Stock options can be used to generate income, hedge your risk, or add more fuel to your portfolio by increasing your exposure to certain stocks and indexes. But because options are inherently more complex than simply buying stocks or funds, options traders arguably need to be more selective in choosing the right brokerage. In the article below, outline exactly what to look for when selecting an options broker.

We tend to think that investors and traders who use options should be more selective about the brokerage they pick for two main reasons. First, investors who use options are likely to demand more from a brokerage than someone who simply buys stocks or funds sparingly. Secondly, commissions and fees for options trades can vary wildly from brokerage to brokerage, and the difference can really add up.

Most brokers charge about $5 to $7 to trade up to 10,000 shares of stock. Thus, the difference in price between brokerage firms is really immaterial for stock investors — at worst, it’s a $2 difference per trade. However, when it comes to options, the stakes are higher because the differences in commissions are larger.

An options trade that costs $25 at the cheapest options broker might cost as much as $81.95 at another. Since people who use options tend to be more sophisticated investors who trade more frequently, the difference adds up over time.

For this reason, our review of options brokers is primarily focused on cost — commissions, exercise and assignment fees, and commissions to close low-priced options contracts. Brokers often advertise their specific features and trading platforms, but getting a good understanding of the costs of trading requires reading a lot of fine print. For more information on the top stock brokers, view our best online stock brokerages page.

Together we’ve written more than 2,500 articles that have been syndicated to leading financial website that include Yahoo! Finance, MSN Money, and more. As self-directed investors who use options in our own portfolios, we know what to look for when choosing an options brokerage. Here at The Ascent, we’re combining our personal experience with discount brokers, and our review of their costs and features, to highlight the best brokers for people who use options in their personal portfolios.

Most brokerages use a “base-plus” commission schedule for options trading. That means you pay a flat fee plus a variable commission based on the number of options contracts traded. Thus, it costs more to trade 50 options contracts than it does to trade 10 options contracts.

The most common price point is roughly $5 in base commissions, plus $0.65 per contract. Thus, to buy 10 contracts, a trader would pay $11.50 to make the trade ($5.00 + $0.65 × 10 = $11.50). To buy 100 contracts, the same trader would pay about $70 in commissions to make the trade.

Pricing varies wildly by brokerage firm, as detailed in the table below.

Note that Interactive Brokers and TradeStation are the only discount brokers that offer a truly variable commission schedule. Variable pricing can be an advantage for options traders who typically place trades sized at 1-5 options contracts, since there aren’t any base fees that make small trades more expensive on a per-contract basis.

The table below compares brokers based on the cost to buy or sell ten options contracts.

Brokers charge fees to buy or sell options, but they also charge fees if you want to exercise an option, or if an option you have sold is assigned.

• Exercise fees — Let’s say you own 100 call options on Nike at a strike price of $80. Nike rises to $85 per share by the expiration date, and you decide to exercise your right to buy the stock at $80 per share. Most brokerages will charge you a fee to exercise your options and buy the underlying stock.
• Assignment fees — Let’s say you sell a covered call on Nike at a strike price of $80. Nike rises to $85 per share by the expiration date, and the owner of the options decides to exercise them, paying you $80 per share for the underlying stock. Most brokers will charge you an assignment fee for this transaction.

Exercise and assignment fees vary wildly. Interactive Broker’s options fees for exercise and assignment rank the best at $0, while TD Ameritrade’s are relatively high at $19.99. If you plan to exercise options you buy, or expect to have options assigned relatively frequently, the difference in fees may be very important to you.

While only you can decide to exercise an option, and thus incur a fee for doing so, options assignment can be an unpredictable occurrence, triggering fees because of someone else’s decision to exercise options that you sold to them.

An example for why exercise and assignment fees matter

Sophisticated investors often use put options as a way to buy stock at a certain price and get paid to do it. If you want to buy 100 shares of stock at $50, you could simply enter a stock limit order to buy the shares at $50. Alternatively, you could sell one put contract at a strike price of $50. If the stock falls below $50, the option buyer will exercise the right to sell (assign) the stock to you at $50 per share.

