How do options work etrade

How do you trade put options on E*TRADE?

To trade put options with E-trade it is necessary to have an approved margin account. Investors may sign up for margin accounts with E-trade at us. etrade. Investors are faced with deciding whether they prefer to buy and sell options and whether they want to write options, either covered or naked. Writing naked options involves additional approval because it entails a significant amount of risk. Options are a type of derivative. Calls bet that stocks are going to increase in price. Puts bet on decreases in price. An option is the right, but not the obligation, to buy or sell a set amount of stock for a predetermined amount of time at a predetermined price.

Once investors have an approved margin account they may then log in to their accounts at us. etrade. To buy options, investors are required to research which company or index, strike price and expiration month they are interested in buying. Once they have this information they may enter an order to buy on the E-trade website. Options can change in value quickly. Investors are free to sell any options they have purchased at any time before they expire. Holding options for long periods of time is risky because options lose value through time value decay.

Customers interested in writing options as an income strategy must either have the corresponding quantity of the underlying stocks in their account or be permitted to perform naked option writing. Option writers need to research which months and strike prices are available for the options they want to write. Nearby strike prices and months may offer better values than others. Covered call option writers may have their stocks called away from them. Naked option writers may be faced with buying stock or entering a short position in the open market in order to meet the obligations of their naked positions being exercised. E-trade contacts the writers of naked option positions quickly at the telephone number or address provided if options that they have written are exercised. E-trade may close positions that do not fulfill margin requirements quickly.

Options Basics: How Options Work.

Options contracts are essentially the price probabilities of future events. The more likely something is to occur, the more expensive an option would be that profits from that event. This is the key to understanding the relative value of options.

Let’s take as a generic example a call option on International Business Machines Corp. (IBM) with a strike price of $200; IBM is currently trading at $175 and expires in 3 months. Remember, the call option gives you the right , but not the obligation , to purchase shares of IBM at $200 at any point in the next 3 months. If the price of IBM rises above $200, then you “win.” It doesn’t matter that we don’t know the price of this option for the moment – what we can say for sure, though, is that the same option that expires not in 3 months but in 1 month will cost less because the chances of anything occurring within a shorter interval is smaller. Likewise, the same option that expires in a year will cost more. This is also why options experience time decay: the same option will be worth less tomorrow than today if the price of the stock doesn’t move.

Returning to our 3-month expiration, another factor that will increase the likelihood that you’ll “win” is if the price of IBM stock rises closer to $200 – the closer the price of the stock to the strike, the more likely the event will happen. Thus, as the price of the underlying asset rises, the price of the call option premium will also rise. Alternatively, as the price goes down – and the gap between the strike price and the underlying asset prices widens – the option will cost less. Along a similar line, if the price of IBM stock stays at $175, the call with a $190 strike price will be worth more than the $200 strike call – since, again, the chances of the $190 event happening is greater than $200.

There is one other factor that can increase the odds that the event we want to happen will occur – if the volatility of the underlying asset increases. Something that has greater price swings – both up and down – will increase the chances of an event happening. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.

With this in mind, let’s consider a hypothetical example. Let's say that on May 1, the stock price of Cory's Tequila Co. (CTQ) is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. On most U. S. exchanges, a stock option contract is the option to buy or sell 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.

Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits – unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride.

By the expiration date, the price of CTQ drops down to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down by the original premium cost of $315.

To recap, here is what happened to our option investment:

So far we've talked about options as the right to buy or sell (exercise) the underlying good. This is true, but in reality, a majority of options are not actually exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE​, only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthless.

At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and extrinsic value, also known as time value. An option's premium is the combination of its intrinsic value and its time value. Intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. Refer back to the beginning of this section of the turorial: the more likely an event is to occur, the more expensive the option. This is the extrinsic, or time value. So, the price of the option in our example can be thought of as the following:

In real life options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.

