Levels of options trading are one of the most overlooked areas in the realm of option trading. When novice traders open a brokerage account, the brokers assign them one of four approval levels depending on the account holder’s trading experience and needs.
More often than not, the beginners looking to start trading options I come across don’t know what these option approval levels are, and only a few of them are even aware that they exist. You definitely don’t want to be part of either group as you embark on your journey.
By understanding each trading level, why they exist, and how brokers determine where a trader belongs, you’ll become a more educated and efficient options trader.
But before we review the four option approval levels, what is options trading?
Also Read: Options Trading Books
Contents
- What Is Options Trading?
- Purpose of Options Trading Levels
- The Four Different Options Trading Levels
- FAQs
- Conclusion
What Is Options Trading?
If you bought and sold stocks before trade options piqued your curiosity, I hope you’re prepared for the “a-little-more” sophisticated options strategies. Why? Well, unlike trading options, selling and buying stocks is a straightforward concept – it’s akin to buying and selling any other thing. You use credit or cash to make purchases and try to buy at the lowest price possible. When you sell, your goal is to sell for way more than you paid and, in turn, make a profit.
Selling and buying options contracts is an entirely distinct concept. These contracts are agreements that award the contracts’ holders the option (but not the obligation) to buy or sell an underlying security at a set price (aka predetermined strike price) by an agreed-upon date.
The practice involves two parties: the writer (sometimes referred to as the seller) and the holder (buyer.) The holders are experienced investors who purchase the contracts as writers create them. The holders pay the writers a premium for the right to buy or sell a particular stock by a specified day. The premium paid is usually a charge per share and is the maximum amount holders can lose if the options contracts expire worthless.
What’s more? There are two types of options: puts and call options. A call option offers the contract holder an opportunity to buy shares at the stock price indicated in the contract. A put option is just the opposite. You allow contract holders to sell the assets in question at the share price indicated in the contract.
As you can already tell, trading options is an appealing investment option because it allows holders to make bets on how a share price may fare without having to risk more than their initial investments. That said, while that may sound simple, the trading strategies involved in selling and buying options can be pretty complex, hence the creation of option approval levels as risk mitigating methods.
Purpose of Options Trading Levels
As derivatives, there are many ways that options contracts can be traded. This includes distinct types of options trades (e.g., naked write options and covered calls) as well as advanced trading strategies, such as credit and debit spreads.
Most importantly, some strategies and trades are easy to understand and carry low risk. Others, however, carry a high risk of loss (unlimited losses in some cases), and traders have even been known to lose more than they have invested. In these cases, if an option trader’s brokerage account doesn’t have sufficient capital for the shares of stocks put on them or called from them (or for option contract executions at an expiration date), then the broker directly steps in to complete the transaction on the market.
That’s why trading levels are necessary. Brokers want to limit these risks to the best of their ability and leave every substantial risk primarily with options traders.
As such, whenever new accounts are created, brokers conduct a risk assessment of each account’s holder. Based on results from this risk analysis as well as resources of the trader (do they have a healthy account balance?), brokers assign one of four option approval levels to limit the trader’s access to options trading as required.
So do not be surprised if you just opened an account but can’t trade your favorite options strategies just yet. Keep reading to discover the different approval levels and tricks you can employ to get your broker to bump you up a level.
The Four Different Options Trading Levels
Usually, you’ll find a tiered system of four approval trade options levels, generally ranked from one to four, the 4th being the highest approval level.
Unfortunately, there are no standardized option approval levels. This implies that brokers get to pick the strategies that fall under each trading level. Also worth noting, most brokers have four “tiers” of options trading levels, but a few others have a fifth one. I’ve included it here as well as a bonus.
Feel free to call your broker and request their option approval documentation anytime.
Level 1 – Covered Calls and Cash Secured Puts
At this first options approval level, an options trader is permitted to go for a covered call, cash secured put, and long protective put. That said, there is a catch. At this level, a trader isn’t allowed to buy call options but is permitted to buy puts only in the amount they hold and on the same stock they own. That’s because the trader can’t borrow money from the broker on margin.
So, as an example, let’s say Johnson has an investment account where he holds 1,000 shares of ABC stock, and he’d like to start trading options. First, he’ll need to create an account with an options broker and fill out a questionnaire stating that he has little to no experience with options trading.
Once his application is reviewed after submission, he receives an approval level 1 trading account, which allows him to sell covered calls. Since he already owns 1,000 shares of ABC, and each contract represents 10 shares, he’s only eligible to write 100 contracts. If he tries writing more than that which his shares can cover, the order won’t go through.
As for cash secured puts, it simply implies that the trader has the cash to buy the shares at the agreed strike price to satisfy the exercise of either a call or put. Since the stock price is set at a fixed strike price, there isn’t a risk that the underlying security price can exceed the trader’s ability to pay.
