I've been catching up on a number of finance blogs that I used to read quite regularly, and came across and interesting article from DoughRoller called "A Simple Yet Profitable Call Option Strategy". Much like DoughRoller, I haven't really considered dealing with options until now. Normally they are only good for two things:
- Managing risk in a portfolio.
- Wild Speculation.
Options are basically a promise to buy or sell stock (or other goods) at a certain price by a particular date. You have the option to buy or sell at that price regardless of the current value of the stock.
When used to manage risk, you can do things like preserve value of your assets even if the market takes a steep dive. This is good for someone who has a short term need to persevere value such as an estate executor maintaining an inheritance for someones heirs or a trust fund for a minor. Since options used in this manner generally limit your upside gains and cost money that you usually will never see again, I have avoided them.
You can also use them to increase your leverage by making promises to buy or sell stocks that you don't actually own. Wild speculation like that gets many people in trouble with options because if you make good bet, you can win lots of money with very little down but if you bet poorly, you can lose more than you would think possible. For that reason options trading accounts have a little more stringent rules than your normal stock brokerage accounts. Anyone considering options trading should put more than due diligence into their research to understand the risks and rewards. This article on investopedia has a good overview of why people use options, but don't let their talk of rewards and risk management cloud your judgment. Options are not a long term strategy.
I still remember and episode of "Saved by the Bell" where the class plays with stock portfolios during a lesson and Zack ends up selling the stock and buying potato futures on margin. When the potato market crashes, somehow he is left with a parking lot full of potatoes.
The third thing options are good for is generating extra income by selling options contracts on stock I already own aka, a "covered call". Basically I'm letting someone buy the right to purchase my stock at a particular price before a certain date. Since I'm inclined to sell some of my current stock anyway, I think writing options contracts and making a profit on the income is a win-win for me. Whatever happens I get the contract price. If the options expire without being exercised, I still have my stock. If the options are exercised and my stock gets sold, then I make a profit( or maybe take a loss?) that I was going to take anyway.
My preferred stock broker is Zecco.com because of their free trades. They don't have as many features as some of the more expensive brokers, but I don't really need those features for my basic stock trades. To make things simple I'll keep my options account with them as well.
At Zecco
- Options fees are $4.50 + 0.50 per contract.
- You must complete an options agreement form, which is basically a risk assessment form followed by 2 pages of legalese, and mail it in to Zecco. You can do this anytime during or after account opening.
- You will be given a level of 1,2,3, or 4 based on what you want to do and the risk Zecco feels comfortable taking on you. For my basic purposes I only need a level 1 clearance, but I'll apply for level 2 to "keep my options open"(haha).
Levels 3 and 4 require margin accounts, which is basically a line of credit or loan used for purchasing stock. It's another form of leverage. Level 4 requires a minimum account balance of $250,000 and allows the riskiest trades such as uncovered equity(naked) options where you do not own the stock you are promising to buy or sell.
I'm mildly annoyed that I have to snail mail the form in but I remember having to do that for my inital account opening as well. I guess I'm spoiled by the interent age and want instant gratification.
