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Before You Start Buying Options, Read This

By Motley Fool Staff - Apr 5, 2017 at 7:19AM

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Options aren’t as easy to get into as stocks. Watch this clip to find out what you need to do before investing in options.

Options are a somewhat advanced investing strategy, and there are a few hurdles that investors will need to jump over if they want to get into them.

In this clip from the Industry Focus podcast, options expert JP Bennett explains what steps would-be options investors will need to take before they are allowed to make options purchases, why these restrictions are in place, and why it's so important to not just dive into options headfirst before you're clear about the basics.

A full transcript follows the video.

This video was recorded on March 24, 2017.

Dylan Lewis: One other thing I think is probably worth touching on with options and your brokerage is, this is something you need to opt into and apply to with pretty much all brokerages. If this conversation is something that piqued your interest and you want to learn more, please read up first. But if you want to go about possibly trading options down the road, it's not as simple as logging into your brokerage and going to the options center and making things happen, right?

JP Bennett: Right. Again, this gets back to something we touched on multiple times. These are instruments that have leverage. The broker, because of self-interest, they just don't want to let anyone trade options. And also because of rules and laws and things like that. But, if you don't have the knowledge, you can do a lot of harm really quickly, and not really even understand it. So, basically, yeah, there is an application process that you have to go through. Nine times out of ten, depending on your broker, it's relatively basic and straightforward. Basically, what they're trying to get a feel for is, have you traded options before, how much do you know about options, how big is your account? If your account is really small, the damage that you can do is exponentially larger than someone who has a much larger account than you. Basically, after they get a feel for those types of things, there are different permission levels. I think it's foolish that there isn't a standardized permission level hierarchy. Some have levels one through three, some have zero through four, some have one through four. Basically, the higher up you go, the more permission you have. Level one, you're looking at stuff like covered calls, because there isn't a whole lot of damage you can do there. You can't write more calls than shares you already own. If the stock falls, you already own the stock, so there's not much damage there. You're not on the hook to buy shares, and you don't have the cash. But, the higher up in the permissions that you get, the more strategies you can get, and also, the more danger you can get yourself into. So, before they give you those keys, they want to be comfortable that you're not going to, in the first month of receiving permission, go out and basically blow up your account and make them have to close it.

But, one important thing to remember is, we often see this with members who join Options, is some brokers have our favorite strategies a little bit higher up on the hierarchy, and some members are frustrated, because they can only follow some of our recommendations, and they want to follow all of them. That probably isn't the best thing to do if you're just getting started. But, the thing to keep in mind here is, you can always go back and apply for a higher permission level. If you only get level one permission, do a couple trades, demonstrate to them that you know what you're doing, and then go back and ask for a higher permission level. It's very likely that you will receive it. There are very few cases where they won't. But, making sure that you don't get frustrated, and stick with it. Also, because there's a high learning curve, it's not the worst thing in the world, right?

Lewis: Yeah, it's something that saves you from yourself.

Bennett: Right? The way I like to think of it is, kind of like if there's an S curve with options. You learn about the extreme basics, and it's like, "There's only two options, you can only buy or sell, that's easy." And then you start studying and you realize, there's a lot here, and it can be pretty quick to get overwhelming. But if you stick with it, there's just this point where it clicks. And once you get a couple basic concepts down pat, the rest of it is smooth sailing.

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