Options Trading 101

Options Trading 101

How to Trade Options

Investing, Investing Strategy, Investments

How to Trade Options

Investing, Investing Strategy, Investments
How to Trade Options

When you buy a stock, you decide how many shares you want, and your broker fills the order at the prevailing market price. The process is more complicated for options trading.

When you buy an option, you’re purchasing a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price by a certain date. In order to place the trade, you must make three strategic choices:

  • Decide which direction you think the stock is going to move.
  • Predict how high or low the stock price will move from its current price.
  • Determine the time frame during which the stock is likely to move.
  1. Decide which direction you think the stock is going to move

This determines what type of options contract you’ll buy. If you think the price of a stock will rise, you’ll buy a call option. A call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price within a certain time period.

If you think the price of a stock will decline, you’ll buy a put option. A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.

  1. Predict how high or low the stock price will move from its current price

This is the strike price — the agreed-upon share price at which you would buy or sell the stock if you exercise the option. So, for example, if you believe the share price of a company that is currently trading for $100 is going to rise, you’d buy a call option with a strike price that is less than the $100 you’d pay for shares on the open market right now. If the price does indeed rise above the strike price, you make a profit. Similarly, if you believe the company’s share price is going to dip, you’d buy a put option (giving you the right to sell shares) at a strike price above $100. If the stock price drops, your contract has locked in your right to sell shares for more than they’re fetching on the open market.

You can’t just choose any strike price. Option quotes, technically called option chains, contain a range of available strike prices. The increments between strike prices are standardized across the industry — for example, $1, $2.50, $5, $10 — and are based on the stock price.

The difference between the strike price and the share price is part of what determines an option’s intrinsic value. Time is the other part of the valuation formula, which leads us to the final choice you need to make before buying an options contract.

  1. Determine the time frame during which the stock is likely to move

Every options contract has an expiration date that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.

Expiration dates can range from days to months to years. Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable.

The amount of time (called time value) and the intrinsic value (the difference between the strike price and the open market price of the shares) determines the cost of the contract, known as the option premium.

Anatomy of an options trade: Call option example

Let’s go through one of the more basic options trading scenarios that an investor might use: buying a call option.

You believe that XYZ’s stock price is going to increase in the next month, and you want to lock in the option to buy shares at a lower price. You decide to buy a call option on XYZ with a strike price of $90 that expires in one month. The premium on that option is $3 per share. Here’s how much you’ll pay:

  • The per-share cost, or premium: Remember, each options contract typically contains 100 shares. So you’ll pay $300 (the $3 premium multiplied by 100 shares) for the right to buy 100 shares of XYZ stock at $90 per share before the expiration date.
  • Trading costs: Many brokers price options trades in two parts: a base rate (an option commission) and a per-contract fee. If your brokerage charges a $7.95 base rate and a 75 cent per-contract fee, you’ll pay $8.70 in commissions.

That brings your total tab for the call option on XYZ to $308.70.

» MORE: Options trading terms and definitions

The upside: What you can do if your prediction is correct

Let’s say you’re right, and XYZ’s stock price rises to $100. Your option is, in options-speak, “in the money.” For a call option, that means the share price on the open market is higher than the option’s strike price. (For a put option to be in the money, the share price must be lower than the strike price.)

Now you have another choice to make. You can:

  • Exercise the option and hold the shares. If you think the stock will continue to rise, you can exercise the option (buy the shares) and admire them in your portfolio. Your total cost to acquire the shares comes to $9,308.70. (The math: The $90 strike price multiplied by 100 shares, plus $308.70 for the original contract.) Right off the bat, you’ve gotten the equivalent of a 7.4% return compared with investors who waited to buy shares at $100. Note that partial trades are not allowed; options traders must exercise all 100 shares in a contract.
  • Exercise the option and sell the shares. In this scenario, you’d buy the shares at the $90 strike price for $9,000 and sell them right away at $100 per share, for $10,000. Factoring in the $308.70 trading costs, you would make $691.30 — a 124% return on the initial price of the contract.
  • Sell the options contract to another investor. If you don’t want to spend the money to buy the shares, you can always close out your position and sell the contract to another investor. If this is your plan from the outset, ideally the stock price moves shortly after you purchase the contract. The more time there is before the contract expires, the more the contract is worth. Let’s say the premium on your XYZ call increases to $12 from the $3 you originally paid. If you close out your position, you’ll pocket $891.30 ($1,200 as the recipient of the option premium minus the $308.70 you paid for the original contract).

