Trading options sounds like a good idea. Suppose you buy some stock options. You will risk much less money than you would if you bought the shares or sold the stock short, but you stand to make just as much profit. The catch is that your risks are much greater. For some types of options transactions, your risk is unlimited. For options trades with unlimited risk you must have a margin account.
The Nature of Options
Options are contracts in which the buyer may purchase or sell a security such as shares of a stock for a guaranteed amount called the strike price. The buyer may exercise the option at any time until the date it expires but is not obligated to do so. The seller of the contract is called the option writer. The writer is obligated to fulfill the option contract if it is exercised. When you trade options, you may buy contracts or you may write them. Traders often use combinations of options and other securities to generate extra profits and reduce risks.
Options and Margin
Options brokers define five trading levels based on the risk of the transaction type. Levels three to five require a margin account because you may lose more money than you invest in the trade. A margin account allows you to use all of the funds in your account as collateral for such trades. This means that if you lose more money than you put up to make a trade, your broker can cover the loss by debiting the extra money from your account. For example, if you write a “naked call” you might have to buy shares of stock for $30 and deliver them to the buyer of the contract for an exercise price of $20. Your broker can deduct the extra $10 per share from the balance in your account.
Cash Accounts and Options
The risk for options transactions classified as level one or two is limited to the amount of money you invest. These trades include buying put or call options for which the most you can lose is the fee, called a premium, which you pay to buy the options contract. You may also write a covered call. In a covered call, you write a call option against stock you already own. If the option is exercised, your risk is limited to what you paid for the shares. Some brokers allow you to make level one and two trades with a cash account. Cash accounts are brokerage accounts in which all transactions are settled for cash, meaning you have to pay the entire potential cost of a transaction up front.
Opening a Margin Account
Before a broker will open a margin account, you must provide information about your assets and income. Your credit rating will be checked and you must sign an agreement making the assets in the account collateral for loans. Under Federal Investment Regulatory Authority rules, you must deposit a minimum of $2,000 to open a margin account. Your broker may require more. Just opening a margin account does not mean you may trade using the riskier options strategies. Before approving you to make level three, four or five trades, your broker assesses your financial resources and the experience you have as an options trader. Most investors must limit themselves to the less risky trading strategies until they gain experience.