Enabling Income Generation in Your Brokerage Account by Thomas Moore As you’ll notice as you read my twice-weekly blog posts, the OptionThink.com web site is focused on generating monthly income by selling equity options. Specifically, I use put selling on stocks that I don’t already own, and covered calls on stocks that I do own. If you are new to options trading, or if you have only bought call and puts, then starting a trade by selling options first might seem a little counter-intuitive. You can refer to the Homestudy Kit area of the website to get more specific information about how put selling and covered calls are done; there is a lot of information in the training videos and in my book, A Trade for All Seasons, that is available to you to get more familiar with how these strategies work. Before you can work with either covered calls or put selling, you have to make sure that your broker has reviewed and approved your account twice: once for options trading, and again for selling naked options. In this report, I want to take a little time to explain what this means, how the rules brokerages generally put in place for these types of trades affect you, and the steps you need to take to get the process started. If you have already been set up for options trading and put selling specifically, this report may still be useful as a review of the requirements you need to pay attention to as you place trades. Options Trading Authority Like stocks, options are also regulated by the Securities and Exchange Commission (SEC). All equity options contracts are listed through the Chicago Board of Options Exchange (CBOE). While not all stocks that are publicly traded on U.S. exchanges offer equity options, and not all brokerages are set up to facilitate options trading, the result is a consistent environment that gives all traders a fair opportunity to place the options trades they want and have them processed in an efficient and equitable fashion. In order to make options trading available, brokers are required to review each client by way of an application process above and beyond the establishment of the brokerage account by itself. The options authority application typically includes a simple questionnaire (mandated by federal regulation) about your investment objective, available funds, previous investment experience, and current investing objectives. Depending on your answers, the broker will approve or deny the application. Approval for options trading by your broker is broken down by trading tiers or levels; each level allows one or more different types of options trading activity. While some brokers use different terminology to describe these levels, they are most often boiled down to the following: !1 of !8 Options Authority Description Level 0 Buy Stocks, Bonds, and Mutual Funds Level 1 Covered Call writing/sell Stock short Level 2 Buy Calls and Puts, Cash-secured Put Selling Level 3 Debit Spreads Level 4 Credit Spreads/Naked Put Selling Level 5 Naked Call Selling/Naked Index Put & Call Selling Note that being approved for a higher level of trading also includes all of the levels below it. For example, if you are approved for Level 4 trading, you will also be able to use any of the strategies in Levels 0, 1, 2, and 3. If you are approved for options trading, your broker will notify you which level you have been approved for. The reason these different strategies are broken into different levels or tiers is because the higher level strategies, like debit or credit spreads and naked put selling, are very complex trading strategies; since they are harder to manage and can involve a higher level of risk, brokers limit these types of strategies to traders who have the required knowledge and experience to place and manage them as well as the larger sums of capital that are usually required to cover the underlying risk associated with them. Since the OptionThink blog uses Covered Calls and Put Selling as its primary trading strategies, you will need to request approval for Level 2 trading authority at minimum. If you haven’t already applied for options trading approval, talk to your broker for details on how to submit a new request. Options Trading and Margin Some of the strategies I’ve listed in the table above, such as selling a stock short, selling a naked equity call or put option, or selling naked index options, are only available if you have also set up a margin account along with being approved to trade options. Margin trading can be thought of as being able to borrow a portion of the amount of money required to place a trade from your broker. In simple terms, it gives you the ability to cover certain types of trades with money that you don’t have. The reason margin is required for these strategies is because by selling the options first, you accept the responsibility, or obligation, to fulfill the terms of the contract at some point in the future. In the case of a naked call, for example, you could be required to sell the stock to the option buyer at a fixed price that is below the stock’s current price. Since the current market price you would be forced to buy the stock at is uncertain, it isn’t a given you will have sufficient funds in your account to buy the stock and fulfill the obligation, so your margin account gives you the ability to make up the difference (up to a point) so you can deliver the stock to the call buyer. For the convenience of helping you cover the obligation, your broker will charge you an interest fee. The risk of margin trading is that if the stock has made a big move against you, your margin may not be sufficient to cover the trade, which means the broker would have to issue you a margin call. A margin call would require you to deposit additional funds in your !2 of !8 account to cover whatever shortfall exists; if you cannot do so, you may be forced to surrender other assets or property. Keep in mind that brokers each have their own margin trading requirements, rules, and limits. If you are interested in margin trading, check with your broker to get a complete breakdown and detailed explanation. Make sure you have a complete understanding of how their requirements will impact your trading before you use any available margin in the account. Cash-Secured Put Selling vs. Naked Put Selling A few paragraphs ago, I told you that to work with the strategies that are the focus of OptionThink, you need to be approved for Level 2 options trading at minimum. Covered calls and cash-secured puts do NOT use margin; instead, the potential obligation of covering a stock assignment from a put sell is covered by available cash in your account. If you aren’t approved for margin trading, this also means that you will not be able to sell puts on stocks that would create a larger obligation than you have the money to cover. Let’s use an example to illustrate. Suppose that you have a $50,000 trading account, and you read one of my weekly trading highlights on a stock that is currently trading at $53. In my post, I suggest selling a put option with a $50 strike price. Selling a put option means that you are giving the put buyer the right to sell the stock back to you at the option’s strike price - $50 in this case. As long as the stock stays above $50 the buyer will have no reason to exercise the option, so the option will simply expire worthless, and you’ll keep the entire premium you received when you initiated the trade (which is the reason I suggested selling the put in the first place). What if the stock has dropped below $50 before the put expires? Let’s suppose the stock is at $40 on expiration day. Now the put buyer is certain to exercise their option; they can buy the stock at the current market rate ($40) and force you to buy the shares from them at $50. They will make a $10 per share profit, less the premium they paid you at the beginning of the trade. Here’s the part that you need to keep in mind for the duration of the trade: the strike price of the put option you sell is the price you could be required to buy the stock at, which means that to cover the trade, you have to have enough cash available to buy the stock at that price. Remember that one option contract contract controls 100 shares of the underlying stock; suppose that in our example trade, you sold 2 contracts. You would need to have enough cash in your account to cover buying 200 shares of the underlying stock at $50 per share. 200 shares X $50 per share = $10,000 cash requirement If you already have open positions in your account that have taken up all of your available cash, and you aren’t approved for margin trading, you won’t be able to sell another put option until you either deposit more cash in the account or close one of your existing positions to make cash available. Now let’s use the same example trade on a margin account. For the sake of our example, we’ll assume that your broker requires you to maintain at least 50% of the strike price you’ve sold, so for this trade, they are willing to extend as much as $5,000 of credit to you to cover the trade.