A revolution has occurred over the past 10 years or so within the brokerage industry. Commissions have fallen dramatically and online trading has made buying and selling securities, especially stock options, quicker 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 0 to 0 commission charges on “market” orders, and I believed it made sense to tailor the number of shares I was buying to the optimum commission threshold. However you’d have thought I asked for the guy’s Social Security Number and bank card number based on the look he gave me. Then his response was something like, “There’s just too many factors affecting the fee … 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 purchase 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 your self on-line for as little as , , , and even totally free (up to a certain number of trades monthly or per year) based on the brokerage firm you pick. Of course, whenever you trade online, there’s nobody second guessing you (yea!!), and you may make mistakes (be careful). In this article, I’m going to discuss the nuances of buying and selling stock options online.

When you buy and sell stocks on-line, everything’s fairly easy; just specify whether you wish to buy or sell, the ticker symbol for the stock, whether or not it’s a “market” order (i.e., buy at the current “ask” price or sell at the current “bid” price), and whether or not the order is good today only or until you cancel it.

Stock option orders, however, require a little more information. Basically, you must 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 will get a little more complex. I’ll talk about each of these items below.

Let’s begin with opening an online trading account …

This part is pretty simple. You first choose an online brokerage firm. You can search for articles that assess the totally different brokerage firms based on commissions, quality of customer support, pace 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 may want more help in placing orders, but you will pay more for every transaction and I doubt you’ll need “help” very long.

Three deep discount brokers I’ve worked with include Wells Fargo, ETrade, and Zecco Trading. Wells Fargo offers up to one hundred free stock trades per year, but their on-line software is incapable of making several important, although slightly complicated option trades. For example, you can’t sell naked puts or place spread orders online. Nevertheless, customer support is pretty good. ETrade has good customer support and loads of powerful research features, however 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 when it comes to “ease of placing complicated orders” and getting orders filled. Basic option purchases, selling naked, credit spreads and debit spreads, collars, straddles, and strangles are all simple 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 every month and option trades are only .50 plus a few pennies per contract. Zecco customer support is okay.

Once you have chosen 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 have to to mark your investment goals to include “speculation”, and you will have to claim you have options trading experience. Some options privileges (e.g., selling naked puts) would require large balances too.

Once your account is opened and funded, you may start trading. The following dialogue outlines how to place various kinds 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. Every 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 purchase an option, you need to specify the following:

Quantity: What number of 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 price 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 prepared to pay)
Premium: What price are you willing to pay?
Term of the Offer: Day order (good for the remainder of the trading day) or Good Til Cancelled (GTC: Means the order will stand day after day until filled or till you cancel it)

Example: BUY 2 June2011 XYZ 50 Calls for .90 (giving a price implies a Limit order) Good Til Cancelled

2. Selling Puts and Calls. A basic sell order works precisely like the basic purchase except you state you are selling instead of buying.

Example: SELL 2 June2011 XYZ 50 Calls for .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 various 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 purchase a 25 call and sell a 30 call for XYZ stock assuming the premiums are as stated below:

XYZ 25 Call: .50 bid x .00 ask
XYZ 30 Call: .00 bid x .30 ask

As a market order, you’d pay .00 for the 25 call and receive .00 for the 30 call. Your net cost would be – = per contract (i.e., 0 net cost per contract since each contract represents 100 shares). However we already know you can beat the market price, so let’s try to buy the 25 call for .80 and sell the 30 call for .10. The difference is .80 – .10 = .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 .70 Good Til Cancelled.

If your order is filled, you’ll pay a maximum of .70 per contract (i.e., 0 considering each contract is 100 shares of stock). Notice this is 0 less than the market order would have cost you. Since the position took cash out of your pocket, this is a “debit” spread, and since both calls expire in the same month, it’s 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 0 per contract (plus commissions). For a spread order, you don’t care what the individual option costs were. For example, your 25 call might have cost .00 (the Ask price) while you sold the 30 call for .30 (also the Ask price), but you don’t care because your “Net Cost” was only .70.

If you sold the 25 Call and acquired the 30 Call “as insurance” instead … perhaps you think the stock won’t rise in price and may even fall … then you will receive more cash for the 25 call than the 30 call cost you. This position places money in your pocket; thus, it’s 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 .70 Good Til Cancelled.

Then you receive 0 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 totally different expiration dates, it would be a “calendar credit” spread.

Identical to 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. Just about 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 simply combinations of spreads so far as placing the order goes. Straddle and strangle orders work the same way as spread orders, they’re just different mixtures of options.

These are the basics of how to trade stock options online and place different types of stock option orders. For more information relating to which strategies to use and which options to select, refer to my option strategies articles.