The downside: What happens if your prediction is wrong

First, the good news: When you buy a put or call option, you are in no way obligated to follow through on the trade. If your assumptions about the time frame and direction of XYZ’s trajectory are incorrect — if the stock never rises above $90 or if it drops below your strike price — your losses are limited to a maximum of the $308.70 you paid for the contract and trading fees.

Had you been speculating and bought shares of XYZ on the open market before the price took a dive, your financial loss would cut a lot deeper.

The bad news, as you probably guessed: When your prediction doesn’t pan out during the time frame specified in your contract, the option expires worthless. Or, in the gentler terms of option traders, it’s out of the money.

However, if you’re a quick enough draw, you may be able to salvage a little of your initial investment. The option’s intrinsic value may have tanked, but you could limit your losses if you sell the contract before it expires, while it still has time value.

» MORE: Options trading strategies

Before you can start trading options …

If anything you’ve read so far gives you pause — the amount of capital required to trade options, the complexity of predicting multiple moving parts, the reliance on timing — that’s a good thing. That’s exactly what brokers require potential options investors to do before awarding a permission slip to start trading options.

Every brokerage firm screens potential options traders to determine their experience and understanding of the inherent risks of options trading and whether they’re financially prepared to handle them.

Account minimums and trading costs are important considerations for investors looking for the best brokerage firm to use. But even more important, especially for investors new to option trading, is finding a broker that offers the tools, research, guidance and support you need.

Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim.

Updated Nov. 17, 2016.

Options Trading 101

5 Tips for Choosing an Options Broker

Brokers, Investing, Investments

5 Tips for Choosing an Options Broker

Brokers, Investing, Investments
5 Tips for Choosing an Options Broker

Options trading can be complicated. But if you choose your options broker with care, you’ll quickly master how to conduct research, place trades and track positions.

Here’s our advice on finding a broker that offers the service and the account features that best serve your options trading needs.

1. Look for a free education

If you’re new to options trading or want to expand your trading strategies, finding a broker that has resources for educating customers is a must. That education can come in many forms, including:

  • Online options trading courses.
  • Live or recorded webinars.
  • One-on-one guidance online or by phone
  • Face-to-face meetings with a larger broker that has branches across the country.

It’s a good idea to spend a while in student-driver mode and soak up as much education and advice as you can. Even better, if a broker offers a simulated version of its options trading platform, test-drive the process with a paper trading account before putting any real money on the line.

2. Put your broker’s customer service to the test

Reliable customer service should be a high priority, particularly for newer options traders. It’s also important for those who are switching brokers or conducting complex trades they may need help with.

Consider what kind of contact you prefer. Live online chat? Email? Phone support? Does the broker have a dedicated trading desk on call? What hours is it staffed? Is technical support available 24/7 or only weekdays? What about representatives who can answer questions about your account?

Even before you apply for an account, reach out and ask some questions to see if the answers and response time are satisfactory.

3. Make sure the trading platform is easy to use

Options trading platforms come in all shapes and sizes. They can be web- or software-based, desktop or online only, have separate platforms for basic and advanced trading, offer full or partial mobile functionality, or some combination of the above.

Visit a broker’s website and look for a guided tour of its platform and tools. Screenshots and video tutorials are nice, but trying out a broker’s simulated trading platform, if it has one, will give you the best sense of whether the broker is a good fit.

Some things to consider:

  • Is the platform design user-friendly or do you have to hunt and peck to find what you need?
  • How easy is it to place a trade?
  • Can the platform do the things you need, like creating alerts based on specific criteria or letting you fill out a trade ticket in advance to submit later?
  • Will you need mobile access to the full suite of services when you’re on the go, or will a pared-down version of the platform suffice?
  • How reliable is the website, and how speedily are orders executed? This is a high priority if your strategy involves quickly entering and exiting positions.
  • Does the broker charge a monthly or annual platform fee? If so, are there ways to get the fee waived, such as keeping a minimum account balance or conducting a certain number of trades during a specific period?

4. Assess the breadth, depth and cost of data and tools

Data and research are an options trader’s lifeblood. Some of the basics to look for:

  • A frequently updated quotes feed.
  • Basic charting to help pick your entry and exit points.
  • The ability to analyze a trade’s potential risks and rewards (maximum upside and maximum downside).
  • Screening tools.

