Stock Option Buying Checklist
Stock options allow you to profit from a rising or falling stock price with a small amount of money at risk. To make money with options, you need to correctly forecast the direction a stock will move, and that price change must occur before the options expire. You have many choices of option contracts, so you need a system to pick the ones that give you the best chance to make profits.
Options Trading Authorization
To buy options, you must have a stock brokerage account with options trading authorization. The options approval can be added to any existing account. Your broker will require a couple of extra forms, including information about your investments and trading experience. Options trading authorization includes a trading level that may restrict the types of strategies you can use. Even an inexperienced investor can qualify for the trading level needed to buy put or call options.
Picking the Stocks
To make money from buying options, you need to select stocks you believe will make a sharp upward or downward price change in the near future. To profit from a higher stock price, you buy call options. Put options increase in value if the stock declines. Options are limited-term contracts, with expiration dates ranging from one to nine months in the future; for you to profit, the stock must make the forecast price move before the options you buy expire.
Selecting Option Parameters
Once you know that you want calls or puts on a stock, you need to narrow the selection to a specific option. A stock will have options with up to five different expiration dates between now and nine months in the future. Longer-term options give the stock more time to make its move, but they are more expensive, so the stock price change must be larger for the trade to be profitable. Options at each expiration date come with a range of strike prices -- the stock prices at which the option can be exercised. For call options, the stock must move above the strike price to turn a profit; with puts, an option has value when the stock goes below the option strike price. The strike price selection is a balance between how far the stock must move to cross the strike price and the cost of the option.
Closing out Option Positions
You can close out a purchased option position at any time before the expiration date by selling the options. Once the stock has made its price move and hit your target, sell the options to lock in your profits. If the stock price has not met your expectations, you can sell the options to recover a portion of the premium you paid to buy the contracts. It is generally not a good idea to let purchased options expire, especially if the share price in relation to the strike price gives the option a positive value.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.