by Investing Daily, Investing Daily
— this post authored by Scott Chan
Options are not as complex as some investors fear. If you ignore the world of options, you’re leaving money on the table.
Here’s a quick rundown on how to get started. Options are an especially valuable wealth-generating tool, amid the market volatility we’re seeing now.
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Set Up Your Account
If you want to try to use options to boost your portfolio’s return, you will first need to make sure that your brokerage account is properly set up. If your account isn’t already cleared to trade options, you will need to apply.
Typically, you will have to fill out a form to ask your broker to enable option trading in your account. Depending on what type of option trading you want to do, you may need to add margin as well (more on this later).
The form is usually painless and will ask you questions about your investing background, investment goals, and what level option clearance you want. You will also have to read disclosures and then sign to state that you understand the risks involved in trading options. The form will usually spell out the cash and margin requirements.
Pick Your Level
The form will ask you what option trading level you want. You need to select the level that allows you to do all types of option strategies that you want to use.
If you need to increase your level of clearance later on, you will need to fill out another form.
What You May See
I will use Charles Schwab to give you an idea of what to expect. Keep in mind that different brokers may have different names and definitions of each level, so make sure you carefully read through the level description on the form before you select the right level for you.
Schwab has four levels to choose from, from Level 0 to Level 4.
Level 0: Covered options and cash-secured equity puts. The strategies here include selling covered calls, selling cash-secured puts, and buying protective put.
A covered call is when you own shares of the underlying stock and you sell calls against them at a higher price. A cash-secured put is when your account has enough cash to buy the underlying stock in case the put option is exercised.
A protective put is when you have shares of the stock and you buy a put to guarantee that during the life of the option you can sell the stock at no worse than the option’s strike price.
Level 1: Purchasing options. The strategies here include everything in Level 0 plus long calls, long puts, long straddles, and long strangles.
Long calls and puts mean straight forward buying calls and puts. A long straddle involves buying a call and a put option with the same expiration date and same strike price in the same stock. The goal of a straddle is to bet on a big move in the stock and profit whether the stock goes up or down. A long strangle differs from a long straddle in that the call and the put have different strike prices.
For Levels 0 and 1, margin is optional. It’s not required.
Level 2: Spread trading. The strategies here including everything in Levels 0 and 1 plus different types of spreads.
A spread strategy involves simultaneously buying and selling calls or puts on the same stock but at different strike prices and/or expiration dates. The three main classes of spreads are vertical, horizontal, and diagonal spreads.
A vertical spread has options with the same expiration but different strike prices. A horizontal spread has options with the same strike price but different expiration dates. A diagonal spread has options with both a different strike price and a different expiration date. Within each class, there are many different strategies.
Schwab automatically adds margin to your account at Level 2 and higher.
Level 3: Naked options. This includes all previous levels plus all types of uncovered option shorting. This means selling calls or puts without having either the underlying stock or sufficient cash to cover the purchase of the stock in case the options are exercised.
Be Mindful of Commissions
You cannot use Individual Retirement Account (IRA) assets as collateral, so if you plan to trade options in an IRA account, you will be limited to the option trading strategies that don’t require margin. However, spread trading is allowed, if no margin is used.
Also keep in mind the cost of trading. The broker typically will charge you a base commission that’s fixed no matter how many contracts you trade, plus a variable fee per contract. For example, Schwab currently charges $4.95 plus $0.65 per contract, so it would cost you a $5.60 commission to trade one contract, $6.25 for two contracts, and so forth. If you are opening a new account, shop around to see the best deal you can get to save on commissions.
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