Buy Authorize Account with all investments have risk. Real estate, stocks, and mutual funds have risk, and of course options have risk. But have you ever considered the risk of cash? Not the risk of someone breaking into your house and stealing the money under your mattress, but the risk your money in the bank doesn’t retain buying power.
This week we’ll discuss option trading accounts and how brokerages look at them. If you lack an option trading account, knowing almost everything about them won’t help you make any money. This will not be a recommendation to any specific broker or brokerage. Its an individual decision, like picking a favorite flavor of ice cream, my favorite flavor shouldn’t be yours, no matter how much I know about ice cream.
You shouldn’t chose a broker by low commission rates, but the trading authority they will allow. If you have a more complicated or “more risky” strategy that consistently has made money in the past and your broker won’t let you trade it, you need a new broker. In defense of the broker, if you’re consistently betting the milk money on “long shot losers”, he doesn’t need the risk of a lawsuit for allowing you to speculate away your grocery money. Don’t laugh, brokers get sued all the time. Good brokers don’t want the label of a churn and burner, using tactics making more commissions than profits. Brokerage won’t allow everyone shovels to dig themselves holes they can’t get out.
By reading these articles, many of you will know more about options than your broker. If they won’t allow you to trade strategies they don’t understand, no matter how much you understand, consider changing.
Different brokerage firms might have different rules and requirements, but this is as close to industry standard as it gets. There are five levels of option trading authority. These levels are based on risk and complications. Risk to you the trader, but more important the perceived risk to the broker. Some strategies are complicated, both to the investor and the broker.
The five levels are:
Level One; selling covered calls. Level Two; buying puts and calls. Level Three; spreads. Level Four; selling uncovered (naked) puts. Level Five; selling uncovered (naked) calls.
Options are a contract between two parties. The buyer has rights, the seller has obligations. Call options give the buyer the right to buy a stock at a predetermined price (the strike price) within a predetermined time period (the expiration date). The seller, also known as the writer, is obligated to deliver the stock if the buyer exercises his right.
Most investors should easily attain Level One trading authority. Considered so safe a strategy, the IRS allows it in IRA accounts. When a investor owns stock, he may sell a call, giving the buyer the right to purchase the stock. The brokerage liens the stock, they won’t allow you to dispose of it since it guarantees your ability to perform your part of the contract. Think of it this way, the broker is covered. The chain of events flows. If the call buyer exercises his right, the broker doesn’t have to contact you. The stock is sold automatically.
The broker takes it out of your account, and puts in money. If the call buyer doesn’t exercise his rights before the call expires, the lien disappears. You’re free to sell the stock, or another covered call. Pretty safe, pretty simple. Covered calls have two risks, both related to market fluctuations. First, like owning stock, you run the risk of the stock price declining. You also run the risk of not participating if the stock makes a major upward move.