A brief word on options pricing. As we’ve seen, the relative price of an option has to do with the chances that an event will happen. But in order to put an absolute price on an option, a pricing model must be used. The most well-known model is the Black-Scholes-Merton​ model, which was derived in the 1970’s, and for which the Nobel prize in economics was awarded. Since then other models have emerged such as binomial and trinomial tree models, which are also commonly used.

Understanding Stock Options.

Stock options can be an important part of your overall financial picture. Understanding what they are can help you make the most of the benefit they may provide.

How Do Options Work?

Stock options, once vested, give you the right to purchase shares of your company’s stock at a specified price, usually called the strike or exercise price. Each option allows you to purchase one share of stock. The value of a stock option depends on the price of the company’s shares, which fluctuates over time.

A stock option is said to be “vested” when the holder has the right to exercise the stock option and purchase the shares at a predetermined price. The stock options may vest over a set schedule. Details regarding the grant, including, but not limited to the exercise price, expiration date, and vesting schedule are described in your grant agreement. The exercise price, vesting schedule, and expiration date for each of your option grants are displayed on the My Stock Plan Holdings page on etrade. You can access this page by selecting My Stock Plan from the Accounts menu on etrade, and then clicking Holdings .

As an example, consider if you were given a grant of 100 stock options at $10 dollars each. After a vesting period of three years, the company’s share price has risen to $25. You are now entitled to buy the shares for the exercise price of $10, a full $15 below the current stock price. This process of purchasing the shares underlying the option is known as “exercise”.

Know the Types of Stock Options.

Details regarding your options will be covered in the grant documents provided by your company. Before taking action on your Stock Options, review the company’s plan documents on the Company Resources page (Accounts > My Stock Plan > Company Resources). The type of stock options you have been granted will be listed on the My Stock Plan Holdings page ( Accounts > My Stock Plan > Holdings ) on etrade.

Incentive stock options (ISOs)

Incentive stock options (ISOs) are eligible for preferential tax treatment. Taxes are not due at exercise. Rather, the taxes due are deferred until the holder sells the stock received following option exercise. Among other requirements, as long as the sale is at least two years after the options were granted and at least one year after they were exercised, any proceeds will be subject to taxation at the lower, long-term capital gains rate. If these holding periods are not met, the sale will be considered a disqualifying disposition. A disqualifying disposition subjects a portion of the sale proceeds to taxation as ordinary income. The amount of ordinary income will be the difference between the price on the date of exercise and the cost to acquire the shares (the grant or exercise price). If shares are held after exercise, the eventual gain or loss when the shares are sold would be treated as a short-term or long-term capital gain based on the holding period.

Non-Qualified Stock Options (NQSOs)

Non-qualifi stock options (NQSOs) are not eligible for preferential tax treatment when exercised. In contrast to ISOs, non-qualified stock options result in additional taxable income to the recipient at the time that they are exercised, the amount being the difference between the exercise price and the market value on that date. If shares are held after exercise, the eventual gain or loss when the shares are sold would be treated as a short - term or long-term capital gain based on the holding period.

Exercise Types.

Same-Day Sale (Cashless Exercise) – Immediately sell the shares in the open market. Some of the proceeds from the sale will be used to pay the costs of exercise and the rest (if any) will be deposited into your account.

Cash Exercise (Exercise & Hold) – Deposit cash into your account and buy shares at the exercise price. Shares will be deposited into your account.

Sell-to-Cover – Some of the resulting shares are sold to pay the exercise costs. Whatever shares remain (if any) are deposited into your account.

U. S. Tax Information.

Before you take action, you’ll want to carefully consider any possible tax consequences.

Tax treatment for each transaction depends on the type of option you own. For advice on your personal financial situation, please consult a tax advisor.

Taxes on Exercise.

Incentive Stock Options (ISO) – In most cases, no taxes are due at exercise. Non-Qualified Stock Options (NQSO) - Taxes at exercise are based on the difference between the current share price and the exercise price. This amount is typically taxable in the year of exercise at ordinary income rates.

Taxes at Sale.