Related Selling Put Options Articles

If you’re like a lot of investors you have tried once or twice to have options explained to you properly, but for one reason or another had a difficult time really understanding even stock options basics. You should know that virtually everyone had to make an effort to really “get” options in the beginning, but I can assure you that understanding them is not beyond you. I have had to explain them professionally, and I found that by explaining both sides of an options trade people often have an easier time understanding the concepts.

By “both sides of the trade” I do not mean puts and calls. I mean the transaction in which the option buyer and seller of a call option OR a put option are involved. I’ll illustrate the mechanics with calls, as a simultaneous put options explanation might be confusing.

Let’s say you own 100 shares of XYZ stock, and it’s currently trading at $100 per share. After a recent run-up you fear that the price may drop back but you still feel good about the fortunes of the company and stock for the long-term, so you don’t want to sell. You could sell an option contract to purchase your 100 shares but let’s say $110 per share. The stock option contract has an expiration date, in this case let’s say it’s two months away from right now.

Let’s say that two months from now the stock is trading at $120 per share. Having sold the “XYZ 110 call option”, you are obligated to deliver your 100 shares to the buyer of the option for $110 per share. The option is “in the money” so the option buyer is very happy, as after buying the 100 shares at 110 for $11,000 he could immediately sell the shares for $12,000. The only money he put up to enable him do this was the premium amount he paid you when he bought the stock option from you. Remember, he did not initially buy the stock from you. He bought the right buy the stock at a certain price by a certain date from you.

So what’s the difference? Well, what if by the expiration date the stock was trading under 110? At that point the right to purchase shares at 110 would be worthless because no one would ever buy shares at a higher price than where there are currently trading in the market. The right that he bought, i.e. the option, would expire worthless for this reason and he would lose all of the premium amount they pay you for the option. As you keep this premium, your cost basis for owning the stock is lowered slightly, which means that selling the option functioned as insurance before you. Remember that you have decided to keep the stock when it was trading at 100, so if it goes to 90 or 80 by expiration you are not happy but you are slightly better off than if you had not sold the option.

On the other hand if the stock is at 120 two months from now, you still benefit from the run up between 100 and $110 per share. You also still keep the premium amount that the option buyer paid you. You simply do not benefit from the move between 110 $120 per share, the buyer does.

You can see that by selling the option you received some small amount of insurance in case the price of the stock moved against you. The option buyer risked a relatively small amount of money in the hope that a relatively large move in the stock price would result in him making multiples of his original investment.

In this way it should be clear to you that the motivations of the option buyer and seller are diametrically opposed. The option buyer purchases a leveraged position with a relatively small amount of money in the hope of making a large percentage gain. The option seller buys a little bit of protection at little or no risk to his stock position, outside of the opportunity cost of getting his shares called away from him in the event that the stock price really rockets upward.

I hope you understood this short explanation. Even if you did however, you should paper trade options before you actually use real money to trade them, either on the buy or sell side. Options are unpredictable and extremely volatile, and there’s a big difference between understanding the concepts and applying them successfully in the markets.

Option is a legal agreement between buyer and seller to buy or sell security at an agreed price in a certain period of time. It is quite similar to insurance that you pay an amount of money in order that your property is protected by the insurance company. The difference between these two is option can be traded whereas, insurance policy cannot be traded. There are two types of option contracts; call options and put options. We buy call option when we expect the security price will go up and buy put option when we expect the security price will go down. We also can sell call option if we expect the security price will go down and vice versa if we sell put option. Usually, option is counted by contract, one contract equivalent to 100 unit options. 1 unit option protects 1 unit share. So, one contract protects 100 unit shares.

Before learning how to trade option, terminologies that you need to know are as follow:
a)    Strike price: Strike price is the price that is agreed by both buyer and seller of the option to deal with. That means if the strike price of the call option is 35, seller of this option obligates to sell security at this price to the buyer of this option even though the market price of the security is higher than 35 if the buyer exercises the option. Buyer of this option can buy a security with a price that is lower than the market price. If the current market price is $39, the buyer will earn $4. If the security price is lower than the strike price, buyer will hold the option and leave the option to expire worthless. For put option strike price, buyer of the option has the right to sell the security at the strike price to the seller of the option. That means if the put option strike price is 30, seller of this option obligates to buy the security at this price from the buyer if he or she exercises the option even though the market price is lower than this price. If the market is $25, the option buyer will earn $5. It looks like a lot of transactions have been involved; but actually, seller of the option will not buy a security and sell it to the buyer. The broker firm will do all the transaction but the extra money that has used to buy the security has to be paid by the seller. This means, if the seller loss $4, the buyer will earn $4.

b)    Out of the money, in the money and near/at the money option: Option price comprises of time value and intrinsic price.