Those venturing into more advanced trading strategies may need deeper analytical and trade modeling tools, such as customizable screeners; the ability to build, test, track and back-test trading strategies; and real-time market data from multiple providers.

Check to see if the fancy stuff costs extra. For example, most brokers provide free delayed quotes, lagging 20 minutes behind market data, but charge a fee for a real-time feed. Similarly, some pro-level tools may be available only to customers who meet monthly or quarterly trading activity or account balance minimums.

5. Don’t weigh the price of commissions too heavily

There’s a reason commission costs are lower on our list. Price isn’t everything, and it’s certainly not as important as the other items we’ve covered. But because commissions provide a convenient side-by-side comparison, they often are the first things people look at when picking an options broker.

A few things to know about how much brokers charge to trade options:

  • The two components of an options trading commission are the base rate — essentially the same as thing as the trading commission that investors pay when they buy a stock — and the per-contract fee. Commissions typically range from $3 to $9.99 per trade; contract fees run from 15 cents to $1.25 or more.
  • Some brokers bundle the trading commission and the per-contract fee into a single flat fee.
  • Some brokers also offer discounted commissions based on trading frequency, volume or average account balance. The definition of “high volume” or “active trader” varies by brokerage.

If you’re new to options trading or use the strategy only sparingly you’ll be well-served by choosing either a broker that offers a single flat rate to trade or one that charges a commission plus per-contract fee. If you’re a more active trader, you should review your trading cadence to see if a tiered pricing plan would save you money.

Of course, the less you pay in fees the more profit you keep. But let’s put things in perspective: Platform fees, data fees, inactivity fees and fill-in-the-blank fees can easily cancel out the savings you might get from going with a broker that charges a few bucks less for commissions.

There’s another potential problem if you base your decision solely on commissions. Discount brokers can charge rock-bottom prices because they provide only bare-bones platforms or tack on extra fees for data and tools. On the other hand, at some of the larger, more established brokers you’ll pay higher commissions, but in exchange you get free access to all the information you need to perform due diligence.

» MORE: NerdWallet’s top brokers for options trading

Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim.

Options Trading 101

Best Options Trading Brokers and Platforms

Brokers, Investing

Best Options Trading Brokers and Platforms

Brokers, Investing

NerdWallet offers financial tools and advice to help people understand their options and make the best possible decisions. The guidance we offer and info we provide are deeply researched, objective and independent.

We spent over 300 hours reviewing the top online brokers before selecting the best for our readers. And to help you find the one that’s best for you, we’ve highlighted their pros, cons and current offers.

Who is the best options broker today? The answer depends on whom you ask and what they value. For some investors, the best broker for trading options is the one with the cheapest commissions. Others prioritize trading tools, platform design, research, customer service or all of the above.

While most of the brokers on our best-of list below would be a good, all-encompassing choice for many investors, we’ve also highlighted the standout candidates in specific areas that matter most to options traders.

Unsure what you’re looking for? See how to choose an options broker for more on what can make or break an options trading experience.

Best overall for options trading

Our top picks cover all the option trader needs — access to high-quality research, analytical tools, a user-friendly platform — at reasonable prices.

TD Ameritrade and OptionsHouse by E-Trade earn high marks for options investors for the same traits that made them NerdWallet’s Best Online Brokers for Stock Trading: no inactivity fees or account minimums, advanced trading platforms, advanced research and tools, plus their high-caliber options trading capabilities.

TD Ameritrade handily serves option traders no matter where they are on the learning curve. The broker’s thinkorswim platform offers a robust options trading experience for active investors seeking professional-grade tools to identify trading opportunities, analyze potential risks and rewards, test trade strategies and quickly place even the most complex options trades.

The broker’s web-based Trade Architect platform is for investors just getting into options or those who don’t require a high-octane platform. Its stripped-down, easy-to-use interface won’t overwhelm newbies. And although Trade Architect isn’t as fully stocked with tools and data as thinkorswim, it’s no slouch, either. Intermediate investors will find advanced features like a market/options heat map, screening and tradefinder tools, and streaming news. Get details in our TD Ameritrade review.

OptionsHouse’s roots as a broker for self-directed active options traders is reflected in its highly regarded web-based trading platform, which was enhanced even more when the company merged with TradeMonster several years ago. In OptionsHouse you’ll find a customizable platform that offers fast and easy trade execution and significant automation capabilities. Its lineup of tools enable investors to explore “what-if” scenarios, scan live market data for strategies based on specific criteria and set up trigger alerts to execute pre-populated orders from the web or OptionsHouse mobile app. See our OptionsHouse review for more details.

