This means that if you lose more money than you put up to make a trade, your broker can cover the loss by debiting the extra money from your account.
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The risk for options transactions classified as level one or two is limited to the amount of money you invest. These trades include buying put or call options for which the most you can lose is the fee, called a premium, which you pay to buy the options contract.
You may also write a covered call. In a covered call, you write a call option against stock you already own. If the option is exercised, your risk is limited to what you paid for the shares. Some brokers allow you to make level one and two trades with a cash account. Cash accounts are brokerage accounts in which all transactions are settled for cash, meaning you have to pay the entire potential cost of a transaction up front.
Before a broker will open a margin account, you must provide information about your assets and income. Your credit rating will be checked and you must sign an agreement making the assets in the account collateral for loans. Your broker may require more. Just opening a margin account does not mean you may trade using the riskier options strategies.
Before approving you to make level three, four or five trades, your broker assesses your financial resources and the experience you have as an options trader. Most investors must limit themselves to the less risky trading strategies until they gain experience.
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He writes about business, personal finance and careers. Adkins holds master's degrees in history and sociology from Georgia State University. He became a member of the Society of Professional Journalists in Buy Stock Shares. Essentially, you pay for the right to sell your shares at a price you specify.
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While it will eat into your profits to a certain extent, a protective put can also save you from bigger losses in the event that a stock price really tanks. Options are a wasting asset because their time value erodes as the option approaches expiration. As with any insurance, there is an associated cost. If you buy insurance for a long period of time, the time value that you will lose will be high.
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Short-term insurance will be less expensive because the time value will be less, but you will have to purchase more insurance protective put options when they expire. Also, it is often during volatile times that investors seek to insure their portfolios. Volatility drives up the price of options, so insurance costs will be highest when you are most interested in being insured. For these reasons, effective use of protective puts requires an element of market timing. If your options expire before the expected correction, they will not provide the insurance you desire.
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If you wait too long to purchase the options, the market may correct before you are insured. Want to learn more? Read Understanding Options to learn how options could fit within your investment strategy.