Time Value + Intrinsic Value = Option Price

Time value is the amount of money that the option worth due to the time the option has until its expiration date. Longer the time the option has until its expiration date, higher the time value of this option. Time value of an option will become zero if the option has expired. Intrinsic value for in the money call option is the difference between current market security price and option strike price. Conversely, in the money put option’s intrinsic value is the difference between option strike price and current market security price. If the current security price is lower than the call option strike price, this option is an out of the money option. It only has time value. Call option with strike price that is lower than the current market security price is an in the money option. This option has time value and also intrinsic value. Near or at the money option is the option, which strike price is close to the current market security price.

c)    Delta value: Delta value shows the amount of the option price will change when the security price changes by $1.00. It is a positive value for call option and negative value for put option. It ranges from 0.1 to 1.0. Delta value for in the money option is more than 0.5 and out of the money option is less than 0.5. Delta value for deep in the money option usually is more than 0.9. If the option delta value is 0.6, meaning that when the security price goes up $1, option price will go up $0.60. If the security price goes up $0.10, the option price will goes up $0.06. Usually, $0.06 will round up to $0.10.

d)    Theta value: Theta value is a negative value, which shows the decay of the option time value. Option, which has longer time to expiry, has lower absolute theta value than option, which has shorter time to expiry. High absolute theta value means the option time value decays more than the low absolute theta value option. A theta value of -0.0188 means that the option will lose $0.0188 in its premium after passage of seven days. Options with a low absolute theta value are more preferable for purchase than those with high absolute theta value.

e)    Gamma value: Gamma value shows the change of the delta value of an option when the security price increases or decreases. For an example, gamma value of 0.03 indicates that the delta value of this option will increase 0.03 when the security price goes up $1. Option, which has longer time to expiry, has lower value of gamma than option, which has shorter time to expiry. The gamma value also changes significantly when the security price moves near the option strike price.

f)    Vega value: Vega value shows the change of the value of option for one percent increase in implied volatility. This value is always positive. Near the money option has higher vega value compared to in the money and out of the money option. Option, which has longer time to expiry, has higher vega value than the option, which has shorter time to expiry. Since vega value measures the sensitivity of the option to the change of the security volatility, higher vega value options are more preferable for purchase than those with low vega value.

g)    Implied volatility: Implied volatility is a theoretical value, which is used to represent the volatility of a security price. It is calculated by substituting actual option price, security price, option strike price and the option expiration date into the Black-Scholes equation. Options with a high volatility stocks are cost more than those with low volatility. This is because high volatility stock option has a greater chance to become in the money option before its expiration date. Most purchasers prefer high volatility stock options than the low volatility stock options.

Actually, there are twenty-one option trading strategies, which most of the option investors and traders use in their daily trading. However, I’m only introducing ten strategies as follow:

a)    Naked call or put
b)    Call or put spread
c)    Straddle
d)    Strangle
e)    Covered call
f)    Collar
g)    Condor
h)    Combo
i)    Butterfly spread
j)    Calender spread

Naked call and put meaning buy call and put option only at the strike price, which is close to the market security price. When the security price goes up, the profit is the subtracting of the security price to the strike price if you buy call and the reverse if you buy put.

Call and put spread is established by buying in the money or near the money option and selling out of the money option. When the security price goes up, in the money call option that you buy will generate profit and the out of the money option that you sell will loss money. However, due to the difference of the delta value, when the security price goes up, in the money call option price goes up with a higher rate compared to the out of the money  call option. When you deduce the profit from the loss, you still earn money. The purpose of selling the out of the money option is to protect the depreciation of time value of in the money call option, if the security price goes down. However, if the security price continuously goes down, this will cause an unlimited loss. Therefore, stop loss has to be set at certain level. This strategy also has a maximum profit that is when security price has crossed over in the money option strike price.

Straddle can earn money no matter the security price goes up or down. This strategy is established by buying near the money call and put option at the same strike price. The disadvantage of this strategy is the high breakeven level. The sum of the call and put option ask price is the breakeven level of this strategy. You only generate profit when the security price has gone up or down more than the breakeven level. If the security price fluctuates within the upside and downside breakeven level, you still loss money. The money that you loss is due to the depreciation of the option time value. This strategy is usually applied for the security, which has high volatility or before the release of the earning report. The maximum loss of this strategy is the total amount of call and put option price. This strategy can generate unlimited profit at either side of the market direction

Strangle is quite similar to straddle. The difference is strangle is established by buying out of the money call and put option. Because both the options are out of the money option, therefore, both options have different strike. The maximum loss of this strategy is less than the straddle strategy, but difference between the upside and downside breakeven level is slightly higher than the straddle strategy. For this strategy, the upside breakeven is calculated by adding the total call and put option prices to the call option strike price. While, the downside breakeven level is calculated by subtracting the put option strike price with the total call and put option prices. The difference between the strike prices usually is about 2.50 or 5 depending to which stock that you select to buy with this strategy.  If the security price fluctuates within the upside and downside breakeven level, you still loss the money due to the loss of the option time value. Application of this strategy is the same as the straddle strategy.