As you can see, at this level, no potential risk lies on the broker’s part through the cash secured puts, covered calls, or any underlying positions because the shares can be easily retrieved from the trader once the strike price is hit. As such, this level is specially assigned to inexperienced traders to avoid beginner mishaps.
By the way, this is usually the only level most brokerages will approve for individual retirement accounts (IRAs.)
Level 2 – Buying Calls, Puts, and Long
This trading level is an incremental improvement over the first level, allowing investors to speculate on market price movements. Here, a trader is allowed to execute all strategies on the first level, plus buying calls and puts. Unfortunately, margin access is still restricted at this level, so some options strategies remain out of reach.
Here is an example of how buying calls or puts works.
Let’s say John has a bullish (long) bias on XYZ corp and wants to profit from the increase in its stock price. In this case, John buying a call on the underlying security with a strike price above what the share is currently trading will be profitable if the price rises past the contract’s strike price.
That said, if the stock drops in price or doesn’t rise enough, the option contract will expire worthless.
Conversely, if, at the same time, another trader named Joanne had a bearish (short) sentiment on XYZ corp, then buying a put option allows her to profit if the stock price drops below the strike price. After the contract is profitable, the trader sells the put option for the difference between the strike price and the original share price.
Level 3 – Options Spreads, Such As Spreads, Iron Condors, Iron butterflies, and Calendars
Once traders develop consistent trading schedules and garner sufficient trading experience, the broker may consider them level 3 option traders. The third approval level allows traders to execute multiple positions and use complex strategies like spreads or iron condor.
Spread trading requires familiarity and a deep understanding of options trading since these trades typically involve multiple distinct option contracts, usually with various potential purchases and sales at different points in time.
A debit spread is an options strategy that results in net debits in your account. The debit is the highest amount you can lose in any short or long position. On the other hand, credit spreads put money in your options trading account immediately. Note, however, that you cannot place credit spread orders at this 3rd trading level.
Also, access to margin is offered for spread trading at this level. That’s why brokers reserve this trading level only for experienced investors with proven competence in options trading.
Level 4 – Naked or Uncovered Calls and Puts (Stock Options)
As the highest option approval level in most accounts, level 4 represents the highest amount of additional risk for both traders and their brokerage account providers. As such, only the most experienced traders can access this trading level.
What’s more? Any strategy can be performed at this level, provided the size of the trader’s account is to the broker’s liking (usually a significant amount.) Before granting you access, brokers will also want to see several years of options trading experience.
Regarding strategies, credit spreads, short selling, and naked long calls & naked puts are all possible at this level. Selling naked options refers to when you sell an option even though you do not own the underlying stock.
That said, note that most trades at this level, be they a short position or long position, can usually lead to unlimited losses if the stock price has a substantial adverse move against the option writer. If the underlying security goes against you, you’ll have to buy back the shares at a significant loss.
Level 5 – Naked or Uncovered Calls and Puts (Index Options & Stock Options)
This trading level isn’t available on most brokerage accounts, but it’s undoubtedly the highest level one can achieve where applicable. Usually, with this level, you’ll get permission to do everything discussed in the four levels above, plus the opportunity to write uncovered options in indexes.
Basically, if you’d like to write a naked put or call option on the S&P Index ETF, you’ll be able to do that with a level 5 options trading account.
FAQs
Can You Trade Options In Cash Accounts?
Some brokers allow traders to trade options in cash accounts, but others don’t. Also, note that compared to margin accounts, cash accounts approved for trading options usually have way fewer options in regard to strategies.
Can You Trade Options In An Individual Retirement Account (IRA)?
Yes, brokers allow for options trading in IRA accounts. That said, the strategies allowed in IRA accounts are often limited since most of these accounts are limited to the first trading level. Since only so much is contributed to IRA accounts each year, brokers know it’ll be hard for investors to compensate them if a trade ever moves against them beyond their account’s value limits.
How Can I Move From Level To Level?
There is no guaranteed way to rise to the next trading level with your brokers. Usually, brokers review accounts automatically and periodically, then increase them if appropriate. If this hasn’t happened to you and you think you’re ready for the next level, contact your broker directly and ask for an upgrade. That said, this isn’t excellent investment advice if you’re just getting started. The levels exist for a reason, and you should consider them friends, not enemies.
Conclusion
Trading options can be highly profitable to those with tried-and-tested options strategies. Unfortunately, it can also be tremendously risky for individuals without proper risk assessment guidelines or even those who accidentally get caught in bad trades.
That’s why it’s essential to stick to the options approval level assigned to you by your broker. These are there to protect both your interests and those of your broker. On the trader’s side, each trading level protects inexperienced traders from biting off more than they can chew by engaging high risk strategies.
On the broker’s side, each trading level helps ensure that every trader gets access to the proper margin account that can accommodate their ability to control their position risks.
