You Ask, We Deliver: Your Guide to Start Trading Options
By Michael Salvatore, Editor, TradeSmith Daily
Reading through the emails in the TradeSmith Daily feedback inbox (that's feedback@TradeSmithDaily.com, keep 'em coming!) is a consistently joyous part of my workday.
Your emails offer me and the whole TradeSmith team a useful perspective on where you're at as an investor… How you're responding to the insights we publish… And any help you might need to get going where you want to be.
The best emails — like this one, from Joseph C. — offer all three:
Michael,
You and your cohorts (especially Mike Burnick) are always harping on options trading and how great it is for your retirement account.
What you guys haven't done is write an article explaining how to set up an account to trade options in. You can't just go into your Charles Schwab or Fidelity account and just start trading options, they won't let you do that.
An article explaining how to set up an options account in your retirement portfolio would be a big help to the vast majority of your TradeSmith subscribers, I think.
—Joseph C.
Joseph, you're absolutely right. Before you trade a single option, your brokerage has to clear you to do it. And it's not always easy to figure out how to get that clearance.
Today's your lucky day: I'm going to show you how.
First though, I must say we "harp on" options trading so consistently because it's an effective — dare I say necessary — trading tool for times of volatility and uncertainty. Especially if we're heading for a Lost Decade scenario, as I've remarked a few times in these pages.
Further, the options strategies we employ at TradeSmith are extremely robust — giving you the ability to generate income, multiply the profit of a directional move in a stock, hedge for a volatile move in either direction, and a whole lot more. (For example, you should check out what we've been doing with Predictive Alpha Options — our proprietary algo that helps us make quick income hits with a 96% success rate.)
Having access to these strategies is incredibly important not just for making money, but simply for being a well-rounded trader.
So today, I'll take your suggestion to heart.
I'll walk you through the steps you need to take to get an account set up for a basic level of options trading at the two brokers you mentioned.
I'll also show you how to go about getting access to higher levels, once you're ready for them… and show you a way to practice trading these strategies with zero risk.
To start, we have to break down what each level of options trading lets you access. Before you apply, it's important to know which strategy you want to use and what you'll need to do so.
As the levels progress, so does the potential, but so do the risks. That's why it's critical to understand exactly how they work and if they're right for you.
Level 1: Covered Calls & Cash-Secured Puts — This level lets you sell covered calls against stocks you own, or trade cash-secured puts to hedge against potential stock price declines. Both of these strategies earn you income in exchange for giving other traders the right to buy your stocks, or sell you their stocks, respectively.
Level 2: Long Options & Option Spreads — This level allows you to buy call and put options. This is the most commonly used option technique, typically as a way to leverage stock price moves.
Level 3: Advanced Spreads — Here, you get access to more complex strategies involving multiple options — iron condors, butterflies, and calendar spreads. These strategies typically involve combining two to four options contracts to capitalize on market movements while limiting risk.
Level 4: Selling Options Uncovered — This level lets you sell options without owning the underlying asset (uncovered). This strategy has unlimited risk potential since you're obligated to buy or sell the underlying asset at the strike price if the option is exercised. That means it requires having a healthy account balance to cover potential share assignments.
Level 5: Advanced Strategies with High Risk — The highest level includes complex strategies like selling uncovered index options, which is typically reserved for the major leaguers — hedge fund managers and the like.
I'm 99% certain that Level 4 is the highest level you'll ever need (or want) to go. And that's only if you're interested in selling options uncovered — which is part of several TradeSmith strategies, like Predictive Alpha Options, Constant Cash Flow, and Infinite Income Loop. However, I would recommend any new option trader work their way through the levels gradually.
Start at level 1, using covered calls and cash-secured puts to generate income. Then graduate to level 2, buying speculative call and put options.
Only once you have a solid grasp on options fundamentals should you graduate to the more complex strategies of level 3. And once you have a healthy account balance that can cover potential share assignments, only then should you graduate to level 4.
