Ignoring the Brokerage cost when buying Options
The Brokerage cost of the Options is very high. Unlike stocks where there is a flat fees for trading stocks, most of the brokerage firms have a pricing by contracts for Options. The price can be around $10-$40 fixed and around 50c to $1 additional per contract. So the net cost may come out to be around $1 to $3 per contract depending on the number of contracts traded and the mode of trade (internet, IVR or broker assisted).
What you don’t know?
There is not much difference between making an order through Broker, IVR or Internet. In fact, it is easier to make the trade through Internet since you can see all the Options and choose the best that suits you. But the brokerage firms change a very high premium for broker assisted trades and it is not worth the premium. It may be worth of you are trading options worth 5-10 K.
There are 100s of brokerage houses and many of them offers option trading at very low prices. It is very important to find the brokerage house that satisfies your trading needs.
You pay brokerage both ways- when you buy the Stocks/ Options and also when you sell it. The point worth noting is that you pay the brokerage even if you have made a loss in the transaction. The brokerage firms are not like Uncle Sam who will sympathize with you when you make capital loss and don’t tax you. They will charge you despite of your loss making trade when you exit.
What to do to avoid this?
You can avoid this by making sure that you consider the brokerage cost when trading the options.
You should make sure that the brokerage cost for your trade is not more than 1-2% of your trade. If you buy 10 out of money CALL contracts for GM for say 30c each, the cost of 10 contracts will be $300 (each contract is 100 stocks). If you have called the broker to make the trade, your commission will be say $40 fixed plus 75c each contract i.e., $47.5 for the trade. So you have paid the commission of around 15% for your trade.
When the Option price reaches to 40c, you plan to get out of trade. So you sell your 10 contracts and receive $400 but $47.5 is again paid as commission to brokerage firm. You may assume that you have made a profit of $100 on the investment of $300 i.e., 33% on this trade. But the real gain was $100 - $95 (paid as commission) i.e. just $5. So a big share of the gain in Option was made not by you but by your brokerage house.
On the Other side, if you put a stop loss at 20c, you will like to get out of trade when the Option price falls to 20c.
So you close your positions and receive $200 but you have to pay $47.5 as commission for the trade. So in net you suffered a loss of 100 because the option price went down but on top of that you suffered a loss of 95 as brokerage.
This is the blunder that I made in my first trade. I bought 20 CALL Options for BAC paying the premium of 4c for each contract. The trade was for $80 and there was $12.5 of brokerage. I exit the trade at 3c and got back $60 but ended up paying 12.50 again to close the positions. So, out of my total loss of $45 in my first Option trade, $20 was because of fall in Options price and $25 was because of brokerage cost.
So what did I do? I shopped around and moved to another brokerage firm that charges just 50c per contract and no additional fixed cost.
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