Rules for Buying Stock Options

The first step toward buying stock options is to apply for options trading authorization for your brokerage account. The broker will require you to complete forms that provide information about your investment and trading experience. The broker will give your account an options trading authorization level ranging from 1 to 5. To buy options you need level 2 authorization, which brokers will give to almost any account. The higher levels allow traders to use advanced and riskier option trading strategies.

A call option gives you the right to purchase 100 shares of the underlying stock at a certain price, called the strike price. All options have an expiration date, which is the close of business on the third Friday of the listed expiration month.

One option contract covers 100 shares of the underlying stock, and the putting cost of the option is 100 times the quoted price. So if you see an option quoted at $2.50, it would cost you $250.

A specific call option will be defined by the underlying stock, the strike price and the expiration date. The value of a call comes from the relationship between the strike price and the stock price. You want the stock price to be above the strike price -- called in the money -- and moving higher.

A put option gives you the right to sell 100 shares of the underlying stock at the option's strike price. A put gets more valuable if the stock price falls and you want buy puts on a stock you think will go down in value. Prices and expiration dates function exactly the same as with call options.

It can be more difficult to get a grasp on the function of puts, because most new traders think about investments going up in value. With a put, the put value goes up only if the underlying stock price goes down.

As the buyer of call or put contracts, you decide whether to exercise the contracts. With calls you would buy the shares, and with puts you must have the shares to deliver if you choose to exercise. However, the value of your options will track the changes in the share price, so in most cases you will just sell your options to realize any gains.

If you own options that are in the money -- worth exercising -- at expiration, the contracts will be automatically be exercised, and you will own shares or have sold shares when the markets open Monday. In this case it is important to have either the cash or shares already in your account. Options that are out of the money at expiration expire without value, and the money you paid for them will be a 100 percent loss.

Your broker will charge a commission when you buy, sell or exercise an option contract. Traders often buy multiple contracts at once, and commissions are usually a flat rate plus a per-contract charge, such as $10 plus $1 per contract. Brokers often charge $25 or $50 to exercise a contract.

You can buy puts or calls with the cash in your account, and no extra money is required in case of an exercise, primarily because you decide whether to exercise. However, at expiration your broker is obligated to handle the exercise of in-the-money contracts, and you must make sure you have the resources to fulfill your end of the contract.