Investing Strategies: How to Open an Options Account

Although many traditional brokers still recommend against them and many equity investors are fearful of using them, options are becoming increasingly essential to success in today's unsettled stock market environment. And that means you have to figure out how to open an options account.

"New financial times require new financial tools, and I believe options are a must in today's fragile markets," says Money Morning Chief Investment Strategist Keith Fitz-Gerald. "Learning to use options effectively takes some time - particularly if you are set in your ways - but market conditions have changed so much in such a short time that you have to make the effort if you expect to both maximize profits and guard against major reversals."

Fitz-Gerald regularly employs both stock and index options in his Geiger Index advisory service, which has scored a remarkable 32 profits in 32 tries since its inception.

Because of the dramatic changes in the markets, it's no longer enough to merely search out good stocks, buy them and hold them, hoping for a profit.

"The very definition of stupidity is applying the same tired old techniques to radically changed markets and expecting different results," maintains Fitz-Gerald.

Today, he says, you need to be able to buy quality shares at bargain prices, generate added income while you hold them, hedge against volatile short-term moves and sell your stocks at a premium when the time is right.

Options enable you to do all those things - and more - with many of the techniques described in recent articles in Money Morning's ongoing "Defensive Investing" series.

But, for maximum efficiency and optimum results, you need a designated options account - preferably one you can access online to get real-time quotes and instant entry of both your stock and option orders to the electronic trading systems offering the best prices at any given time.

"Despite the fact that most full-service and discount stockbrokers have options-trading capability, many of these mainstream firms remain far behind the curve when it comes to options," Fitz-Gerald warns. "They have much less effective order execution, excessive margin requirements, prohibitive commission rates and they're often reluctant to grant options-trading approval to anyone who isn't a highly experienced investor."

Understanding Your Goals

So, how do you go about finding the right options specialist and opening your own trading account?

Actually, the first step is to sit down, examine your own situation and determine what you want to do with options - and what percentage of your resources you want to commit to the new account. That's because, while their specific requirements may vary slightly, virtually all of the major online options brokers customize their client accounts based on three primary criteria:

Trading experience: While mainstream brokers may restrict access to options out of ignorance, firms specializing in options fully recognize both their potential and their risks. For that reason, these firms will want to ensure that you have a reasonable degree of investing experience in stocks and other assets - enough so that you understand both the nature of risk and the impact of taking the inevitable loss.

If you have only minimal investment experience and haven't traded options before, nearly all firms will limit the types of trades you can do until you learn more about the markets, various options strategies, the basics of trading "on margin" and the forces that typically drive stock price movements and dictate option premiums. [Editor's Note: This education process will begin with a requirement that you review the firm's "Risk Information" and "Margin Disclosure" statements and acknowledge that you understand them.]

At the same time, their Websites and trading platforms will provide a variety of instructional articles, strategy tutorials and analytical tools - including everything from stock screeners and price charts to volatility ratings and valuation calculators (plus many more). That's on top of the basic quote-retrieval mechanisms for stocks, indexes, some futures and the links to "option chains" - a listing of all currently traded options on a given stock. Some even offer individual coaching and strategy suggestions based on your existing holdings.

As you learn the ropes and your skill levels improve, you'll eventually use most of these tools and services, so make sure the firm that you're considering offers them before signing on the dotted line.

Account size: Nearly all online options brokers will let you open an account with a minimum deposit of $5,000, and some will let you in for as little as $2,000. However, with accounts of that size, the types of trades you can do will be limited - usually restricted to the buying of stock, outright purchases of plain-vanilla "call" or "put" options, the sale of "covered calls" or the positioning of basic bullish or bearish "option spreads."

If you want to do more-advanced or higher-risk strategies - such as straddles, strangles, condors, diagonal spreads, credit spreads, the sale of cash-secured puts, or other similarly complex maneuvers - you'll have to put up at least $10,000, and many firms will require a minimum of $20,000. (If you think you'll one day be engaging in such sophisticated options strategies, that's yet another reason to make sure the trading firm that you sign on with offers strong educational and analytical support.)

Finally, if you intend to engage in really high-risk strategies - such as the sale of "naked" calls on stocks or the writing of index options - you may be looking at an initial outlay of $50,000 or more.

Most firms further enforce trading limits by requiring clients to designate an approved "Trade Level" for their accounts. There are typically four to six levels, with the lowest restricted to the most basic trades, such as stock-and-bond purchases, and the highest allowing virtually all strategies. Try to trade above your designated level, and the program will refuse your order, dictating that you consult with an account representative to get approval to upgrade to the needed next level.

Intended trading strategies: As just noted, the strategies you plan to use will dictate the initial minimum deposit that your options broker will require when you open your account. However, the final decision is up to you, and will be based on your available assets, your knowledge, your personal comfort levels and your ultimate investment objectives.