Incentive Stock Options (ISO)

Ordinary Income: The amount of ordinary income recognized when you sell your shares from an ISO exercise depends on whether you make a qualifying or disqualifying disposition. A sale of shares from an ISO exercise can be considered a qualifying disposition and possibly result in favorable tax treatment if, among other requirements, the following conditions are met:

You do not sell the shares for at least two years and one day after the option grant date, and You do not sell the shares for at least one year and one day after the date of purchase (the exercise date).

In general, selling shares from an ISO exercise in a qualifying disposition will not trigger ordinary income and the entire gain or loss (sales price minus cost of the shares) will be considered a long-term capital gain or loss. If you fail to satisfy the requirements described above, your sale of shares from an ISO exercise might be considered a disqualifying disposition.

In general, selling stock in a disqualifying disposition will trigger ordinary income. The amount of ordinary income is generally the difference between the stock price on the date of the exercise and the option exercise price. The ordinary income from the disqualifying disposition will appear on your Form W-2 or other applicable tax document, issued by your employer. Any remaining gain or loss will be considered short-term or long-term, depending on how long you В held the shares after exercise. If you held the shares one year or less, the gain or loss would be short-term. If you held the shares more than a year, the gain or loss would be long-term.

Ordinary Income: No additional ordinary income is recognized upon the sale of shares from a Non-Qualified Stock Option exercise.

Capital Gain or Loss: Any difference between the stock price on the exercise date and the stock price at sale will be treated as a capital gain or capital loss. If shares are held for at least one year and one day after exercise, any resulting gain is typically treated as a long-term capital gain.

Tax on Dividends.

If you exercise your options and hold the shares, any dividends received on your shares are considered income and are taxed as such in the year they are received.

A Closer Look at Potential Tax Scenarios for Each Option Type.

This example assumes a $10 exercise price on a grant of 100 options. The stock price at exercise is $25. The stock price at sale is $45.

OPTION TYPE.

TAXES AT EXERCISE.

TAXES AT В SALE.

Incentive Stock Option (ISO)

In most cases, no taxes are due at exercise.

Scenario 1: Qualifying Disposition:

100 shares X $35 = $3,500 taxed as capital gains (long term)

Scenario 2: Disqualifying Disposition: 100 shares X ($25-$10)

= $1,500 taxed as ordinary income.

100 shares X $20 = $2,000 taxed as capital gains (long term or short term depending on how long shares were held)

Non-Qualified Stock Option (NQSO)

100 shares X $15 = $1,500 taxed as ordinary income.

100 shares X $20 = $2,000 taxed as capital gains (long term or short term depending on how long shares were held)

Exercising Your Options.

Once you exercise your vested options, you can sell the shares (subject to any company imposed trading restrictions or blackout periods) or hold them until you choose to sell.

Follow these steps to create an order to exercise your options and hold or sell your shares:

1.В В Create Order.

A. В В В Log on to etrade. From the Stock Plan Overview page, click the Exercise tab.

B. В В В Choose to exercise your options and hold or sell the resulting shares by selecting one of the following:

   a.    Cash: “I’d like to sell the resulting shares and receive cash”.

   b.    Shares: “I’d like to receive shares”.

C. В В В В If you choose cash, choose your price type by selecting one of the following:

   a.    Market: “I’d like to sell at the next available market price”.

   b.    Limit: “I’m willing to wait until the stock reaches a specific price”.

D. В В В If you choose shares, choose how you would like to fund the exercise:

   a.    Sell-to-Cover: “I’d like to sell shares to cover the cost of the exercise”.

       i.   Market: “I’d like to sell at the next available market price”.

       ii.    Limit: “I’m willing to wait until the stock reaches a specific price”.

   b.    Cash/Margin: “I’d like to use cash or margin to cover the cost of the exercise”.

E. В В В В Choose Options to Exercise: Enter the number of options you would like to exercise from the available lots.

F. В В В Select how you would like to receive your cash proceeds.

2.В В Preview Order.

