A stock option is an investment vehicle comprising a legal contract giving the buyer the right (but not obligation) to buy or sell 100 shares of a stock at a specific price up until a particular point in time. The right to buy the 100 shares is a call and the right to sell the 100 shares is a put. The seller of the put or call is motivated to sell it because he charges a premium for putting his 100 shares at risk (the larger the premium, the more time until the option expires). Stock options can provide great leverage if the stock moves significantly up or down, but can expire worthless if the stock does not move in the direction the buyer anticipates.
Some General Requirements for Trading Options
The requirements for trading stock options vary among different brokerages and these requirements are often loosened or tightened up relative to the current economic climate, but at least some experience trading stocks is always required. Most brokerages offer three levels of options trading – just selling options on stocks that someone already owns (i.e., selling covered calls), the ability to buy calls and puts as either investments or hedges, and the ability to sell calls and/or puts on stocks that are not actually owned (i.e., selling “naked” puts/calls).
Level 1 – Selling Covered Calls
The requirements to sell covered calls, that is, to sell calls based on stock that already owned, are typically that someone be a trader with at least six months experience and be approved for a margin/options account. As an example of selling covered calls, if an investor owns 2000 shares of company A, then they could sell up to 20 calls (representing 100 shares each). Generally investors will have to be approved for a margin account if they are not already but there is not usually an additional income or capital requirement to be approved for this relatively low-risk type of options trading.
Level 2 – Buying Puts and Calls as Investments or Hedges
Being approved to buy puts or calls as investments or hedges typically requires both one to two years experience trading stocks and has higher asset or margin requirements (often a minimum of $50,000 in non-real estate assets). The reason for this is that buying puts and calls is speculative and is very high risk (and reward). By the same token, approval for this level of options trading usually involves a credit check. However, some brokerages have lower requirements and/or even offer limited accounts or mini-contracts for the smaller investor.
Level 3 – Selling Naked Puts & Calls
Trading “naked” calls and puts (that is, where investors do not own the underlying security) is extremely risky and can result in making or losing large sums of money very rapidly if a stock moves significantly. Keep in mind that investors will be responsible for buying 100 shares of the underlying security for each option contract sold if/when the buyers of the options choose to exercise them. Only highly experienced traders with at least $100,000 in assets are involved in this kind of high margin requirement stock options trading, which is really more the area of institutional traders and professional stock investors.