Weekly Option Trader

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.

Level Two is buying options.  The option purchaser pays the option premium hoping for a favorable move in the underlying stock.  The investor actually speculates the value of the option will rise.  It’s not a complicated scenario, try to buy low, sell high.  Buying options is less complex and less commission intensive than covered calls.  The pitfall requires risking entire amount ventured.  If an option runs out of time and has no intrinsic value then it’s worthless.  Zip, Zero!  Because of the possibility of total loss, not everyone will be allowed Level Two authority.  Not difficult to get, but with few exceptions not allowed in retirement accounts.  The determining factor generally is account size.  It’s the grocery money issue.

Levels Three through Five require a margin account.

Level Three:  spreads.  In my opinion, the least risky, but most complex of all transactions.  A brief explanation; a spread is a position with two or more components.  Simultaneously buying or selling two different options changes the risk/reward curve.  Spreads can have predetermined risk with predetermined reward, but done right, unlimited possibility!  My attempt, this week, is not to teach spreads, but to help you know about setting up your account.  I would encourage all option investors to have spread writing authorization.  Make it a goal.  If you don’t have it set up, find out what it takes for approval.  Be aware, many brokerages require one year prior account activity before okaying spreads.  If your broker demands more time than your account has been open don’t fret, you’ll be given the tools to profitable trade until such time.

Level Four, selling uncovered (naked) puts.  Think of it this way, the seller acts as the insurance company, the buyer is the policy holder, the put sold the policy, the strike price equals policy value, and the option premium collected the insurance premium.  The policy states that if on or before expiration the stock price is below the strike price, the policy holder may sell the stock at policy value, regardless the actual market value.  The put seller obligates himself to buy the stock no matter how low the price drops.

A funny thing about Level Four naked puts, without margin, the risks are identical to Level One covered calls.  Think about it, in both, if the stock price is above the strike price the option seller won’t own the stock.  If the stock price is below the strike price, the covered call writer keeps his stock; the naked put writer is obligated to buy the stock.  The reality is naked puts have lower margin requirements, and therefore higher leveraged potential returns.  Everybody knows with higher rewards, there must be higher risk.  I like naked put selling, but I feel the same high returns are available, with less danger with put spreads (Level Three).

Level Five, selling uncovered (naked) calls.  Only money guarantees your ability to deliver the stock, and it takes a lot!  Technically this strategy has unlimited risk.  The sky is the limit.  The seller is obligated to deliver stock he doesn’t own.  Unless you have a lot of experience and a ton of money, your broker won’t allow you to sell naked calls.  Don’t ask.  The bright side is, I only know one circumstance worth considering using Level Five authority.  If you have a calendar spread on expiration Friday, with the short option out of the money, consider selling the next month’s call without waiting until the following Monday.  You won’t lose two days of time decay nor have unknown market exposure.  You’re entering into a new spread without closing the old one.

Often out of the money options have too much value on the ask side on expiration day.  Market makers know most option traders can’t sell uncovered options, and to keep a spread hedged over the weekend following expiration Friday, option traders need to buy back their short position to close.  Hence, they overcharge for them.  Market makers are not stupid.

If you can’t understand this situation, don’t worry, you don’t want Level Five authority, nor will your broker approve.