Getting Started in Options Trading

To start trading options, you will need to have a trading account with an options brokerage. Once you have setup your account, you can then place options trades with your broker who will execute it on your behalf.

Opening a Trading Account

When opening a trading account with a brokerage firm, you will be asked whether you wish to open a cash account or a margin account.

Cash Account vs. Margin Account

The difference between a cash account and a margin account is that a margin account allows you to use your existing holdings (e.g. stocks or long-term options) as collaterals to borrow funds from the brokerage to finance additional purchases. With cash accounts, you can only use the available cash in your account to pay for all your stock and options trades.

Minimum Deposit

There is usually a minimum deposit required to open a trading account. The amount required depends on the type of account that you are opening as well as the brokerage firm. Little or no deposit is required to open a cash account while federal regulations require a deposit of at least $2000 to open a margin-enabled account.

Online Brokerage vs. Offline Brokerage

To trade options effectively, I find it necessary to trade via an online brokerage account as there are simply too many variables in a typical options trade, as compared to a stock trade. Having to communicate too many details in one trade to your broker over the phone also increases the chance of miscommunication which can prove very costly.

With technology so advanced these days, online brokerages for options now offer highly intuitive user interfaces where it is far easier to place option trades online than having to do it over the phone. Moreover, while a human broker can only handle one client at a time, online brokerages can handle thousands of orders simultaneously. Thus, it is no coincidence that the rise of option trading also coincide with the rapid advancement of internet technologies.

Finding the Best Options Broker Online

When opening an option brokerage account, don't just go with the cheapest broker. You will find it worthwhile to spend some time evaluating their quality of service first. Read on for tips on how to find the best online options brokerage for your trading needs.

Full-Service Broker vs. Discount Broker

There are two main types of options brokerage firms in the market - the full service brokerage and the self-directed discount brokerage.

Full service or traditional brokerages provide a wide range of services at extra charges. Their services include advice to their clients on where to place their investment money.

Discount brokers are geared towards the self-directed trader. They do not provide any investment advice, leaving their clients to make their own financial decisions. Discount brokerages merely execute your orders and consequently their charges are much less than their full-service counterparts.

There are also brokerage companies that offer both services to their customers, letting them to choose the level of service they require.

Most option traders that I know opt to go with the discount brokerages since anyone who is confident enough to trade complex instruments such as options are usually financially savvy enough not to require trading advice from their brokers, especially when the broker's remuneration is based upon the frequency of trades rather than the quality of their recommendations.

Quality of Service

When determining which is the best options brokerage, commission charges should not be the only consideration. When it comes to online brokers, site availability, speed of execution and ease of use are just as important, if not more so, than price.

Availability & Speed of Execution

Site availability and responsiveness are perhaps the most crucial aspects to look out for when selecting an online brokerage. No matter how low the commission charges, if the trade does not get through because the brokerage site is overwhelmed by ultra high load and becomes unavailable, the amount of transaction fees you save is not going to be worth it.

Responsiveness of the site affects the timeliness of the real-time price quotes you get. Remember, we are living in the information age. News travel fast, round the globe, 24 hours a day. Markets react to breaking news events faster than ever before. You don't want to be lagging, even if it's just seconds behind, especially when the trading action is fast and furious.

Quality of Execution

The National Best Bid or Offer (NBBO) is an SEC requirement that brokers must guarantee customers the best available ask price when they buy securities and the best available bid price when they sell securities. Look for brokers that guarantee trade execution prices that meet or exceed the NBBO.

Ease of Use

With option trades already complicated enough on their own, it sure doesn't help when you still have to puzzle over how to use the order placement form. An easy to understand user interface helps minimize errors, which can be extremely costly when thousands of dollars are changing hands every trade. Look for option trading brokerages that offer single-screen order entry forms for covered calls, condors, butterflies and other multi-legged option strategies.

Commissions and Fees

To differentiate themselves from their competition, options trading brokerages are very creative when charging commissions. For options trades, if you take a look at their commission and fees page, you should see two charges: 1) a per trade fee and 2) a per contract fee.

Per Trade Fee (or Ticket Charge) - There is usually a minimum fee per transaction, regardless of how many (or rather, how few) contracts are involved in each trade.

