For many investors, there has been a sea change in how their accounts operate. Once we had Joe, our personal broker who called us with trade suggestions, remembered our birthday, and if we had a large account, invited us to lunch occasionally.
Today many, if not most, of us take advantage of the extraordinary power of online investing. No more waiting for our broker to get back from lunch before we can place an order. Now we have instant information, analyses, charts, order placement, and our account status at our fingertips with a mouse click.
While this is clearly a more efficient method for gathering information, placing orders, managing our trades, and reducing transaction (commission) costs, the migration to online investing has also laid a trap for the options investor.
Too often they decide on where to house their option accounts on the basis of whom they use for their stock trades and/or which company offers the lowest commission on options.
Falling into the convenience or consider-commission-only trap can slice your Rate of Return in half!
What Makes A Brokerage firm “Options-Friendly?”
These are the criteria, listed in order of importance, that I believe make a brokerage “options-friendly.” And let’s be clear, if your brokerage is not options-friendly, it is almost certainly costing you money.
- Favorable margin policy (CRITICAL)
- Competitively low commissions
- Online Trading Platform – should offer user-friendliness for order entry, no cost live price and news data, in-depth analytical resources, trade training courses, and account status information.
- Options-Knowledgeable People – You must be able to quickly reach a human options specialist to place a trade by phone, or have a question answered or a problem resolved.
- Prompt Reply to Emails or Phone Calls – Firms vary greatly on this one.
- Identical commission rate for telephone or online orders.
- Absence of “inactivity fees.”
- Practice Accounts – to familiarize you with the online platform, and for practice trades without risking actual money.
The Top Two Criteria For Brokerage Firm Consideration By Option Investors
1. Margin policy re: Iron Condors
This puppy is definitely critical if you are an investor seeking a monthly stream of income via option credit spreads.
Specifically, the issue is how the brokerage firm handles margin requirements with respect to the Iron Condor – a type of option trade that supercharges your rate of return without increasing your risk. The Iron Condor involves placing both a Bear Call Spread and a Bull Put Spread on the same underlying index, stock, or ETF. Both spreads can provide the investor with a premium (income).
Thus, there are two credit spreads involved in the trade, one with strike prices placed above the current market, and the other with strike prices well below the current market.
As with all credit spreads, the objective is to establish spreads far enough away from the current market as to make it unlikely that spread will be in-the-money at option expiration day. When the options expire worthless (out-of-the-money), the investor keeps the entire initial premium he earned when placing the spreads.
An options un-friendly brokerage demands that you employ margin for both spreads involved in the Iron Condor trade.
An options-friendly brokerage, on the other hand, recognizes the fact that it’s absolutely impossible for both spreads to wind up in-the-money on options expiration day. (That’s basic physics; you can’t be in two places at the same time.) Accordingly, at an options-friendly firm you only need to have margin coverage for one side of the trade.
Why is this critical? Because if the firm requires two margins, it cuts your rate of return, i.e. your return on margin investment, in half!
Therefore, if the brokerage firm requires margin on both sides of the trade, it makes sense to immediately disqualify it from consideration as your options broker. I would not even bother to see how such a firm qualifies on the rest of the criteria on the list.
You should not have to pay more than $2.00/option, and you should be offered a lower rate if you typically trade multiple contracts.
Also, if they hit you with an “inactivity fee” if you are not trading enough to suit them, you have good reason to scratch that brokerage off your list.
Nowadays, most major brokerages have excellent online trading platforms and support facilities. The problem arises if they charge extra for real-time quotes, charts, or other resources you would expect be covered by the commission you pay, rather than being a costly add-on.
Does Size Matter?
In the matter of options – particularly option credit spreads established for monthly income – the answer is “not really.”
Perhaps surprisingly, several very well-respected major firms whose stellar reputations are well deserved in a general sense, are decidedly unfriendly when it comes to their option clients.
Investigating First Is Time Well Spent
The bottom line metric for your investments is your rate of return. While your trade selection is obviously a very important factor in determining your success, your necessary “partner” in the undertaking is the brokerage firm you select.
For this reason, if options – especially credit spreads – are or will be a significant element of your investment activity, take the time to check out your current or prospective brokerage options policies and facilities before opening your account.
If you are able to read (you obviously are since you are reading this!), or can use email or a telephone, you can easily determine if the firm you are considering for your option investments is options-friendly or not.
You can also review published reports that rank brokerage firms in terms of the various considerations of option-friendliness described above..