Choosing an Options Broker

by Beth Gaston Moon | April 12, 2012 2:25 pm

OptionsTradingBasics logo Choosing an Options Broker[1]Most of the leading online brokerage firms are well-versed in trading options. There are also a number of options-specific brokerages that have tools to assist options traders.

Keep in mind, though, that in general, the lower the commission, the less customer support you can expect. Full-service brokers can charge $2–$5 per options contract, while discounters might charge a low flat commission per trade, regardless of the number of contracts traded.

HOW TO TRADE OPTIONS:
- What Are Options?[2]
- What Are Options Contracts?[3]
- Price of Options[4]
- How to Read Options Symbols[5]
- How to Price Options[6]
- How to Read Options Quotes[7]
- Understanding Options Risk[8]
- Common Mistakes to Avoid[9]
- Options Trading Strategies[10]
- Choosing an Options Broker[11]

Applying is easy, and often the entire process can be done online. Expect to pay anywhere from $5.00 to $19.95 in commissions per transaction (opening and closing) for an option trade. Some option brokerage firms have a per-contract commission schedule, with a minimum of, say, $14.95 per trade. (In other words, even if you only trade one contract, they will still charge the $14.95.)

Choosing an Options Broker: Margin — Getting “Approval” to Trade Options

When you’re ready to open an options trading account, you’ll be asked if you want to open a “cash” or “margin” account. As you might know, a margin account allows you to borrow the broker’s money to buy certain securities, which means you can hold double the amount of shares you could otherwise afford. More specifically, you are only allowed to borrow money against “marginable securities,” which includes most stocks, bonds and mutual funds.

However, options themselves aren’t marginable securities — therefore, you cannot buy them on margin. They are “cash-only trades.” Because options settle during the same day or within one business day, enough cash must be in your account to cover the amount of the trade.

More advanced option trades (such as selling puts) require that you have some funds set aside in your account, just in case you are called upon to perform your obligation of buying a certain amount of shares at a set price by a certain date. This is called the “margin requirement.”

When opening an account, it’s always a good idea to check the “margin” box — even if you don’t plan to use margin at all. The fact is, if you want to be able to do more advanced kinds of options trading, you must first have a margin account approved, even if you never use the margin available to you within this account.

Having clearance in your account does not mean you will be forced to go on margin with your options trades. If you have enough cash or stock holdings in your account to cover the margin requirements, then a trade will not trigger the activation of the margin (borrowing capacity) that is available to you.

Getting set up can be as easy as checking the “margin” box. Bottom line, a second of your time now could earn you amazing rewards when you’re ready to get started with options trading strategies.

Choosing an Options Broker: Options Approval

Each broker has different rates and requirements, but there are four different levels of option trading you can be approved for. Most brokers will approve new customers for levels 0 or 1. Make sure you’re approved for level 1 or higher so you can buy calls and puts.

Level 0 — This is the first level of approval and where you would be required to have the most stocks or money to cover your positions. At this level, you would be able to sell calls and puts on the underlying stocks you own in your account.

A call sold on an existing stock is also known as a “covered call.” The covered call is one of the most conservative and least risky option strategies available. For that reason, it is an option strategy favored by many options-trading beginners. Before you sell the calls, you have to own the stock (i.e., you’re “covered”) in the event the stock gets called away from you. It’s simple, and there’s virtually no risk to the brokerage firm. If you are forced to fulfill your obligation as a call seller (i.e., selling the shares at the strike price), the shares are readily available in your account.

Buying calls and puts involves having cash in your account (which is how all options settle). You buy a call or a put, and you are limited to losing the amount of your investment and nothing more. Again, the brokerage firm is not assuming too much risk here because you have the money/stocks in your account and they place a freeze on them to make sure they are covered in case the trade does not go your way.

Depending on your account size, the brokerage firm and your past experience, you might not be approved (initially) for higher levels.

Level 1 — Here you would also be able to buy puts and calls without owning the underlying securities.  You could also do long straddle spreads, which involve buying equal numbers of calls or puts on the same stock and at the same strike price.  You would do this if you thought the stock were going to make a big move, but were not sure which direction it would be.

Another strategy you would be able to do is the long strangle trade. This involves the same number of calls and puts on the same underlying security at different strike prices but with the same expiration date. Here you are again hoping that the stock makes a big move but you’re not sure at what price (or in what direction).

Level 2 — At level two, not only are you approved to do everything in the other two levels, but you can now begin to do spread trades. When you speak to your broker, we recommend you try to get approval for at least Level 2 so you can participate in basic credit and debit spreads often discussed on InvestorPlace.

We have found that not only will you spend less to get into spread trades, but your profit potential and winning percentage can be huge. There’s nothing traders like better than to get paid to open on a trade such as a credit spread. At Level 2, you will also be required to have less upfront cash or securities tied up for your option trades.

Level 3 — This is the highest level for which you can be approved by your broker. This level allows you to sell “naked puts” or “naked calls” and trade more complex strategies.

There is also a higher margin requirement for certain strategies such as selling naked puts. Since you’re taking on an obligation to buy stock, the brokerage firm wants to cover their risk if you’re selling 50 put contracts on a $50 stock … that’s a $250,000 obligation if you are suddenly forced to buy 5,000 shares of stock at $50 each!

Each broker is different, but they will require you to have a certain amount in cash or stocks held in your account so they can see you can make good in the event you have to fulfill your obligation.

As a general rule, you must have at least 25% of equity in your account, and the broker will front you 75% on margin. If you sell a put (giving somebody else the right to buy shares from you), the broker may freeze the total amount of equity in your account to cover this trade because they want to protect themselves if you have to cover the trade and buy the stock.

Again, rates vary among brokers so make sure you talk to them about their specific margin rates and policies.

Below you will find a glossary of options terms and also a few worksheets with some quizzes that will really help you lock in the information you just read. With this basic understanding of options, you can see how it can help you profit in any type of market – up, down, trending, or volatile.  With a little practice, you’ll be trading options like a pro in no time!

Endnotes:
  1. [Image]: http://investorplace.com/how-to-trade-options-options-trading-basics/
  2. What Are Options?: http://investorplace.com/2012/04/what-are-options/
  3. What Are Options Contracts?: http://investorplace.com/2012/04/what-are-options-contracts/
  4. Price of Options: http://investorplace.com/2012/04/price-of-options/
  5. How to Read Options Symbols: http://investorplace.com/2012/04/how-to-read-options-symbols/
  6. How to Price Options: http://investorplace.com/2012/04/how-to-price-options/
  7. How to Read Options Quotes: http://investorplace.com/2012/04/how-to-read-options-quotes/
  8. Understanding Options Risk: http://investorplace.com/2012/04/understanding-options-risk/
  9. Common Mistakes to Avoid: http://investorplace.com/2012/04/common-mistakes-to-avoid-when-trading-options/
  10. Options Trading Strategies: http://investorplace.com/2012/04/options-trading-strategies/
  11. Choosing an Options Broker: http://investorplace.com/2012/04/choosing-an-options-broker/

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