Per Contract Fee - This fee is charged for every option contract involved in each trade.

It is important to know how they are used to calculate the total commission costs per transaction. Usually, the following method is used:

Total Commission = $X per Trade + $Y Per Contract

But some brokerages use the following formula:

Total Commission = $X per Trade or $Y per Contract, whichever is higher

Market or Limit Order

Some companies charges different brokerage fees for different types of orders. You should note the fee for limit orders since you almost never place market orders.

Internet or Broker-assisted Trade

Broker assisted trades can cost as much as several times more than internet trades. The only reason to place a broker-assisted trade is when you are cut off from the internet and a very good trading opportunity happen to arise.

Volume Discount

There are options brokerage houses which charge a lower rate if your trading frequency exceeds a certain threshold. So, if you are an active trader making dozens of trades a month, it makes sense to look out for a brokerage firm that offers such a discount scheme.

Hidden Fees

To offset their low commission charges, some discount brokerage firms charges a slew of hidden fees. So if an option brokerage charges an unusually low fee compared to the industry norms, make sure you find out whether there are other fees that you should be aware of. Some common hidden fees include:

Account Inactivity Fee - Some brokerages charges a fee if you did not make any trade after a certain period of time.

Annual Maintenance Fee - This is a fee levied every year as long as you have an account with the brokerage firm, whether or not you have made any trade.

Minimum Balance Fee - This is a fee that is levied periodically (say monthly or quarterly) when your account balance is below a certain threshold.

Commissions can have a significant impact to an option trader's overall profit or loss, especially if your trading capital limits you to prudently buy/sell only 1 or 2 contracts per trade or if you are just starting out and your win/loss ratio is 6:4 or lower. Finding a low-commissions options broker can boost trading profits by as much as 50%.

Options Chain

Not all stocks have options listed for trading. There are some criteria's that the public company will need to meet before their stock options can be listed for trading. To find out whether options are available for trading, the simplest way is to enter the stock ticker symbol to retrieve the stock quote information and find out if there is a corresponding options chain available. The availability of an options chain will mean that there are options being traded for that stock.

The options chain shows the available call and put strike prices for a specific underlying security and expiration month. Depending on the online brokerage service that you use, the interface may be slightly different but in general, the layout and available information should be very similar.

Below is the options chain interface from OptionsXpress. The most important information is shown right at the top and they are usually the underlying security, along with its latest market price, and the expiration month. This is common sense as you don't want to purchase an option only to realize that it's for the wrong underlier or the wrong expiration month!

Calls and Puts

Calls are usually listed on the left hand side while puts are typically displayed on the right hand side. In-the-money options are usually highlighted to differentiate them from out-of-the-money options. If you wish to trade at-the-money or near-the-money options, they are positioned on either side of the horizontal 'border' created by the highlighting.

The Strike Price

Down the middle is the range of strike prices available for trading for the selected expiration month. The strike price intervals vary and depends on the price of the underlying. For lower priced stocks (usually $25 or less), intervals are at 2.5 points. Higher priced stocks have strike price intervals of 5 point (or 10 points for very expensive stocks priced at $200 or more).

Options Symbol

Option symbols are unique to every option contract and they denote the type of option, the underlying asset and the expiration month, provided you have a good understanding of options symbology. However, they are seldom used nowadays since with modern computer technology, these information are often presented to the trader in a user friendly interface - the options chain! While you can enter the symbol directly when placing an order, it is advisable to select the desired options using the options chain interface to minimize human error.

Last Done Price

The last done price reflects the latest transacted price for the specific option. As the most recent transaction may be hours or days ago, especially for thinly traded contracts, you should check the bid-ask price rather than the last done price to get a better picture of the current market value of the option you wish to trade.

Bid-Ask Spread

The bid and ask shows the price at which buyers are willing to pay and sellers are looking to receive for the particular option. The bid-ask spread is the difference between the bid and the ask and the size of the spread depends on the liquidity of the option. As a general rule, the lower the open interest, the wider the bid-ask spread. Furthermore, near the money options usually have higher open interest and hence better liquidity and narrower bid-ask spreads.

