What Is an Option Account in Trading?
Options are derivative contracts that trade against the value of specific stocks, exchange traded funds or stock indexes. There are two types of option contracts: calls and puts, which can be used to profit from short-term price changes of the underlying security. The range of option trading strategies allow traders to set up trading combinations to profit from any predicted price action.
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Identification
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Option trading accounts are regular stock brokerage accounts with additional authorization to trade option contracts. Authorization for simple option strategies can be added to a cash brokerage account. Traders who want to use more complicated or high-risk strategies will need a margin account from the broker. A margin account allows an investor to borrow money from the broker to pay for a portion of the cost to buy stocks.
Function
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Options contracts have value based on the value of the underlying stock and give the option holder the right to buy (call options) or sell (put options) the underlying stock at a specific price. Options have specific expiration dates ranging from one month to two years in the future. A call option buyer makes money if the underlying stock increases above the strike price, where the option can be exercised, before the option expires. Put option holders make money if the stock falls below the strike price before expiration.
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Considerations
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Option buyers can only lose the amount of money they paid for the contracts if the stock is not below (puts) or above (calls) the strike price at expiration. Option contract sellers are subject to much larger losses because they are required to sell the stock for calls or buy the stock for puts if an option buyer elects to exercise a contract. For example, a trader sells a call with a $25 strike price and the underlying stock goes up to $50. The call seller would have to buy 100 shares of the stock at $50 and deliver them to the option holder who will pay $25, the strike price of the contract. The trader will lose $2,500 on this one contract for which he may have only received a few hundred dollars in premium.
Significance
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To allow investors to trade options but not take on more risk than is prudent for their experience, stock brokers have different authorization levels for accounts approved for option trading. Investors who want to add option trading to their brokerage account must complete an investment experience form and sign off on an option's risk disclosure. The broker will assign an authorization level to the trader's account based on her investment experience. The authorization level can be increased as the trader gains experience.
Potential
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The occasional option purchase or sale can be beneficial even to the investor or trader who primarily buys and sells stocks. Adding the basic level of option trading authorization is not difficult and every investor with a brokerage account should consider adding option trading just in case the ability to trade options is desired in the future.
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References
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