Both brokers allow prospective clients to test-drive the goods without putting any real money on the line. TD Ameritrade offers a paperMoney virtual trading account to test out the thinkorswim platform. At OptionsHouse, once customers open a real account (which has no minimum funding requirement), they can set up a paperTRADE account that offers investors hands-on practice trading virtual currency in a live market environment.

Best brokers for low-cost options trading

These brokers offer competitively priced options trading commissions and have eliminated or dramatically capped minimum trading fees.

In early 2017 most of the mainstream online brokers slashed commissions to levels once reserved for their deep-discount peers. That doesn’t mean that they’re the best deal in town for every investor.

For active options traders, eOption earns five stars from NerdWallet for its low options trade commissions. The company charges a fixed $3 base plus 15 cents per contract. Another plus: eOption is known for having some of the lowest margin rates available. Although eOption charges a $50 annual inactivity fee on accounts that have placed fewer than two trades in the past 12 months or have less than $10,000 in credit or debit balances, the minimum trade workaround isn’t onerous, even for infrequent traders.

OptionsXpress, which is owned by Charles Schwab, changed from a tiered commission schedule to a flat-fee one in early 2017. Now both companies charge the same $4.95 base rate plus 65 cents per contract, putting them within spitting distance of their deep-discount peers.

Commissions aren’t the only costs associated with trading options. Platform, data and other fees can quickly cancel out what you save on commissions. Another important note: Neither broker is known for having standout trading platform features or research tools. (See our full reviews of OptionsXpress and eOption for details on what they offer.) But for those simply looking for a cheap way to execute trades, OptionsXpress and eOption get the job done.

For cost-conscious, active options traders looking for low costs and a platform with a lot more meat on its bones, Interactive Brokers may be more your style. Interactive Brokers charges just 70 cents per contract with no base fee ($1 minimum order), plus discounts for larger volumes, if you can manage the $10,000 account minimum. Its Trader Workstation platform (with an options strategy lab) is considered one of the best and most sophisticated around. But watch other fees to ensure that the lower commissions pay off.

Best options trading platforms

These brokers offer some of the most powerful trading platforms available for a reasonable price.

Judging a broker’s trading platform by the number of features it offers is like buying a car based solely on what you read in the dealer brochure. While all investors have their must-have features, what’s more important is how the platform feels when it’s in their hands.

The trading platforms at TradeStation and Ally Invest offer a wide variety of analytical tools, provide stable and speedy trade execution, and allow investors to customize the tools and design to best suit their needs.

TradeStation is best left to more experienced, tech-savvy investors who want to experience options trading using the same tools as pro traders. The broker provides all the tools needed to design, test-drive, monitor, automate and speedily execute the most complex trades via direct-market access (no pesky middleman to slow down the process). Its OptionsStation Pro platform is fully integrated into TradeStation’s regular trading platform. An added bonus is the broker’s active investor forums, where traders discuss ideas, ask questions and get help.

Access to all of TradeStation’s bells and whistles used to come at a steep $99.95 monthly platform fee for those who didn’t meet account balance or trading activity minimums. But in March 2017 TradeStation eliminated the service fee, lowered its trade commissions for stocks and options and tossed in free real-time market data and free access to its market-monitoring and portfolio-level back-testing tools. Educational tools and platform tutorials are plentiful, which is a plus: Because of the sophisticated nature of the platform, it may require some time to become familiar with all that it offers. See more in our TradeStation review.

Unlike TradeStation, Ally Invest (formerly TradeKing) is technically a deep discount broker as reflected in its commissions (options traders pay a $4.95 base plus 65 cents per contract with only one base charge per spread), $0 account minimum and free access to research and data. Frequent traders (those who place 30 or more trades per quarter or who carry a balance of $100,000 or more) pay a discounted $3.95 base and 50 cents per contract.

But don’t be fooled by the lower prices: Customers get a lot of platform power for free.

Ally is suitable for newer options investors. The browser-based platform resembles the offerings of its pricier competitors and comes with free options trading tools for screening and advanced charting. Navigation is easy and streamlined. Customers can create a custom dashboard with movable modules with the data and features they want to use. The setup extends to what users see across all devices, including mobile and tablet.

Best research and options trading education

Both offer extensive research and data for free, as well as live classes and webinars for beginning and advanced options traders.

