One of the most overlooked aspects of options trading is option approval levels.
When you start trading options, you can’t go and execute any trade you want. Brokerages have put safeguards in place to protect you from yourself.
These safeguards can be frustrating if you are an experienced options trader who wants to get started trading right away.
However, these safeguards do perform as advertised. They keep new traders from blowing out their portfolio because they clicked a wrong button. Don’t worry; even skilled traders click the wrong button from time to time. It happens.
As you will see, not all brokerages follow the same guidelines for establishing levels, and these option levels will detail out which trades you are allowed to place.
The Reason For Option Approval Levels
Option levels are there for you to protect your account. They are also there to protect the options brokerage. At the end of the day, it is the brokerage who is on the line for debts paid. If a brokerage gets careless and allows a trader to run up an enormous debt that they can’t afford, the debt still has to be settled. This is why brokerages have large risk departments.
A brokerage always knows how much risk it has on the table. They will not let a lousy trader with a massive debt bankrupt their business.
Some strategies have very limited risk, both to the trader and the brokerage. We will find these strategies in lower, more accessible to reach levels. We will see the more advanced, unlimited risk strategies at higher, harder to reach levels.
What Are The Option Trading Levels
Not all brokerages classify their option levels the same way. Brokerages do, however, all follow a similar classification system.
Option Level 1
Level 1 is reserved for defined risk strategies. Even though there are many defined risk strategies, Level 1 is usually for covered calls and cash secured puts.
Covered calls get the pleasure of being titled the ultimate beginner strategy.
They are typically very easy to implement, and the risk is both, defined and minimized.
A covered call is an option strategy that consists of owning shares of the underlying stock and then selling a call on those shares. For every 100 shares you own, you want to sell one call contract. The reason this is a beginner strategy is that you can’t lose money on your options.
There are three scenarios for covered calls.
- If the underlying stock rises above your strike price, your shares will get called away at expiration. The downside is that the underlying rises so far above the strike price that you miss the increase in stock price.
For example, you own 100 shares of The Option Prophet (sym: TOP) at $45, and you sell 1 call contract at the 50 strike. This is a covered call. If TOP is trading at $51 at expiration, your call option would be assigned, and you would sell your 100 TOP shares at $50. That is great. This is what you wanted to happen. You would make money on the increase in the underlying plus the credit for which you sold the call option.
However, if TOP is trading at $75 at expiration, you would still sell your shares for $50. You would generate the same profit as if TOP was trading at $51. The downside is that you missed the increase in stock price.
When you trade covered calls, you need to be okay with having your shares called at the strike price. Not understanding and not being okay with having your shares called away from you is how you lose money trading covered calls.
If the underlying fails to move up to the strike price by expiration, your call will expire worthless, allowing you to collect the full credit of your option. You will keep your shares, and you can sell another covered call on the position.
The other hidden downside is if your underlying begins to move lower. Again, this won’t affect your option. In fact, you will still collect the full premium for your short option, as in the other scenarios.
The downside happens because you are “stuck” in your position. If you have a short call open, you cannot sell your shares without first closing the short call position. If you closed the shares and left the short option open, you would have a naked call. More than likely, you will still collect a small profit from closing your call option.
Besides covered calls, you can also trade cash-secured puts in Option Level 1. A cash-secured put is another options strategy where it is hard to lose money on the option trade.
A cash-secured put involves selling an out-of-the-money put option with the goal of being assigned on the option and buying the underlying shares. For every one contract you sell, you would purchase 100 shares of the underlying if you are assigned at expiration.
The risk with cash-secured puts is to have the underlying drop far below your strike price. When you are assigned the shares, they would be at the strike price.
For example, you sell a put option on TOP at the 50 strike when TOP is trading at $55. TOP ends up dropping to $35 by expiration. You would still have to buy the shares at $50 even though TOP is trading at $35.
When utilizing cash-secured puts, you should be comfortable holding the underlying and purchasing the shares at the strike price you select. This will help eliminate the risk of the underlying falling.
Both of these strategies, covered calls, and cash-secured puts, are set up, so it’s difficult to lose money on the option position. Neither of them requires margin, but they do need a large enough portfolio to buy the shares.
Option Level 2
When you upgrade to Option Level 2, you are now permitted to purchase options. The two strategies that are available are long calls and long puts.
The reason these are reserved for Level 2 is that you can lose money on the option positions. Long calls and long puts don’t require margin and are typically used for directional bets. If you believe the underlying is going to move higher, you purchase a call. If you think the underlying will move lower, you buy a put.
Okay, it’s not that easy.