G. В В В Review your order and estimate your proceeds by clicking the Preview Order button.

H. В В В From the Preview Order page, you can change or cancel your order; click Place Order when you are ready to place your order.

3.В В Confirm Order.

I. You will receive a confirmation that your order has been placed.

We’ll alert you when your order has been executed and when settlement occurs.

You can also track your order status on the Orders screen ( My Stock Plan > My Accounts > Orders ) on etrade.

Have Questions?

Visit our Customer Service Online at etrade/service or call us at 1-800-838-0908 , 24 hours a day, weekdays. В From outside the U. S. or Canada, call +1 650 599 0125 . One of our dedicated professionals will be happy to assist you.

Related Content.

Your Stock Plan Experience with E*TRADE.

Understanding Stock Plan Purchase Plans.

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The fund's prospectus contains its investment objectives, risks, charges, expenses and other important information and should be read and considered carefully before investing. For a current prospectus, visit etrade/mutualfunds or visit the Exchange-Traded Funds Center at etrade/etf.

Important Note: Options transactions are complex and involve a high degree of risk, are intended for sophisticated investors and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options before you begin trading options. Also, there are specific risks associated with covered call writing including the risk that the underlying stock could be sold at the exercise price when the current market value is greater than the exercise price the call writer will receive. Moreover, there are specific risks associated with buying options including the risk of the purchased options expiring worthless. Because of the importance of tax considerations to all options transactions, the investor considering options should consult his/her tax adviser as to how taxes affect the outcome of each option strategy. Commissions and other costs may be a significant factor. An Options investor may lose the entire amount of their investment in a relatively short time.

E*TRADE Financial Corporation and its affiliates do not provide tax advice, and you always should consult your own tax advisor regarding your personal circumstances before taking any action that may have tax consequences.

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How to Trade Options on E-Trade.

Items you will need.

An account with E-Trade Options trading application form.

E-Trade has a user-friendly trading platform and offers extensive options brokerage services. After opening an account with E-Trade, you need to fill out an additional application and obtain approval for options trades. Once approved, you should familiarize yourself with the user interface on the options screen and follow a number of options before making large trades. Always remember that options involve far greater risks than stocks. Their values can easily decline to zero, and often do.

Open an account with E-Trade. Visit E-Trade and apply to open an account. Since all accounts need a signature, you must send in at least some of the forms by mail or deliver them by hand to a local E-Trade branch. You will be asked to provide a U. S. residential address, date of birth, Social Security number or tax ID number and the name and address of your employer (if applicable). Upon acceptance, you must fund your account either electronically or with a mailed check.

Apply for option trading privileges. Once your account is up and running, you can apply for the right to trade options. Since your signature will already be on record, this application can be made on-line. You will be asked to detail your investment experience and assess your risk tolerance. This step is to ensure that investors fully understand the dangers involved with options and are capable of making informed investment decisions about these complex instruments.

Get to know the interface. After the approval of your options trading application, thoroughly familiarize yourself with the user interface on the options trading screen. You can access the options page for a particular security by typing the ticker symbol of the stock in the "quote" box on the upper right hand corner and, once you receive the quote, clicking on the "option chain" link. Here, options are classified by their expiration date. Select the expiration date you are interested in from the drop-down menu for a list of all options on a particular security with a specific expiration date.

Start small. Even if you have traded stocks in the past, keep in mind that options have unique characteristics. Watch the options market closely and understand how options prices move in response to changes in the value of the underlying stock before you make actual trades. When you do, start small and do not put all of your eggs in one basket.

Unlike stocks, bonds or currencies, options can easily lose 100 percent of their value. While most financial instruments will usually retain some of their value even under the most adverse circumstances, the value of an option can easily decline to zero and often will. This means you can lose every penny invested in an option, and you must therefore trade options very carefully.

References.

About the Author.

Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.

Photo Credits.

finance image by Chad McDermott from Fotolia.

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