When used this way, puts are effectively a way to get paid to place a limit order to buy a stock, but whether or not this method makes sense can depend on a broker’s commission and fee schedule. TD Ameritrade charges an assignment fee ($19.99) that is higher than the cost of placing a stock limit order ($6.95), so selling puts as a way to buy stock may make less sense at TD Ameritrade than it does at Interactive Brokers, which doesn’t charge an assignment fee.

Options commissions can add up quickly on low-priced options. As an example, many brokers charge $0.65 to trade an options contract. On options priced at $0.05 each ($5 per contract), the $0.65 commission adds up to 13% of the value of the option contract!

Many brokers waive or substantially reduce commissions to buy-to-close short options trades as a risk management tool. The customer doesn’t have to wait for an option to expire worthless to close out the position; instead they can buy-to-cover options priced at $0.05 or less (sometimes $0.10 or less) for free.

Discounts to close low-priced options can be advantageous for people who short options. For example, you might write a covered call on stock that you own at $1.00 per option. As time goes on, and it becomes less likely that the call will expire in the money, the option may fall to a value of $0.05 each, at which point you decide to take profits by buying back the options for $0.05. At certain brokerages, buying to close this trade when the options are valued at $0.05 each wouldn’t cost you a dime in commissions.

We favor brokers that waive or substantially reduce commissions their clients pay to close low-priced short options contracts, but whether it matters largely depends on how you use options in your portfolio. If you don’t short options, then you have nothing to gain from a lower commission on buy-to-close trades.

Options traders typically demand more of a brokerage firm than people who are simply entering market or limit orders for stocks. Active option traders may prioritize brokers based on their selection of calculators or screeners, whereas the infrequent options user may care about commissions alone.

Some features that may be considered “make or break” for your decision are listed below:

• Commissions and fees — While price isn’t everything, what you pay to make a trade ultimately plays through to your profit or loss. It makes very little sense to place a trade where the only likely winner is the brokerage firm.
• Platform — Admittedly, a trading platform often has more to do with personal preference than anything else, as placing a trade through any brokerage is usually a matter of making a few clicks. Some traders may see TD Ameritrade’s fully-featured thinkorswim platform as an asset, while beginning investors may see the complex interface as a liability.

Stock options give an investor the right to buy or sell stock at a predetermined price by a specific date in the future. They derive their name from the fact they give you the option, but not the obligation to buy or sell a stock in the future at a known price.

Options come with their own unique terms, which investors should understand before making a trade:

• Call option — These options give you the right to buy stock at a certain price in the future.
• Put option — These options give you the right to sell stock at a certain price in the future.
• Premium — This is simply what each option costs.
• Strike price — The price at which the option gives you the right to buy or sell stock.
• Expiration date — The date at which the option expires. On this date, the option must be exercised, or it will expire worthless.
• Contract — Options are traded in lots of 100 options. A lot of 100 options is called a contract.

An illustrative example can go a long way to explain how stock options work.

How call options work

Let’s assume you believe that shares of Ascent Widget Company will appreciate from $50 to $70 in the next six months, and you want to make money based on this assumption.

The straightforward way to profit on this wager is to buy 100 shares of stock at $50 and hope that they increase in value to $70 shortly thereafter. If the stock increases in value as you expect, you’d turn $5,000 into $7,000 for a profit of $2,000. In all, you’d stand to earn a 40% return on your investment.

Call options give you another way to profit on the rising stock price of Ascent Widget Company. We’ll assume that call options with a strike price of $50 are trading for $5 each and expire in 6 months. Buying these options would cost $500. By purchasing these options, you have the right to purchase shares of Ascent Widget Company for $50 per share at any point in time over the next 6 months.

If you’re correct about the prospects for Ascent Widget Company stock, you stand to earn a lot of money with call options. If the stock rises to $70 before the expiration date, your call options would be worth $20 each. (Each option gives you the right to buy a share of stock worth $70 for just $50 per share, so each option is worth $20.)

