Editor’s Note: It’s no secret to Market Minute readers that Jeff thinks the bear is in charge. But, that doesn’t mean all bad news…
Jeff also thinks now is the best time in years to be an option trader. That’s why, for today’s Market Minute, we’re running a classic essay that will get you prepared to open a trading account, and take full advantage the coming bear…
Happy Friday, folks.
Today, let’s open up the mailbag and respond to one of the most frequent questions I receive from new subscribers…
Dear Jeff: I just subscribed to your Delta Report and I’m excited to start trading options. But, I don’t have any experience in the option market. And, my broker requires some level of experience before it will approve my account for trading options. How can I open an option trading account without any experience trading options?
It might help to understand why “experience” is required for approval of an options trading account.
In 1987, just before the October crash, the only requirement most firms had for approving full trading in options accounts was being able to fog a mirror. In other words, if you were breathing, then you were approved for pretty much any option strategy you wanted to trade.
In September 1987, option premiums started to inflate. Many brokerage firms sold uncovered put options on broad stock market indexes – like the S&P 500 and S&P 100 – and they recommended their clients do the same. The premiums were so large, it would have taken a “crash” to lose money on those trades.
Of course, the stock market did crash on October 19, 1987. The uncovered put trades that so many brokerage firms recommended to their clients were hugely underwater. And, since the margin requirements for that sort of trade at the time were quite mild, traders were way overleveraged on their positions.
They were sitting on HUGE losses. And in many cases, their accounts did not have enough money to buy the index at the price they agreed to.
They had negative equity – which means they could close their positions and still not have enough money in their accounts to absorb the loss.
In that case, the brokerage firm is liable.
In other words… If the brokerage firm lets you take on a position you can’t handle, then the brokerage firm has to make good on the trade.
No brokerage firm ever wants to be put in that situation again. So, they’ve set up restrictions on folks who want to open option trading accounts. You have to show that you have some experience trading options. And you have to have the financial capability to handle the risk.
Almost every brokerage firm will approve new accounts for selling covered call options – which is a conservative strategy – and for buying speculative call and put options, as long as you have the money in the account to do so.
At most firms, this is considered “Level 1” trading. It’s available to anyone who wants to trade options. As long as you have the cash available to make the trade, there aren’t any restrictions.
Getting approval to sell uncovered put or call options takes a little more work. While these sorts of trades are often lower-risk than buying or shorting the underlying stock, the brokerage firm is ultimately liable to fulfill the contract if you don’t have the funds to do so. That’s why the firms have more restrictive requirements.
To overcome this objection, you may need to call your broker. Pick up the phone and tell your firm exactly what it is you want to do. For example, if you want to sell uncovered put options on XYZ stock, then make sure you have enough cash available in your account that you can buy the stock at the price you’ve agreed to. In this situation, most firms will approve your account for selling uncovered put options.
Selling uncovered put options is lower-risk than buying the underlying stock itself. If your brokerage firm doesn’t grasp this simple concept, and they’re not willing to approve your account for this sort of trade after you’ve discussed your intentions with them, then find another brokerage firm.
In my experience, Interactive Brokers and TD Ameritrade have no problem at all approving accounts for the type of trading I recommend in the Delta Report. I’m sure there are other firms that will approve accounts for my sort of trading.
Again, pick up the phone. Tell your brokerage firm what it is you would like to do. They shouldn’t have any trouble approving your account for the sorts of trades we do in the Delta Report.
Brokerage firms want your business. If you explain your trading objectives in a way that reduces the firm’s exposure to risk, you should easily gain approval for advanced option trading. Otherwise, look for a more accommodating firm.
Best regards and good trading,
Jeff Clark
P.S. Like I’ve been telling readers recently, we’re entering bear market territory. So, next week, I’m going to make a major announcement about where I see the markets headed – and what you should do to prepare. Make sure to keep an eye on your inbox for that next week.
Reader Mailbag
What are some other aspects of options trading you’d like to learn more about? Do you feel prepared for the bear?
And as always, send any other trading questions, suggestions, or feedback to [email protected].