One last thing to address since Joseph mentioned it: trading options in retirement accounts. I generally don't recommend doing this.
Some 401(k)s prohibit options trading entirely outside of covered call strategies. Similarly, Roth IRAs do not allow you to borrow money, limiting you to Level 1 and Level 2 options access.
Besides that, retirement accounts simply aren't the place to be speculating with options. The risk of diminishing such an important asset is too great. That's why they're designed to be passive, buy-and-hold affairs that you can set and forget.
Again, it's possible to do some options trading in some retirement accounts. But I don't recommend it. It's best to fund an individual investment account (or sign up for a paper trading account, more on that in a bit) and do your trading there.
Now, let's quickly walk through the process of applying for options trading access on two major brokerages: Charles Schwab and Fidelity. (The process should be similar on other brokerages, and should also have resources on those websites to help you through the process.)
Charles Schwab
Go to the Charles Schwab website (www.schwab.com) and either log in or create a brokerage account.
In the upper-right corner, click the Profile tab and then click Margin & Options from the dropdown menu:
On this page, you'll find a screen showing the different levels of options access, along with the associated risk levels and descriptions. Depending on what level of access you currently have, you will find a link to apply for the level under one of them.
For example, my account currently has Level 3 access and I had the option of applying for Level 4. (Before I took this screenshot, I went through the application process for Level 4 to get familiar with it.)
Once you select a level to apply for, you'll begin the application. The application asks things like your experience level, marital status and dependents, employer, trade frequency and dollar volume, and liquid and total net worth.
All of these answers are given voluntarily and will be considered for your application. I strongly encourage you to only apply for levels you can honestly and confidently say you will be able to manage.
If you're having trouble or the application is rejected, I suggest calling your broker on the phone and telling them exactly what you want to do. Often, speaking to a live representative with knowledge of options products will help you get approval and understand what level of access is most appropriate for your situation.
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Log in to your account with Fidelity (www.fidelity.com) or create one if you haven't already.
Under the Products tab on the top row, click "Options"
On the next page, click the "Start Trading Options" button and then the "Apply for Options" link.
On the next page, select the account you'd like to trade options in and go through the application process — which is very similar to the one for Charles Schwab.
As you can see, the setup is simple after a little digging to find where each brokerage site hosts its application screen.
An important note for all this: It's important not to overextend your abilities and jump into risky strategies that you've never traded before.
Brokerages can and will allow users to trade options strategies that they aren't really capitalized or experienced enough to use. They're a business, after all, and their top priority is creating customers who will use their platform.
I say this because, since all the information in the application is given voluntarily and you're not subject to background checks, it's easy to fool the system into thinking you're more prepared to trade advanced strategies than you actually are. Do not do this under any circumstances.
It is very easy to blow yourself up trading options if you don't know what you're doing. If you're a beginner, you should trade like a beginner until you learn enough to access the next level. I really can't stress this enough.
And a great way to learn what you're doing is to sign up for a paper trading account. Charles Schwab offers this, and it gives you $100,000 in simulated money to trade the markets in real time. Another option is Investopedia's Stock Market Simulator. Before you risk any real money, you can use these paper accounts to test various strategies out and see how they work.
I hope this helps the — to borrow Joseph's term — cohort of TradeSmith Daily readers who want to get started trading options.
The world of options unlocks a huge amount of potential in your portfolio. Just remember: with great power comes great responsibility. It's incredibly important to wade into these waters with caution, and only ever risk what you can afford to lose.
Another light and easy Sunday in the bag! Hope you had a great weekend, and have a successful week of trading ahead.
To your health and wealth,
Michael Salvatore Editor, TradeSmith Daily
P.S. A great way to get acquainted with the world of options and short-term trading is with An-E.
An-E is an A.I.-driven algorithm developed by TradeSmith that can predict stock prices with stunning accuracy.
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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