After subtracting the cost of each option ($5), your total profit on 100 call options would be $1,500. Making a $1,500 profit on a $500 investment is extraordinary.

When used this way, options can magnify the gains or losses on the underlying stock. But not all options trades work out so splendidly.

In order for the call options to gain in value by expiration, the stock would have to rise to at least $55 per share. We can calculate this “breakeven price” by adding the premium paid for each option ($5) to the strike price ($50) for a breakeven price of $55 per share.

If shares of Ascent Widget Company increased in value, but only to $54 per share, the call options would have resulted in a loss. That’s because if the stock is worth $54, the right to buy the stock for $50 is only worth $4 per option.

This is one reason why stock options are much more speculative than simply buying the stock. You can lose money with call options even if the value of the stock increases.

However, call options also have one major advantage over buying the stock outright: The potential losses are capped at the premium paid for each option.

If Ascent Widget Company stock falls in value to $40 per share, buying call options would have resulted in a much smaller loss than buying the stock outright.

Put options work in a similar fashion as call options, with the only difference being that an investor who buys put options stands to make money when the price of a stock declines. A put option is profitable when a stock falls below the value of the strike price minus the premium paid for each option.

How put options work

Let’s assume you believe that shares of Ascent Widget Company will depreciate from $50 to $30 in the next six months, and you want to make money based on this assumption.

The straightforward way to profit on this wager is to sell short 100 shares of stock at $50 and hope that they fall in value to $30 shortly thereafter. If the stock falls in value as you expect, you would gain $20 per share, resulting in a total profit of $2,000.

Put options give you another way to profit if Ascent Widget Company’s stock price falls. We’ll assume that put options with a strike price of $50 are trading for $5 each and expire in 6 months. Buying 100 put options would cost $500. By purchasing these options, you have the right to sell shares of Ascent Widget Company for $50 per share at any point in time over the next 6 months.

If you’re correct about Ascent Widget Company’s stock dropping to $30 per share, the puts will surge in value. If the stock drops to $30 before the expiration date, your put options would be worth $20 each. (Each put option gives you the right to sell a share of stock for $50 at a time it is trading for $30 per share, so each option is worth $20.)

After subtracting the cost of each option ($5), your total profit on 100 put options would be $1,500.

In order for the put options to gain in value by expiration, the stock would have to fall below $45 per share. We can calculate this “breakeven price” by subtracting the premium paid for each option ($5) from the strike price ($50) for a breakeven price of $45 per share.

If shares of Ascent Widget Company fell in value, but only to $46 per share, the put options would have resulted in a loss. That’s because if the stock is worth $46, the right to buy sell the stock for $50 is only worth $4 per option. You paid $5 each for these options, thus resulting in a total loss of $100.

Even though you were right that Ascent Widget Company would decline in value, the stock did not drop enough to cover the premium paid for the option, resulting in a loss even though the stock declined in value. Shorting the stock would have been a better proposition.

Of course, just like call options, put options also cap your potential losses if the stock moves in the wrong direction. If Ascent Widget Company stock rises in value to $60 per share, buying put options would have resulted in a much smaller loss than shorting the stock.

Buying puts or calls is the most basic options trade. Options can get more complex, as traders often use multiple calls or puts simultaneously.

Buying a put and a call option at the same strike price, which is known as a “long straddle,” is a way for an investor to make money if a stock rises or falls dramatically, but isn’t sure which way it will go.

Some investors use puts as insurance in a “married put” strategy, by purchasing…say, 100 puts while simultaneously owning 100 shares of the same stock. You can think of this trade as effectively buying insurance on stock you own, since the puts lock in a price at which you can sell the stock. If you own stock at $50 per share, and buy puts with a strike of $40 for $2 each, your maximum loss is $12 per share. The puts reach breakeven at $38 per share ($40 strike minus $2 premium), thus limiting your losses to $12 per share.