Know What You Want…

Before you begin trading options it’s critical to have a clear idea of what you hope to accomplish. Options can play a variety of roles in different portfolios, and picking a goal narrows the field of appropriate strategies you might choose. For example, you might decide you want more income from the stocks you own. Or maybe you hope to protect the value of your portfolio from a market downturn. No one objective is better than another, just as no one options strategy is better than another – it depends on your goals.

And How to Get It

Once you’ve decided upon an objective, you can begin to examine types of options strategies to find one or more that can help you reach that goal. For example, if you want more income from the stocks you own, you might investigate strategies such as writing covered call options. Or, if you’re trying to protect your stocks from a market downturn, you might think about purchasing puts, or options on an index that tracks the type of stocks in your portfolio.

Are You Eligible?

Based on the information you provide in the options agreement, your brokerage firm will approve you for a specific level of options trading. Not all investors are allowed to trade every kind of strategy, since some strategies involve substantial risk. This policy is meant to protect brokerage firms against inexperienced or insufficiently funded investors who might end up defaulting on margin accounts. It may protect investors from trading beyond their abilities or financial means. The levels of approval and required qualifications vary, but most brokerage firms have four or five levels. In general, the more trading experience under your belt, and the more liquid assets you have to invest, the higher your approval level. Firms may also ask you to acknowledge your acceptance of the risks of options trading.

Doing the Paperwork

Even if you have a general investment account, there are additional steps to take before getting started in options trading. First, you’ll have to fill out an options agreement form, which is a document brokerage firms use to measure your knowledge of options and trading strategies, as well as your general investing experience. Before you begin trading options, you should read the document titled Characteristics and Risks of Standardised Options, which contains basic information about options as well as detailed examples of the risks associated with particular contracts and strategies. In fact, your brokerage firm is required to distribute it to all potential options investors.

Watch the Margins

You can’t purchase options on margin, as you can with stocks. But some brokerage firms require that certain options transactions, such as writing uncovered calls, take place in a margin account. That means if you write a call, you’ll have to keep a balance in your account to cover the cost of purchasing the underlying stocks if the option is exercised. This margin requirement for uncovered writers is set at a minimum of 20% of the underlying security minus the amount the option is out-of-the-money, but never less than 10% of the security value.

If the value of the assets in your margin account drops below the required maintenance level, your brokerage firm will make a margin call, or notify you that you need to add capital in order to meet the minimum requirements. If you don’t take appropriate action, your brokerage firm can liquidate assets in your personal investment account without your consent. Since options can change in value over a short period of time, it’s important to monitor your options trading account and prevent being caught by a margin call.