calls, which may require additional paperwork.
If you already have a brokerage account, you may be able to enable option trading at your current broker. They will also require an option agreement and supply you with the Characteristics and Risks of Standardized Options. Requesting the appropriate Trade Level is key to protecting yourself from risky strategies and implementing your desired approach.
Choose a Strategy
There are hundreds of different option strategies and choosing the right one depends on your risk profile and investment goals. For instance, covered calls are a low-risk strategy for investors interested in generating income from option premiums whereas selling naked puts are high-risk strategies for traders that are bullish on a particular security.
Examples of different strategies include:
|Short Call Spread
Short Put Spread
In addition to choosing a broad strategy, you should determine how you’re going to screen for opportunities and create rules for entering, managing and exiting trades. A rules-based approach to trading can help you quickly find opportunities, avoid second-guessing yourself and generate more predictable performance over time.
The Lattco Trading Platform – Source: Snider Advisors
For example, the Snider Investment Method is a strategy designed to capitalize on covered call opportunities. Using the Lattco trading platform, you can pinpoint covered call opportunities, determine the right entry and exit points and manage trades over time—even when the unexpected occurs and throws a wrench into your plans. Sign up for the e-course!
The Bottom Line
Stock options are a powerful tool for magnifying potential returns, hedging against risks and generating portfolio income. Before getting started, you should have a solid understanding of how options work and what strategies you might use to accomplish your goals. You should also take the time to find the right broker and create a rules-based approach to succeed.
If you’re interested in generating income, the Snider Investment Method is a rules-based trading system designed to support covered calls and cash-secured puts. Take our free e-course to learn more or inquire about our asset management services for a hands-off approach.