Options, by their nature, are much cheaper than purchasing stock. Think leverage. This is a great bonus, especially for smaller portfolios, because now you can do more with less.
The problem is doing too much more. Options allow you to overleverage your portfolio, and if you are wrong about your prediction, you can quickly lose. With stock, if you’re wrong, you can continue to hold your position until, hopefully, it comes back to profit. Unfortunately, options don’t have that luxury. Options have a defined life-span so losses can add up quickly if you are not careful.
Option Level 3
When you move into Option Level 3, the fun begins. You now can trade spreads.
Spreads open a whole world of possible option strategies: bull call spreads, bear put spreads, bull put spreads, bear call spreads, iron condors, and butterflys, are just a few of the strategies now at your disposal.
So if spreads are so great, why do brokerages keep them hidden behind Option Level 3?
When you move to this level, you must have an account with margin. Margin, as stated by Investopedia is, “Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more.”
Margin, if used carelessly, allows you to lose more money than what your account can afford. Now, before you swear off margin completely, know that with Option Level 3, all strategies are defined risk. You cannot lose more than what is in your account.
Spreads are going to require a lot more legwork and education to be able to master. There are a lot of moving parts when trading multiple leg strategies (strategies that involve buying or selling more than one option at a time).
Even though they are difficult and on margin, spread strategies should not be ignored. These are some powerful strategies made available to you. It is a good idea to learn to utilize them in your trading.
Option Level 4
Options Level 4 is typically the highest level you can obtain. Sometimes, brokerages will break the two strategies in here into Option Level 4 and Option Level 5.
The strategies that are locked behind this door are margin strategies with undefined risk, short calls, and short puts.
Both of these strategies allow you to lose more than what is in your portfolio, so they should only be attempted by an experienced options trader. These are great strategies when utilized with care, so they shouldn’t be avoided, just handled with care.
With short calls and short puts also comes short strangles and short straddles. These can be great neutral strategies used to profit when the underlying is in a tight range.
Sometimes, short calls will be moved to the next level, Option Level 5. Short calls pose more of a risk than short puts. Theoretically, an underlying can only drop to zero-dollars, meaning the risk is limited. Calls, on the other hand, can climb to infinitely. Stocks are more likely to run higher and to do it unexpectedly. A buyout announced overnight, or a new CEO is taking control of a company, can trigger an extraordinary run in the stock.
Joe Campbell learned the hard way what happens when you short a pharmaceutical company overnight. He was only short the stock and not calls, but the effect was the same.
How To Get Access To Trade Options
All brokerages have a form to fill out, usually separate from when you open your account, to start trading options. This goal of this form is for the brokerage to learn more about you and your experience with options. Typically, they are going to ask you probing questions about your net liquidity, net worth, affiliations to corporations and insider trading, and investment and trading objectives. They will also want to know about your experience with options and trading in general. Here is TD Ameritrade’s Option Application.
A brokerage will use this information, plus your account information, to assign you an options trading level. Now, it may be tempting to lie on your application. Sure, it’s easy enough to do.
We don’t recommend going down that path. Putting 5+ years’ experience on your application doesn’t guarantee you the highest level of options trading. If you don’t have the minimum $2,000 in your portfolio, you won’t be allowed to trade under margin. Remember, these levels are here to make sure you don’t blow out your portfolio.
What should you do if you are placed in Option Level 1, but don’t want to trade covered calls and cash secured puts?
Don’t worry; you are not alone. Covered calls and cash-secured puts are great beginner strategies, but they are not for everyone. First, you need enough money in your account to purchase 100 shares of the stock on which you want to trade options. Not all traders have that kind of cash with which to start. Even with enough capital, you may not want to trade these strategies.
What are you to do?
Learn. If you didn’t get into the Option Level you desired, you need to spend some time learning about options. There are a lot of online option courses that provide you with a certificate upon completion. These certificates are great to have and to submit with your application when you apply to upgrade your Option Level.
Brokerages created Option Levels to help protect you and themselves. Option Levels 1 and 2 are reserved for nonmargin accounts. These are basic but still useful, strategies such as covered calls, cash-secured puts, long calls and long puts.
When you are upgraded to Option Levels 3 and 4, you are now trading on margin and moving into the more advanced options strategies. Margin allows you to borrow money from your brokerage to trade spreads and naked options. Most of your options strategies are going to fall into these two categories so working to Option Level 3 is a priority for most traders.
If you don’t get the level you want initially, keep learning and building your portfolio. You can reapply whenever you want, and if you show your brokerage that you are ready to move up, they will typically grant you a new level.
Which option level do you typically trade into? Let us know in the comments...