Options trading can be complex, even more so than stock trading. When you buy a stock, you decide how many shares you want, and your broker fills the order at the prevailing market price or at a limit price.
Trading options not only requires some of these elements, but also many others, including a more extensive process for opening an account. Indeed, before you can even get started you have to clear a few hurdles. Because of the amount of capital required and the complexity of predicting multiple moving parts, brokers need to know a bit more about a potential investor before awarding them a permission slip to start trading options.
Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks in options and their financial preparedness. Before you can start trading options, a broker will determine which trading level to assign to you.
Based on your answers, the broker assigns you an initial trading level typically 1 to 4, though a fifth level is becoming more common that is your key to placing certain types of options trades. Screening should go both ways. The broker you choose to trade options with is your most important investing partner. Finding the broker that offers the tools, research, guidance and support you need is especially important for investors who are new to options trading.
For more information on the best options brokers, read our detailed roundup to compares costs, minimums and other features. Or answer a few questions and get a recommendation of which ones are best for you.
In order to place the trade, you must make three strategic choices:. This determines what type of options contract you take on. A call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price called the strike price within a certain time period.
A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires. If the stock does indeed rise above the strike price, your option is in the money. If the stock drops below the strike price, your option is in the money. Option quotes, technically called option chains, contain a range of available strike prices. The price you pay for an option has two components: The price you pay for an option, called the premium, has two components: Intrinsic value is the difference between the strike price and the share price, if the stock price is above the strike.
Time value is whatever is left, and factors in how volatile the stock is, the time to expiration and interest rates, among other elements. Every options contract has an expiration date that indicates the last day you can exercise the option.
Your choices are limited to the ones offered when you call up an option chain. Expiration dates can range from days to months to years.
Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable. Longer expirations give the stock more time to move and time for your investment thesis to play out. A longer expiration is also useful because the option can retain time value, even if the stock trades below the strike price.
If a trade has gone against them, they can usually still sell any time value remaining on the option — and this is more likely if the option contract is longer. Options trading can be complicated. That education can come in many forms, including:. Reliable customer service should be a high priority, particularly for newer options traders. Consider what kind of contact you prefer. Does the broker have a dedicated trading desk on call?
What hours is it staffed? What about representatives who can answer questions about your account? Even before you apply for an account, reach out and ask some questions to see if the answers and response time are satisfactory. Options trading platforms come in all shapes and sizes. They can be web- or software-based, desktop or online only, have separate platforms for basic and advanced trading, offer full or partial mobile functionality, or some combination of the above.
Check to see if the fancy stuff costs extra. For example, most brokers provide free delayed quotes, lagging 20 minutes behind market data, but charge a fee for a real-time feed. Similarly, some pro-level tools may be available only to customers who meet monthly or quarterly trading activity or account balance minimums. But because commissions provide a convenient side-by-side comparison, they often are the first things people look at when picking an options broker.
Of course, the less you pay in fees the more profit you keep. Platform fees, data fees, inactivity fees and fill-in-the-blank fees can easily cancel out the savings you might get from going with a broker that charges a few bucks less for commissions.
Discount brokers can charge rock-bottom prices because they provide only bare-bones platforms or tack on extra fees for data and tools. Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Introduction to Options Trading. How to Trade Options.
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