A revolution has occurred over the last 10 years or so in the brokerage industry. Commissions have fallen dramatically and online trading has made buying and selling securities, especially stock options, faster and easier.
When I was about 10 or 12 years old, I asked a full service broker for a commission schedule. I had already been hit with $100 to $200 commission charges on “market” orders, and I thought it made sense to tailor the number of shares I was buying to the optimal commission threshold. But you would have thought I asked for the guy’s Social Security Number and credit card number based on the look he gave me. Then his response was something like, “There’s just too many factors affecting the commission… you should just place your order and I’ll try to get you a good rate.”…. What a crock!! Even at age 10, I knew enough to never buy through that guy again. By the time I graduated from college, I sold everything I had brought through that brokerage firm and never went back.
Today, the stock broker’s world has turned upside down. You can trade securities yourself online for as little as $12, $7, $5, and even for free (up to a certain number of trades per month or per year) based on the brokerage firm you pick. Of course, when you trade online, there’s no one second guessing you (yea!!), and you can make mistakes (be careful). In this article, I’m going to discuss the nuances of trading stock options online.
When you buy and sell stocks online, everything’s pretty simple; just specify whether you want to buy or sell, the ticker symbol for the stock, whether it is a “market” order (i.e., buy at the current “ask” rice or sell at the current “bid” price), and whether the order is good today only or until you cancel it.
Stock option orders, however, require a little more information. Basically, you have to specify: the stock, call or put, strike price, expiration month, and “market” order or “limit” order and premium you want. If you are using a combination of options, it gets a little more complex. I’ll discuss each of these items below along with some suggested money saving guidelines.
Let’s start with opening an online trading account…
This part is pretty simple. You first select an online brokerage firm. You can look for articles that assess the different brokerage firms based on commissions, quality of customer service, speed of filling orders, quality of user interface, etc. Basically, I recommend you first look for “deep discount” brokers with very low commissions (or even free trades per month or year). You can also go with “discount” brokers if you think you might want more help in placing orders, but you will pay more for every transaction and I doubt you will need “help” very long.
Three deep discount brokers I have worked with include Wells Fargo, ETrade, and Zecco Trading. Wells Fargo gives up to 100 free stock trades per year, but their online software is incapable of making several important, though slightly complex option trades. For example, you can’t sell naked puts or place spread orders online. However, customer service is pretty good.
ETrade has good customer service and loads of powerful research features, but they cost a little more and have no free trades (to my knowledge). If you are going to get into serious stock options trading, Zecco Trading is the best I have found in terms of “ease of placing complex orders” and getting orders filled. Basic option purchases, selling naked, credit spreads and debit spreads, collars, straddles, and strangles are all easy at Zecco. They even have butterfly and iron condors available although I haven’t used them so far. Plus, you get some number of free trades each month and option trades are only $4.50 plus a few pennies per contract. Zecco customer service is okay.
Once you have selected an online broker, complete an application to open an account. If you are going to trade options, you will also have to complete a Margin Account application and an Options Account application. If you want unlimited options trading privileges, you will need to mark your investment goals to include “speculation”, and you will need to claim you have options trading experience. Some options privileges (e.g., selling naked puts) will require large balances too.
Once your account is opened and funded, you can begin trading. The following discussion outlines how to place different types of stock option orders online.
1. Buying puts and calls.
This is the simplest type of option trade. You buy a call if you think the stock is going up and you buy a put if you think the stock price is going down. Each contract is worth 100 shares of stock; please note, this is not true for commodities option contracts (e.g., silver, corn, rice, orange juice, etc.). To buy an option, you need to specify the following:
Quantity: How many contracts are you buying?
Month: In which month and year does the contract expire?
Stock: What is the underlying stock?
Strike price: This is the price reflecting the cost of the underlying stock.
Call or Put: Which type of contract are you buying?
Order Type: Market order or Limit order (specify the premium you’re willing to pay)
Premium: What price are you willing to pay?
Term of the Offer: Day order (good for the rest of the trading day) or Good Til Cancelled (GTC: Means the order will stand day after day until filled or until you cancel it)
Example: BUY 2 June2011 XYZ 50 Calls for $2.90 (giving a price implies a Limit order) Good Til Cancelled
2. Selling Puts and Calls.
A basic sell order works exactly like the basic purchase except you state you are selling instead of buying.
Example: SELL 2 June2011 XYZ 50 Calls for $2.60 (giving a price implies a Limit order) Good Til Cancelled
3. Buying or Selling Spreads.
A spread is a simultaneous buy and sell of different options as a single order where you specify your premium as a net difference between the premiums of the individual options.
For example, let’s say you want to buy a 25 call and sell a 30 call for XYZ stock assuming the premiums are as stated below:
XYZ 25 Call: $2.50 bid x $3.00 ask
XYZ 30 Call: $1.00 bid x $1.30 ask
As a market order, you would pay $3.00 for the 25 call and receive $1.00 for the 30 call. Your net cost would be $3 – $1 = $2 per contract (i.e., $200 net cost per contract since each contract represents 100 shares). But we already know you can beat the market price, so let’s try to buy the 25 call for $2.80 and sell the 30 call for $1.10. The difference is $2.80 – $1.10 = $1.70. So your order would look like this:
SPREAD order to BUY 3 Jun2011 XYZ 25 Calls and SELL 3 Jun2011 XYZ 30 Calls for a net difference of $1.70 Good Til Cancelled.
If your order is filled, you will pay a maximum of $1.70 per contract (i.e., $170 considering each contract is 100 shares of stock). Notice this is $130 less than the market order would have cost you. Since the position took money out of your pocket, this is a “debit” spread, and since both calls expire in the same month, it is a “vertical” spread. If the months were different, it would be a “calendar” spread.
So you have entered a vertical debit spread for a net cost of $170 per contract (plus commissions). For a spread order, you don’t care what the individual option prices were. For example, your 25 call may have cost $3.00 (the Ask price) while you sold the 30 call for $1.30 (also the Ask price), but you don’t care because your “Net Cost” was only $1.70.
If sold the 25 Call and bought the 30 Call “as insurance” instead… perhaps you think the stock will not rise in price and may even fall… then you will receive more money for the 25 call than the 30 call cost you. This position puts cash in your pocket; thus, it is called a “credit” spread.
For example, if your order looked like this:
SPREAD order to SELL 3 Jun2011 XYZ 25 Calls and BUY 3 Jun2011 XYZ 30 Calls for a net difference of $1.70 Good Til Cancelled.
Then you receive $170 into your account for each contract pair in your position. Since both options expire in June, this is a “vertical credit” spread. If they had different expiration dates, it would be a “calendar credit” spread.
Just like with the debit spread, you don’t care what the individual premiums were; you only care about the premium difference.
3. All other pure option orders.
Pretty much all other combinations of options work the same way as explained above; they are either outright options buys or sells or spreads. The more complex stuff like butterflies and iron condors are just combinations of spreads as far as placing the order goes. Straddle and strangle orders work the same way as spread orders, they are just different combinations of options.
These are the basics of how to trade stock options online and place different types of stock option orders. For more information regarding which strategies to use and which options to select, refer to my option strategies articles.
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