If you’re new to options trading or want to expand your trading strategies, a broker that devotes its resources to research and customer education is a must. Because Schwab and Fidelity each have offices across the country in addition to their online options education libraries, they’re able to offer in-person guidance and free seminars on how to trade options, as well as one-on-one guidance on using the tools each platform offers.

Fidelity’s constantly refreshed library draws from more than 20 providers, including Recognia, Ned Davis, S&P Capital IQ and McLean Capital Management. The full suite is available to customers when they sign into the broker’s web-based platform. And you don’t have to stop digging when you’re away from your computer: Fidelity has a strong mobile app that lets customers access the company’s full suite of research through a mobile browser.

Charles Schwab’s options trading capabilities and lineup of trading data and research got a big boost when the company purchased OptionsXpress. But Schwab itself has a fully realized suite of offerings for options traders, including trade assessment tools, customizable screeners, access to Schwab analyst options-market commentary, live online webinars and pre-recorded seminars. Schwab offers two excellent platforms: the web-based platform Trade Source (ideal for beginners) via Schwab.com and the more advanced StreetSmart Edge with elevated charting functionality for active traders.

Best brokers for beginner options investors

These brokers provide ideal conditions (educational resources, user-friendly platforms, customer support and low minimums) for investors just learning the options trading ropes.

OptionsHouse and TD Ameritrade — our top overall brokers — ranked highest in this category, too. But since there are many types of beginners with many different preferences, instead of highlighting the category champions we’ve focused on brokers that are excellent candidates in three key areas:

Low minimum opening balance requirements

OptionsHouse, Ally Invest, TD Ameritrade, Merrill Edge: If you’re not yet ready to devote a lot of your capital to options trading, you don’t want to tie up much in an account to meet the minimum. Many of the brokers on our list require no money to open an account.  However, industry regulations require that traders maintain a $2,000 minimum to trade options.

Strong customer support

Scottrade and TD Ameritrade: On-call help is particularly handy when starting out. One way to test a broker’s level of service is to contact the company with any questions you have about its option trading offerings before you even open an account. Scottrade is known for its standout customer service and huge physical presence of 500 branches. So is TD Ameritrade, with around-the-clock phone and email support and 100 branches where clients can attend seminars and meet with investment associates. At the end of 2017, TD’s acquisition of Scottrade will be complete, increasing each broker’s ability to serve clients.

User-friendly platforms

Ally, Charles Schwab and TD Ameritrade: There’s nothing better than test-driving a broker’s platform before you commit. Check to see if the broker you’re considering offers paper trading (virtual trading on a platform that mimics the real deal) or contact customer service to see if they will set you up with a demo account. As for brokers discussed in this review, Ally Invest’s browser-based platform is intuitive and easy to customize. And both Charles Schwab and TD Ameritrade have multiple platforms customers can use to start learning the ropes, then graduate to more sophisticated tools and trades if desired.

 


Best options trading brokers: summary

Broker
Best
for
Highlights
Commiss-
ions
Promotion
Account minimum
Start investing
TD Ameritrade
Overall + beginners
Top research; two powerful trade platforms
$6.95 + $0.75/contract
$100-$600 cash bonus, depending on account size
$0
OptionsHouse
OptionsHouse
Overall + beginners
Low commissions; superior trading tools
$4.95/trade + $0.50/contract
$1,000 in free trade commissions with deposit of $5,000+
$0
EOption
Low cost
Good for active traders seeking low costs
$3/trade + $0.15/contract
None
$500
OptionsXpress
OptionsXpress
Low cost
Access to Schwab services
$4.95/trade + $0.65/contract
50 commission-free trades with deposit of $5,000+
$0
TradeStation
TradeStation
Trading platform
Advanced research and tools, speedy execution
$5/trade + $0.50 /contract
20% off commissions
$5,000
Ally Invest
Ally
Trading platform
User-friendly platform and free tools
$4.95 /trade + $0.65 /contract
None at this time
$0
Charles Schwab
Charles Schwab
Research
Extensive lineup of investor education options
$4.95/trade + $0.65/contract
$100 to $500 cash bonus for deposits of $10,000+
$1,000
Fidelity
Fidelity Investments
Research
Deep research library and customer education opportunities
$4.95/trade + $0.65/contract
300 commission-free trades with deposit of $50,000+
$2,500
Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim.

Updated March 21, 2017.