Last updated on July 13th, 2022 at 10:45 pm
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The efficiency and flexibility of options make them popular for new investors. Not to mention trading them is thrilling and potentially lucrative.
But are you allowed to buy and sell options without owning their corresponding stock?
You can buy call or put options without owning the underlying stock. However, certain types of stock options require you hold corresponding shares to sell them. Brokers also typically ask you to complete an approval process to trade options.
When buying calls or puts your risk is limited to the premium that you paid to purchase the option. You do not have to hold any stock to buy those.
However if you are selling call options you will have to own another call option or the stock to cover it (this is called a covered call). Most brokers won’t allow you to sell naked call options unless you have a large account and a lot of experience trading options as you can easily lose a lot of money trading naked options.
In this article I will describe how you can trade options without owning the stock. I will also dive into the types of stock options and when holding the underlying shares matters.
How Do You Trade Options Without Owning the Stock?
The simplest way to trade option contracts without owning the stock is by buying regular call or put options through your broker. If you’re new to investing, you might wonder how exactly you do that.
Here are the steps to trading options without owning the stock:
- Research your options.
- Choose a broker.
- Get approval for options trading.
- Order your options.
- Sell, let expire, or exercise your options.
Below, I will explain each of these steps. This guide is not financial advice and I’m not providing trading recommendations. Instead, it’s an introduction for those curious about how to trade these contracts without holding shares.
Research Your Options
Researching how options work and their requirements is your first step to trading them. Buying and selling these contracts is more complicated than dealing with stocks because they only last for a certain amount of time (the expiration date).
Options are also complicated because there are numerous types of options. They’re also trickier to deal with due to the more volatile speculation brought by retail investor sentiments.
It would help if you also investigated the various options offerings from companies. Like stocks, specific sectors of options experience more extreme volatility. Understanding volatility and which options have more is crucial to your success.
Stock options continue exploding in popularity thanks in part to an influx of new, young investors. However, this rapid growth also brings many scams and schemes. To avoid these pitfalls, make sure you research options extensively before trading them.
If you want an introduction to options, here is a good start.
Choose a Broker
Next, you will choose a brokerage service. For this step, you’re in luck. There’s never been a greater variety of brokers to select from.
When selecting one, consider their commission rates. Thankfully, most are low to zero commissions these days.
Also, look into their application process for options trading and what types of options you can trade. Brokers vary in these respects, so you want to make sure you go with one that works best for your purposes.
If you’re not sure what those needs are, don’t worry. Further down in this article I will dive into the different types of options and which ones require underlying stock.
Get Approval for Options Trading
For most brokers, you will need to go through an approval process to trade options. Robinhood, for example, has 3 different levels for users to go through to get the most access to stock options.
These approval processes consist of various questions. Ordinarily, they will ask you things like your net worth, trading experience, and income.
Naturally, it would be best if you were honest on these applications. Providing fraudulent information puts both you and your broker at risk.
After submitting your application, most services will get back to you in around a week. Assuming you’re approved, you should have some access to options trading.
Order Your Options
Now you’re ready to place orders!
The process is relatively simple. To start, you need to place an order to buy an option through your broker. When doing so, you can place a “market” or “limit” order.
Placing a market order buys an option immediately at whatever the current price is. Meanwhile, limit orders have a set limit price where they execute. In other words, limit orders only go through when the market price matches or goes below your limit.
Both options have their pros and cons. The best choice for you depends on the options you’re trading and your investing strategy.
For most people setting a limit order is better especially if the options you are trying to buy are more illiquid.
Sell, Let Expire, Or Exercise Your Options
Finally, you have to decide what to do with your options. You can sell the contracts for a profit, allow them to expire worthless, or exercise them.
Sometimes what happens isn’t up to you. You can trade put contracts without owning the stock but can’t exercise them without corresponding shares to sell. Similarly, options expiring out of the money become essentially useless so they are worthless at expiration.
To recap, you don’t necessarily need to own stocks to buy regular options. However, writing options or exercising them may require you to have those shares or assets.
Types of Options That Don’t Require the Stock
In addition to covering how to trade options without owning the stock, let’s examine the types of options. This knowledge is vital because specific options require you to possess the underlying stock to exercise or write them.
Options generally fall into two categories: calls and puts.
Calls are contracts that allow buyers to buy a stock at a specific strike price. Puts similarly enable you to sell a stock at a specific strike price. You can trade either one through most brokers without owning their stock.
However this is only when buying options. When selling options (puts or calls) you will be required to have either the stock or the money to buy the stock in your account.
Having the stock or the money to buy the stock when selling a put or call is considered “covered”. Options are covered when the writer can guarantee delivery of that contract through owning a corresponding position (the stock) or having the cash to buy it (in the event of selling a put.
Conversely, options are naked if the writer does not own the necessary stocks or short positions (and thus can’t deliver). Selling naked calls or puts is extremely risky.
The problem is that not all brokers allow you to trade naked or write naked options (at least without approval and margin). This is to protect themselves in the event that the trade goes against you.
Why Some Brokers Won’t Allow Naked Options
Calls and puts should be deliverable when exercised. Unfortunately, traders with naked calls and naked puts sometimes aren’t able to fulfill that. So, some brokers prevent retail investors from this type of trading as protection for themselves and the investor.
They also do so because naked trading is considered risky. After all, the potential downside on naked options is often huge.
However, virtually all brokers offer investors options for trading without owning stock. This is because they ensure their stock options are already covered, so traders can freely buy or sell them. If the trader wrote the contracts themselves, they would need the necessary assets to cover them.
To be specific, you’re only trading the contract itself, not the underlying assets. You’re also specifically trading the contracts and not writing them. Creating an option is a separate process from buying and selling existing ones.
You don’t need to own corresponding stock to buy and sell options. But you do need them to write covered options or exercise puts.
Options are undoubtedly exciting to trade. They offer excellent efficiency and an immense potential upside. Not to mention they are more popular than ever thanks to young retail investors.
Trading options doesn’t require you to own the underlying stock. And thankfully, buying and selling options has never been more accessible.