"Options can be used in so many ways that there's really no set rule regarding how much money or what percentage of your investment funds you should put in an options account," says Money Morning's Fitz-Gerald. "For instance, if all you plan to do is buy options for speculation, you can probably open the minimum-sized account - and certainly shouldn't put in more than 2% of your assets."

(Interestingly, because the risk is strictly limited, the speculative purchase of puts or calls is allowed at nearly all Trade Levels - even though it has the lowest probability of success of any options strategy.)

"On the other hand," Fitz-Gerald notes, "if you plan to use options to build a 'core' income portfolio, selling cash-secured puts to buy stocks and then writing covered calls against them, you may want to put in as much as 50% of your investment funds."

The bottom line: It isn't the options themselves that designate risk or asset allocation; it's how they are used - be it for risk management, hedging, income, growth, or speculation, he says.

Shopping for an Options Broker

Keep all of these things in mind when you start shopping for an options broker. Before you make a final choice, compare the experience requirements, account minimums and designated Trade Levels of several firms - as well as their commission rates, other fees, and research and analytical tools.

Most importantly, compare the clarity and ease of use of their order-entry platforms - especially with regard to the specific strategies you want to use. For example, if you plan to use a lot of spreads, make sure you can place actual "spread orders" - buying and selling the options in combination, rather than having to price and order them individually.

The Frequently Asked Questions (FAQs) section of the firm's Web site will provide answers to most of these questions.

Also be sure that the broker provides a National Best Bid or Offer (NBBO) guarantee, which means the firm automatically reviews your qualified orders to assure they get the best execution available at the time on any of the national options trading systems. (Certain orders, such as stops and those well away from the current bid/ask quotes, are not eligible for NBBO treatment.)

One final point: If you truly are a beginning options trader, there's another feature you'll want to look for in an options broker, even before you open your account - the availability of a "practice" trading platform or "paper trading" account.

"Paper trading, paper trading, paper trading - that's the key to learning how option strategies work and how to use them most effectively," says Fitz-Gerald - though he also cautions against trying to learn too many different trading techniques.

"There are thousands of possible trade combinations using options and various underlying assets, meaning your trading program can be as simple or as complicated as you want to make it," he explains. "Personally, I don't believe you need to know or use them all. In fact, after 20 years of trading, I've settled on three or four I use at any one time."

Concludes Fitz-Gerald: "Until you can learn the art of risk management, you're probably best to stick to buying options," he says, "and even then you're going to fork over some 'tuition' from time to time."

A Partial Shopping List

Following is contact information for three of today's leading online options brokers. These aren't recommendations - just a good starting point if you're ready to begin hunting for a firm to help you expand your trading horizons (just click on the firm name and the link will take you to their Web site):

  • TradeKing, P.O. Box 49040, Charlotte, NC 28277-3432; Telephone: 1-877-495-5464: Offers very favorable option and stock commission rates, but has higher account minimums than other firms for certain types of trades. Named No. 1 in customer service for 2010 by SmartMoney magazine.
  • tradeMONSTER, OM Securities LLC, 10 S. Riverside Plaza, Ste. 2050, Chicago, IL 60606; Telephone: 1-877-598-3190: Named "Best for Options Traders" by Barron's and offers paperTRADE™, a practice account you can open and use to test strategies and sharpen your trading skills before actually putting your money on the line.
  • optionsXpress, P.O. Box 2197, Chicago, IL 60690-2197; Telephone: 1-888-280-8020 - Rated "4 Stars-Plus" by Barron's for the past nine years; offers free "virtual trading" to practice your strategies in real time, and has a mobile trading platform that allows you to access your account from anywhere via your smart phone.

The actual mechanics of opening an account - either practice or real - are usually fairly simple. You can complete all of the "paperwork" online, with the firm's Website walking you through the forms step by step. You can even arrange to fund the account with a direct transfer from your bank so you don't have to send in a check and wait for it to clear.

In most cases, the whole process takes only a week or so before you're able to place your first trade.

[Editor's Note: Money Morning's Keith Fitz-Gerald is still perfect.

With his latest trade, Fitz-Gerald is a perfect 31 for 32 with his Geiger Index advisory service. A veteran trader, skilled analyst and noted market tactician, Fitz-Gerald is able to see through the confusing haze of today's quickly changing markets, which enables him to visualize and understand what the future holds. This ability to see into the future -predicting looming changes while also divining the profit opportunities those changes will create - is one of Fitz-Gerald's greatest strengths.

That's a big reason that Fitz-Gerald - Money Morning's chief investment strategist and the editor of the New China Trader advisory service - has maintained a perfect record with the Geiger Index.

If you would like more information about the Geiger Index, please click here.]

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