Commissions Add Expense, Complexity to Options Trades

Options trading is complicated enough. But the commissions brokers charge to trade options add an additional baffling layer of complexity.

The differences in commissions from broker to broker are amazing. You can pay anywhere from $1.95 per option contract to $40 or more.

Fortunately, as you'll see in a moment, competition's helping bring down the price of options trading, and brokers are simplifying their fee structures. But many have a ways to go. (If you want to brush up on your options basics before going any further, see Dan Colarusso's Mirror Mirror on the Wall, Explain for Me a Put and Call.)

Dazed and Confused

Here's perhaps an extreme case. Morgan Stanley Dean Witter charges $1.80 per contract plus 1.5% of the principal amount on trades of options with premiums of 50 cents or less. You receive a 20% discount if you make the transaction online.

The premium refers to the price of the option contract, whether it's the proceeds from selling the contract or the price you pay for purchasing the contract. Since option contracts are for 100 shares, you would multiply a 50 cent premium by 100, making the cost of the contract $50. Morgan Stanley has somewhat higher fee schedules for options with premiums greater than 50 cents.

What is meant by the 1.5% of the principal? Is that the 1.5% of the underlying stock's price or 1.5% of the option contract's price? I had to call to make sure -- It's the price of the option contract. Nevertheless, these prices are pretty steep, as this example illustrates:

This past week, shares of networking software maker Novell (NOVL) were trading at around $8.75. A December call option with a $12.50 strike price was selling for 31.25 cents. That means you'd pay $31.25 for a 100-share call option contract. I'm using Novell as an example because it's a relatively low-priced stock. And for that reason, it yields relatively small option premiums.

So let's do the math. If you bought one contract, you'd pay $1.80 in base commissions, plus 1.5% of the $31.25 option principal, or about 47 cents. That makes your total cost so far $2.27. Now factor in the 20% discount for making the trade online, and your total rounded off goes back down to $1.82.

Well, not quite. Morgan Stanley charges a $35 minimum per trade. So if you bought or sold just one contract of this particular Novell option, the commission would amount to more than the price of the option contract itself!

As I mentioned, Morgan Stanley's commissions are slightly higher for options with premiums above 50 cents. But you can also receive quantity discounts. Did I say this was confusing?

Industry Norms

Scottrade's option commissions are a little more typical. Each time you want to trade an option you pay a $20 base rate, plus $1.60 per contract.

Now, suppose you wish to exercise the contract -- for example, buy the shares at the price stipulated in the call you purchased. If that were the case, you'd pay an additional $17 fee. You would pay that same exercise fee if you sold the option and the buyer chose to exercise the contract.

For example, let's say you owned 100 shares of America Online (AOL), which was selling at around $50 earlier this week. Then you sold a covered call with a strike price of $50 for $2.50 (or $250 per contract). This strategy would allow you to generate some income from owning the stock and provide a little downside protection. But once the options are in the money , they're liable to be exercised. In that case, you'd be obligated to turn over your 100 shares. That would put your total commissions to Scottrade at $38.60:

$20 base rate + $1.60 per-contract charge + $17 exercise fee = $38.60

That commission structure really penalizes people trading small accounts. True enough, if your AOL option contract was exercised, you'd still walk away with $211.40 after commissions. Nevertheless, those commissions amount to more than 15% of the trade.

The commissions really add up if you like putting together some of the more exotic strategies, such as ratio call spreads. This strategy gives you an alternative to buying stock on margin. Like buying on margin, it allows you to leverage any gains made in a stock's price. It's also used as a way to recoup losses when a stock you bought crashes, as columnist Tom Gentile explained in an article last May. Read it before you try this at home.

With a ratio call spread, you buy 100 shares of a stock. At the same time, you buy a call option with a strike price equal to the stock's purchase price. Then you sell two calls with strike prices that are higher than the stock's current price.

Depending on the broker you use and how the stock performs, a ratio call spread can entail as many as six transactions. By the time you buy the stock, buy the option, exercise your call to acquire the shares and allow the calls you sold to be exercised, you'll pay upwards of $100 if your broker charges fees comparable to Scottrade's.

Bargain Shopping

Other brokers charge less. Web Street.com, for example, charges a $17.95 base rate plus $1.75 per contract. Mr. Stock charges $14 plus $1.50 per contract. I mention these brokers because they cater to options traders.

A powerful new player is Datek Online, which just began options trading in October 2000. Datek charges $10 base plus $1.75 per contract. Datek has a huge active-trader client base. And its lower commission schedule will hopefully pressure competitors to lower their commissions as well.

Most brokers still have a ways to go. If you're an experienced trader and you don't need a lot of hand-holding, you might check out InteractiveBrokers, which charges $1.95 per options trade with no base.

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