Understand Levels of Options Trading

You’ll develop into a more knowledgeable and effective options trader by comprehending each trading level, the reasons behind them, and how brokers decide where a trader belongs.

But first, let’s define options trading before we go over the four option clearance levels.

What Is Options Trading?

I hope you’re ready for the “a little bit more” complex options methods if you purchased and sold equities before trading options grabbed your interest. Why? Selling and purchasing stocks is, in contrast to trading options, a simple idea; it’s similar to selling and buying anything else. You strive to purchase at the lowest price feasible while using credit or cash to make transactions. When you sell anything, you want to get a lot more for it than you spent, so that you may turn a profit.

Options for purchasing and selling Contracts are a very other idea. These contracts are arrangements that provide its owners the right to purchase or sell an underlying securities at a predefined price (also known as the predetermined strike price) by a specified date, but not the duty to do so.

Two parties are involved in the transaction: the writer (also known as the seller) and the holder (buyer.) The contracts are bought by the holders, who are seasoned investors, as authors produce them. In exchange for the right to purchase or sell a certain stock by a given day, holders pay authors a premium. The highest amount holders can lose if the options contracts expire worthless is the premium, which is often a fee per share.

What else? Puts and call options are the two different categories of options. An chance to purchase shares at the stock price specified in the contract is provided by a call option. The reverse is true with a put option. You provide contract holders the right to sell the concerned assets for the share price specified in the contract.

As you can see, trading options is a desirable kind of investing since it enables participants to guess how a share price will perform without having to put more money at risk than they initially invested. The trading tactics involved in selling and purchasing options, however, may be rather complicated, which is why option clearance levels were developed as a risk-reduction strategy.

Purpose of Options Trading Levels

Options contracts can be exchanged in a variety of ways as they are considered derivatives. This covers many forms of options transactions (such as covered calls and naked write options) as well as sophisticated trading techniques, such credit and debit spreads.

The fact that some methods and trades are simple to grasp and low risk is most significant. However, there are others that involve a higher chance of loss (in some cases, infinite losses), and traders have even been known to lose more money than they initially invested. When this occurs, the broker intervenes immediately to execute the transaction on the market if the option trader’s brokerage account is insufficiently funded to accommodate the shares of stocks put on or called from it (or for option contract executions at an expiry date).

Trading levels are required as a result. Brokers seek to reduce these risks as far as they can while transferring the majority of the risks to options traders.

Brokers therefore evaluate each account holder’s risk whenever a new account is opened. Brokers award one of four option approval levels to traders to limit their access to options trading as necessary based on the findings of this risk analysis as well as the trader’s resources (do they have a healthy account balance?).

Consequently, do not be shocked if you have just registered an account yet are unable to trade your preferred options methods just yet. Read on to learn about the various approval levels and strategies you may use to persuade your broker to raise your approval level.

The Four Different Options Trading Levels

The four approved trade options levels are typically listed from one to four, with the fourth being the highest approval level.

Sadly, there are no established standards for option approval levels. This indicates that the trading techniques that fall within each trading level are chosen by the brokers. It’s also important to note that while the majority of brokers offer four “tiers” of options trading levels, some companies include a fifth. Additionally, I’ve added it as a bonus here.

You are welcome to call your broker at any time to request the option approval papers.

Level 1 – Covered Calls and Cash Secured Puts

An options trader is allowed to pursue a covered call, a cash secured put, and a long protected put at this initial level of options clearance. But there’s a catch, as they say. A trader cannot purchase call options at this level but can purchase puts on the same stock they already own in the same quantity. This is due to the trader’s inability to obtain a margin loan from the broker.

Let’s use Johnson as an example. Johnson wants to start trading options, and he currently possesses 1,000 shares of ABC stock in his investment account. He must first open an account with an options broker and respond honestly to a questionnaire about his lack of knowledge in options trading.

He acquires an approved level 1 trading account, which enables him to trade covered calls, once his application has been assessed. He can only write 100 contracts since he already owns 1,000 shares of ABC, and each contract equals 10 shares. The order won’t be filled if he attempts to write more than his shares can support.

Regarding cash secured puts, it simply means that the trader has the funds available to purchase the desired number of shares at the agreed-upon strike price in order to meet the execution of either a call or a put. There is no chance that the underlying security price may be higher than the trader’s capacity to pay because the stock price is fixed at a specified strike price.

As you can see, at this point, the broker is not exposed to any risk from the cash secured puts, covered calls, or other underlying positions because the trader can easily get the shares back once the strike price is reached. In order to prevent rookie mistakes, this level is specifically given to new traders.

By the way, most brokerages typically only permit this threshold for individual retirement accounts (IRAs.)