Order Entry

Since this is a basic introduction to options trading, we will be focusing on executing simple orders that just involve buying options.

From the options chain screen, you will have selected the option you wish to purchase by clicking on the options symbol. A separate order entry screen will be displayed and here, you have several things to specify to complete your order.

Quantity

After confirming the underlying security, expiration month and the strike price, the first thing you need to specify is the quantity. For options, this is the number of contracts you wish to buy. Remember, for stock options, each contract covers 100 shares. Commissions are charged for every contract but many brokerages offer discounts for larger orders. Sometimes, depending on your broker, there is also a minimum commission charge for every order.

All or None

This option is available for limit orders. If you select this option, your broker will try to fill all of the quantity you specified. If he is unable to do that, then none of your orders will be filled.

Options Transactions

Unlike stock trading, the contractual nature of options offer four different ways for entering and exiting positions. There is an options seller (writer) and an options buyer (holder). The option seller can enter or exit a transaction, and so can an option buyer.

Opening Transactions

Buy-to-Open

This is the transaction the options buyer make to enter a long position on an option. For example, if you want to buy a call option, you would enter a "buy-to-open" transaction.

Sell-to-Open

This is the transaction the options seller make when he wish to enter a short position on an option. For example, if you are writing call options to earn premiums, you would enter a "sell-to-open" transaction.

Closing Transactions

Buy-to-Close

This is the transaction the options writer make when he wish to exit a short position on an option. For example, if you wish to buy back the calls you had previously sold, you would enter a "buy-to-close" transaction.

Sell-to-Close

This is the transaction the options holder make to exit a long position on an option. For example, if you want to sell a previously purchased call option, you would enter a "sell-to-close" transaction.

Types of Orders

Online brokerages provide many types of orders to cater to the various needs of the investors. The common types of orders available are market orders, limit orders and stop orders.

Market Order

With market orders, you are instructing your broker to buy or sell the options at the current market price. If you are buying, you will be paying the asking price. If selling, you will be selling at the bid price. The advantage of using market orders is that you will fill your order fast (often instantly) but the disadvantage is that you will usually end up paying slightly more, especially when the order is large and the trading volume thin.

Limit Order

With limit orders, you will specify the price you wish to transact. If you are buying, you are instructing your broker to buy at no higher than the specified price. If selling, you are telling him to sell at no less than your stated price. The advantage of using limit orders is that you are in full control of the price at which you buy or sell your options. The disadvantage is that filling the order will take some time, or the entire order may not get filled at all because the underlying stock price has moved way beyond your desired price.

Stop Loss Order

Stop loss orders are orders that only gets executed when the market price of the underlying stock reaches a specified price. They are used to reduce losses when the underlying asset price moves sharply against the investor.

Stop Market Order

A stop market order, or simply stop order, is a market order that only executes when the underlying stock price trades at or through a designated price. Buy stops, designed to limit losses on short positions, are placed above current market price. Sell stops are used to protect long positions and are placed below current market price.

While the stop market order guarantees execution, the actual transacted price maybe slightly lower or higher than desired, especially when the underlying price movement is very volatile.

Stop Limit Order

A stop limit order is a limit order that gets activated only when the underlying stock price trades at or through a specified price. While a stop limit order provides complete control over the transaction price, it may not get executed if the underlying price moves too quickly and the limit price is never reached.

Margin Requirements

In options trading, "margin" also refers to the cash or securities required to be deposited by an option writer with his brokerage firm as collateral for the writer's obligation to buy or sell the

underlying security, or in the case of cash-settled options to pay the cash settlement amount, in the event that the option gets assigned.

Margin requirements for option writers are complicated and not the same for each type of underlying security. They are subject to change and can vary from brokerage firm to brokerage firm. As they have significant impact to the risk/reward profiles of each trade, writers of options (whether they be calls or puts alone or as part of multiple position strategies such as spreads, straddles or strangles) should determine the applicable margin requirements from their brokerage firms and be sure that they are able to meet those requirements in case the market turns against them.

Margin Requirements Manual

A reference manual to the margins requirements of various options strategies has been published by CBOE.

Margin Calculator

Also provided by CBOE is this useful online tool that calculates the exact margin requirements for a particular trade.