There are so many available options and ways to trade them that you might not know where to begin. Getting started is easier than you think, once you determine your goals.
Know What You Want
Before you begin trading options, have a clear idea of what you hope to accomplish. Options can play a variety of roles in different portfolios. Picking a goal narrows the field of appropriate strategies. Perhaps you want more income from the stocks you own. Maybe you hope to protect the value of your portfolio from a market downturn. No one objective is better than another, just as no one options strategy is better than another. It depends on your goals.
…And How to Get It
Once you’ve decided on your objective, examine options strategies that can help reach that goal. For example, if you want more income from the stocks you own, investigate strategies such as writing covered calls. If you’re trying to protect your stocks from a market downturn, you might think about purchasing puts or options on an index that tracks the type of stocks in your portfolio.
More Than Just a Broker
Once you’re ready to invest in options, choose a brokerage firm. Firms may offer helpful advice as well as execute trades. Some firms work with clients to ensure options trading fits into their individual financial plans. They also advise clients about potential objectives and strategies, and outline the risks and benefits of various transactions. Alternately, some discount firms don’t offer personalized advising services but charge lower commissions. Both inexperienced and veteran investors may consider consulting their brokers before opening or closing out a position.
Are Your Eligible?
Your brokerage firm evaluates and approves you for a specific level of options trading. Not all investors are allowed to trade every kind of strategy, since some strategies involve substantial risk. This policy protects brokerage firms against inexperienced or insufficiently funded investors that may default on margin accounts. It also protects investors from trading beyond their abilities or financial means. Levels of approval and required qualifications vary, but most brokerage firms have four or five levels. In general, the more trading experience and liquid assets you have, the higher your approval level. Firms may also ask you to acknowledge your acceptance of the risks of options trading.
Doing the Paperwork
Even if you have a general investment account, there are additional steps required before you can begin trading options. You’ll have to fill out an options agreement form, used by brokerage firms to measure your knowledge of options and trading strategies, as well as your general investing experience. Read the document titled Characteristics and Risks of Standardized Options for basic information about options. Your brokerage firm is required to distribute this document to all potential options investors. This document also contains detailed examples of the risks associated with particular contracts and strategies
Watch the Margins
You can’t purchase options on margin, as you can with stocks. However, some brokerage firms require that certain options transactions, such as writing uncovered calls, take place in a margin account. That means if you write a call, you’ll have to keep a balance in your account to cover the cost of purchasing the underlying stocks if the option is exercised. This margin requirement for uncovered writers is set at a minimum of 20% of the underlying security minus the amount the option is out-of-the-money, but never less than 10% of the security value.
If the value of the assets in your margin account drops below the required maintenance level, your brokerage firm will make a margin call, or notify you that you need to add capital in order to meet the minimum requirements. If you don’t take appropriate action, your brokerage firm can liquidate assets in your account without your consent. Since options can change in value over a short period, monitor your account to prevent being caught by a margin call.