Level 2 – Buying Calls, Puts, and Long

Investors can speculate on changes in market price at this trading level, which is a slight improvement over the first level. In this case, a trader is permitted to use all first-level methods in addition to purchasing calls and puts. Unfortunately, there are still limitations on margin access at this level, making several options strategies inaccessible.

Here is an illustration of how purchasing calls or puts functions.

Consider the scenario where John has a bullish (long) inclination toward XYZ Corp. and wants to make money off the rise in the stock price. In this instance, John will earn if the share price climbs over the strike price of the call option he purchased on the underlying asset with a strike price above where the share is presently trading.

However, the option contract will expire worthless if the price of the stock declines or does not increase sufficiently.

In contrast, if another trader called Joanne had a pessimistic (short) emotion at the same time about XYZ Corp, then purchasing a put option enables her to benefit if the stock price decreases below the strike price. The trader sells the put option for the difference between the strike price and the initial share price once the transaction is profitable.

Level 3 – Options Spreads, Such As Spreads, Iron Condors, Iron butterflies, and Calendars

When traders establish reliable trading routines and accumulate enough trading experience, the broker may classify them as level 3 option traders. Trading with numerous positions and using sophisticated methods like spreads or the iron condor is permitted at the third permission level.

Given that these trades frequently include numerous unique option contracts, often with a variety of potential buy and sales at various periods in time, spread trading necessitates knowledge with and a thorough grasp of options trading.

A debit spread is an options strategy that leaves your account with net debits. The maximum loss possible on any short or long position is the debit. Credit spreads, on the other hand, automatically deposit money into your trading account for options. However, keep in mind that credit spread orders are not permitted at this third trading level.

Additionally, spread trading at this level is permitted with access to leverage. Brokers only allow experienced clients with a track record of success in the options market to trade at this level.

Level 4 – Naked or Uncovered Calls and Puts (Stock Options)

Level 4 represents the biggest degree of added risk for both traders and their brokerage account providers as it is the highest option approval level in the majority of accounts. As a result, only the most seasoned traders have access to this level of trading.

What else? At this level, any technique may be used, providing the size of the trader’s account is acceptable to the broker (usually a significant amount.) Brokers will also ask to see proof of several years of expertise in options trading before providing you access.

At this level, it is feasible to use credit spreads, short selling, as well as naked long calls and naked puts. When you sell an option while holding no ownership of the underlying stock, this is referred to as selling a “naked” option.

The majority of bets at this level, whether they are long or short positions, may often result in limitless losses if the stock price makes a significant move in the option writer’s favor. You’ll have to purchase back the shares at a substantial loss if the underlying investment declines in value.

Level 5 – Naked or Uncovered Calls and Puts (Index Options & Stock Options)

Although most brokerage accounts do not provide this trading level, it is unquestionably the greatest level that may be attained under the appropriate circumstances. With this level, you typically have access to everything covered in the previous four levels as well as the ability to include uncovered choices in indexes.

Essentially, a level 5 options trading account will allow you to write a naked put or call option on the S&P Index ETF.

FAQs

Can You Trade Options In Cash Accounts?

Options may be traded in cash accounts with some brokers, but not all of them. Additionally, keep in mind that cash accounts allowed for option trading typically have far fewer strategy alternatives than margin accounts.

Can You Trade Options In An Individual Retirement Account (IRA)?

Brokers do permit trading in options in IRA accounts. Nevertheless, since most IRA accounts are restricted to the first trading level, the methods that are permitted in these accounts are frequently constrained. Brokers are aware that investors won’t be able to easily compensate them if a deal ever swings against them above the value restrictions of their account since only a certain amount is allowed to be deposited to IRA accounts each year.

How Can I Move From Level To Level?

To advance to the next trading level with your brokers, there is no surefire way to do it. Brokers often automatically and periodically examine accounts and, if necessary, raise them. Contact your broker personally and request an upgrade if this hasn’t happened to you and you feel you’re ready for the next step. Having said that, if you’re just starting out, this isn’t the best investing advise. You should see the levels as allies rather than foes because they are there for a reason.

Conclusion

Those that trade options and use tried-and-true options techniques can make significant profits. Sadly, it may also be quite dangerous for people who lack sufficient risk assessment rules or even for those who unintentionally get themselves in disastrous transactions.

It is crucial that you adhere to the options approval level that your broker has given you. These exist to safeguard both your interests and your broker’s. On the trader’s side, each trading level guards against novice traders taking on too much by utilizing high risk tactics.

Each trading level enables the broker make sure that every trader has access to the right margin account that can support their capacity to manage position risks.