Covered call is established by buying a security at the current market ask price and selling out of the money call option. Selling out of the money option has limited the profit that generated from this strategy. If security price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. When the option has comes to its expiry, if the security price is not moving up significantly, you still earn the total option premium that you have received. If the security price goes up, sure you will earn a limited profit. If the stock price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. Usually, stop loss is set at the security ask price after subtracting by the option bid price. If this security price goes down and passes over the price that you set as stop loss, the loss that is incurred to you is about half of the total option premium that you have received. This is because the delta value of the out of the money call option that you have sold is about 0.4 – 0.5. The out of the money call option strike price must be the closest strike price to the entering security price.

Collar is also known as medium covered call. It is quite similar to covered call strategy. It is only added one more step in order that stop loss is unnecessary to be set in this strategy. This strategy is established by buying a security and near the money put option and following selling an out of the money option. Due to the put option that you have bought, it is unnecessary to set a stop loss because put option will protect the security if the security price goes down. However, out of the money option premium that you have collected has to be used to pay for the put option premium. If the security price goes down, you still loss about half of the total put option premium. This is because out of the money call option premium is less than the near the money put option premium. This strategy is for half or one year long term investment.

Condor strategy has four combinations. Two of them are for stationary market and the other two are for dynamic (volatile) market. Long call and put condor are for stationary market whereas short call and put condor are for dynamic market. The former strategy involves four steps that are buying and selling in the money and out of the money call option with an equivalent amount of contract. With this strategy, profit can be generated as long as the security price does not fluctuate out from the upside and downside breakeven level. Short call and put condor are for dynamic market, which also involves four steps like the long call and put condor strategy. The difference is that in short call and put condor, the strike prices of the options that have bought must be within the strike prices of the options that have sold. For short call and put condor strategy, profit can be generated as long as the security price has fluctuated out of the upside and downside breakeven level. The upside breakeven level is calculated by adding the whole position total pay out or receive to the highest strike price in the strategy. The downside breakeven level is calculated by subtracting the whole position total pay or receive to the lowest strike price in the strategy.

Combo strategy has two combinations that are bullish and bearish combo. Bullish combo strategy is for bullish market and the bearish combo strategy is for bearish market. This strategy involves two steps that are buying out of the money option and selling in the money option. If the security price goes up more than the higher strike price, profit can be generated. But if the security price goes down lower than the lower strike price, loss is incurred. If the security price fluctuates within the higher and lower strike price, you won’t loss anything. This strategy can earn an unlimited profit but also will cause an unlimited loss depending to the market direction and also which strategy you have used.

Butterfly spread strategy is quite similar to the condor strategy. It has also four combinations that are long at the money call and put butterfly spread and short at the money call and put butterfly spread. Long at the money call and put butterfly spread are for stationary market and short at the money call and put butterfly spread are for volatile market. Steps that involve in long at the money call butterfly spread are buying in the money and out of the money call option and following selling at the money call option. At the money option means the strike price of this option is quite close to the current market security price. Number of contract of the at the money call option must double the number of contract of in and out of the money option. Profit can be generated as long as the security price does not move out from the upside and downside breakeven range. The upside breakeven level is calculated by adding the total pay out of this position to the highest strike price. The downside breakeven level is calculated by subtracting the lowest strike price with the total pay out of this position. The short at the money call butterfly spread is established by selling in and out of the money call option and following by buying at the money call option. Number of contract of at the money option must be double the number of contract of in and out of the money option. As long as the security price has move out the upside and downside breakeven range, profit can be generated. This strategy generates limited profit and also cause limited loss if the security price does not go to the right direction.

Calendar spread is also known as horizontal or time spread. This strategy is solely used to earn money from the security, which price trades sideway. There are quite number of stocks have this kind of price trend. This strategy is established by selling at the money call or put option, which has a shorter time to expiry and buying at the money call and put option, which has a longer time to expiry. This strategy merely generates the money from the time value of the option. The option that has shorter time to expiry depreciates the time value faster than the option that has longer time to expiry. Usually, the option that has shorter time to expiry is left for expire worthless. The total money that you receive after closing this position will be more than the total money that you have paid out when opening this position.

With these ten strategies, you can use to earn money from upside and downside market and also the market that trades sideway.