I recently opened an account with TD Ameritrade and wanted to invest $2,000 to begin the option purchasing process. They have emailed me stating that I can only write "covered call options" and since I am a beginner, I really don't understand why or what this means. I don't want to put my money into a company that prohibits me from being able to learn this process since I am investing in stocks for my own personal use, I do not run a business involving stocks, so what is the deal? Can you explain in layman's terms?

Rick N. Layman

Hello Rick,

Layman's terms to Mr. Layman? Is that your real name (rhetorical question)?

Most brokers adopt the philosophy that beginners must be limited in the strategies they use. The idea is to protect them from unnecessary losses. Their hearts are in the right place, but these limitations are often frustrating to the customer.

Covered call writing is a relatively conservative strategy - especially when compared with the common investor strategy of buying and holding stocks. I like this strategy - especially for people who are first learning to use options. Here is the strategy in a nutshell:

You buy 100 shares (or multiples of 100 shares) of stock.

You sell one call option for each 100 shares owned, and collect a cash premium.  That premium is yours to keep, no matter what happens.

The call you sell gives the call buyer the right (but not the obligation - that means it's his/her choice and you can neither force nor forbid the call owner from buying your stock) to buy your stock at a previously agreed upon price.  That price is called the strike price.  If the call owner exercises his rights and elects to buy your stock, you are obligated to sell.  You have no choice.  I don't want to confuse you, but you are allowed to repurchase the calls you sold, as long as you do it before the call owner elects to buy your shares.  This relieves you of the obligation to sell your stock.

The option has a limited lifetime.  Once it expires it is worthless and the seller (that's you in this scenario) has no further obligation to sell his shares of stock. Options expire at the close of trading on the 3rd Friday of the month specified in the contract.

There's more, but those are the basics of how it works.  The brokers like this strategy because you own the stock and collect some cash when selling calls.  That limits your potential gains, but in return the cash collected increases your income stream.  This is a learning strategy and is not suitable for all investors.

You don't have to accept your broker's limitations.  There are a small number of brokers who allow you to adopt any strategy you choose.  The freedom is nice, but you will be using strategies with greater risk.  As an alternative, you can appeal to Ameritrade and ask for permission to use other methods.  There's a small chance they will relent.  I don't want to promote a specific broker here nor suggest that you adopt riskier methods, but if you are unable to find a broker who allows you to do as you please, write again and I'll name a broker for you to consider.

One word of warning from my long-term experience:  It is VERY difficult to make money when buying options.  you must pick the stock's direction.  You must time that move.  And you must have a good idea of how large that move will be.  Very difficult.  Not impossible, but unless you have a proven track record of successfully predicting market direction, and the timing of the move, you are going to have a tough time making money when buying options.  Best of luck to you.

If you are someone who likes to learn something from books, I highly recommend my brand new book: The Rookie's Guide to Options.

Mark

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Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options