How to start trading options

Depending on the investment outlook, an individual investor, fund manager, or financial institution might trade options to invest, help generate income, and/or manage risk, among other reasons.

Anyone can trade options in their brokerage account, if approved. At Fidelity, this requires completing an options application that asks questions about your financial situation and investing experience, and reading and signing an options agreement. It is also possible to trade some options strategies in other types of accounts, such as an IRA.

Options trading strategies involve varying degrees of risk and complexity. Not all strategies are suitable for all investors. There are 3 tiers of options trading at Fidelity, and approval requirements are more rigorous at subsequent tiers, given the additional risks associated with more complex strategies. Your financial situation, trading experience, and investment objectives are taken into consideration for approval.

Options trading on IRAs includes:

• Buy-writes
• Selling covered calls
• Rolling covered calls
• Buying calls/puts
• Selling cash covered puts
• Long straddles/strangles
• Spreads (up to 4 legs)

Options Tier 1 includes:

• Buy-writes
• Selling covered calls
• Rolling covered calls
• Buying calls/puts
• Selling cash covered puts
• Long straddles/strangles

Options Tier 2 includes:

• Buy-writes
• Selling covered calls
• Rolling covered calls
• Buying calls/puts
• Selling cash covered puts
• Long straddles/strangles
• Spreads (up to 4 legs)
• Selling covered puts-short stock secured

Options Tier 3 includes:

• Buy-writes
• Selling covered calls
• Rolling covered calls
• Buying calls/puts
• Selling cash covered puts
• Long straddles/strangles
• Spreads (up to 4 legs)
• Selling covered puts-short stock secured
• For stocks, ETFs, and Indexes
  • Selling uncovered calls/puts
  • Short straddles

One of the benefits of buying options is the leverage that options can provide while potentially limiting the amount of capital at risk.

There are unique risks associated with buying options, compared with buying stock. The primary risk is that the options expire worthless and you lose your investment. Another consideration is that typically when buying options, the underlying security will need more directional movement before the strategy will net a potential gain compared to directly using the underlying security (aka lower probability).

Key decisions for trading options are based on several factors, including the following:

• The outlook of the underlying security price direction (bullish, bearish, and even neutral)
• The time frame (include binary events)
• How long you need for the trade to work
• If you are buying or selling
• Implied volatility

Outlooks on these elements will help a trader select the action (buying or selling), amount of contracts, call or put, expiration, strike, order type (market or limit), and the premium the contract is worth. Another key decision is the exit plan which the trader should consider from the loss side and the profit side.

The underlying security (what is your forecast: bullish or bearish), the trade amount, the number of options, the strike price, the premium, the expiration date, the type of order, and your exit plan.

Call options are considered in the money when the stock price is trading above the strike price, and are considered out of the money when the stock price is trading below the strike price. For puts, options are considered in the money if the stock price is trading below the strike price, and are considered out of the money if the stock price is trading above the strike price. Both call and put options are considered at the money when the stock and the strike price are equal or near. Stock options that are $0.01 or more in the money at the time of expiration will be automatically exercised.

An option's premium is made up of 2 components: time value and intrinsic value. Time value can be considered a measure of uncertainty—the potential that the option could hold more intrinsic value in the future.

An option's premium is made up of 2 components: time value and intrinsic value. Intrinsic value is the measure of the true value of the right the option represents. It is the difference between the stock price and the strike price.

To exercise an option means to take action on the right to buy (call) or sell (put) the underlying position in an option contract at the predetermined strike price, at or before expiration.

An option's contract price is determined by several factors including the price of the underlying, strike price of the contract, the underlying asset's volatility, time until expiration, any dividends that are payable during the life of the contract, and the risk-free interest rate.

There are several factors to consider when picking a strike price: Moneyness, time, and liquidity. For moneyness, in-the-money options are relatively more expensive than out-of-the-money options. For time, holding all else unchanged, a contract with a longer life implies a greater probability that the option will be in the money before expiration. However, it will also cost more than a similar option with less time until expiration. For liquidity, consider almost always looking for options that meet your objectives with small bid-ask spreads if you want to consider reducing your trading costs.