As an options trader, you should learn about the different tiers of trading approval levels. Many new traders, and even some experienced traders, may not know that there are levels of trading or how to learn which level they are currently trading at.
By understanding these levels and how brokers determine where traders should be, you will become a more efficient and educated trader.
There are different levels to protect both the trader and the broker
Options are inherently leveraged instruments, which means brokerage accounts that allow options trading will usually offer margin to the trader. When brokerage firms allow their customers to trade with margin, they can be exposed to a potentially risky position because the trader is using the brokerage's money.
In order to protect themselves from unnecessary exposure, the brokerages use trading approval levels to determine what types of contracts and trades each client can engage in.
Brokers are required to put trading rules and levels in place as part of the FINRA rules, specifically Rule 2090: Know Your Customer Rule (KYC Rule).
The brokerage typically provides a questionnaire asking the client to detail their trading experience and knowledge of options. It is best for the client to be truthful with these questions because the brokerage wants to protect the client’s interests as well as their own.
For example, if a new trader believes that they should have access to more margin they should, and provides inaccurate information to the brokerage, the brokerage may provide the trader with access to more margin than the trader can afford to cover.
If a trade goes against the trader, he may not have enough assets to cover the exposure, and the brokerage would be exposed to a potential loss.
If the trader was truthful about his experience, then the brokerage would not give him the excess margin.
Although each brokerage may use different names for the levels, they generally are grouped Level 1 - Level 4. With additional approval, traders will find access to margin coming with subsequent increases in their current level.
Level 1 - Covered Calls
Most new traders will start at Level 1 because it is the safest and places minimal risk on the broker and ensures that the trader can cover any losses.
Covered calls are well-suited to new options traders because they either own the shares required to cover a contract they write or have sufficient capital to buy the shares if necessary.
Let’s say that a trader has a brokerage account where they hold 1,000 shares of XYZ stock, and she would like to start trading options. She fills out the questionnaire with her broker, who notes her holdings in XYZ and that she has little to no experience in options trading.
Once her application is submitted and reviewed, she receives Level 1 options trading status, which enables her to sell covered calls. Since she has 1,000 shares of XYZ, and each option contract represents 100 shares, she is eligible to write 10 contracts. If she tried to write more than her shares cover, the order would not go through.
Level 2 - Buying Calls, Puts, and Selling Secured Puts
The second level of options trading opens up many new strategies that allow investors to speculate on price movements.
The primary benefit of level 2 is the ability to buy long calls and puts. Buying calls and puts does not expose the brokerage to additional risk, but the maximum loss for the trader is 100% of the premium paid for the contract.
Buying Calls
If a trader is long (bullish) on ABC corp and would like to profit on the increase in the stock price, then buying a call on the stock with a strike price higher than the stock is currently trading would be profitable if the stock price went past the strike price of the contract. However, if the stock does not move high enough or goes down, then the option will expire worthless.
Buying Puts
Conversely, if another investor was short (bearish) on ABC corp, then buying a put option would enable the investor to profit on a downward movement in the stock price. If the share price falls below the strike price, the contract would be profitable, and the investor could sell the put option for the difference between the share price and the strike price. If the stock stays consistent or goes up, then the option will expire worthless.
Selling Secured Puts
Cash secured puts function similarly to covered calls in that they require the seller to set the cash aside to pay for the shares of stock if the option is assigned.
In this strategy, the trader is hoping that the stock price will dip, and the contract buyer will exercise the contract. Once the contract is exercised, the seller will purchase the assigned shares at a discount and sell them to the buyer.
This is an interesting trade because the trader may benefit from the assignment of the shares, but there is a substantial risk that the share price might not come back up, and the seller will take a loss by selling the shares back to the buyer at a higher price than the shares are worth.
Level 3 - Complex Strategies such as Spreads
Once a trader has some experience and developed a consistent trading schedule, the brokerage may consider the investor a level 3 trader. Level 3 enables the trader to take multiple positions and create complex trades such as spreads, iron-condor, or iron-butterflies.
Spreads and similar strategies require in-depth knowledge of option mechanics, and substantial capital to employ. Once traders reach level 3, they will have access to margin in order to create their trades.
Although allowing traders to use margin can be risky for the brokerage, level 3 traders have been vetted and approved for the use of margin. The brokerage may review their trades and have a minimum capital requirement for the accounts in order for the trader to qualify.
Level 4 - Buying and Writing Naked contracts
The highest level of options approval represents the highest amount of risk for both the trader and the brokerage. Naked options have the potential for unlimited gains as well as unlimited losses.
The potential for unlimited gain comes from buying a naked option - either a call or a put. If a trader purchases an out-of-the-money call, and the stock takes off, then the profit is only limited to how high the stock goes minus the premium paid.
With a put, the maximum gain can continue as long as the stock price is falling, even if it reaches $0.00.
Unlimited loss potential is derived from selling naked options - this is why selling naked options is reserved for the most experienced traders. If a trader sells a call on a pharmaceutical startup because he believes that their upcoming drug trial will fail, when it really ends up going well, then he would be on the hook for the shares until the buyer closed the position.
If the example were reversed and the trader sold a put because he thought the price would go up, and the trial ended up failing, then he would be responsible for delivering the shares at the strike price.
How to know what level you are currently
If you are curious about the level of approval you are trading at, there are a couple of options to determine it:
- You can check your brokerage account and identify what trades are available to you
- You can reach out to your broker directly by phone or online, and they should be able to tell you what your approval level is.
What to do to get to the next level
Whether you are at level 1, 2, or 3, and you want to go to the next level, it will require some proactivity on your part. Sometimes your account will automatically upgrade due to the age or amount of capital, but you will most likely need to ask your brokerage to elevate your account to the next level.
If you reach out to your broker and provide them with valid reasoning for upgrading your account, and if you have demonstrated wisdom and consistency in your trades, then you have a good chance of an upgraded approval level.
However, the brokerage may not increase your approval if you do not have enough experience or if you don’t maintain enough capital in your trading account. For some brokerages, level 4 approval may require maintaining six figures in your account.
If you disagree with your brokerage’s reasoning, then you are entitled to shop around for a different brokerage that may approve you for the next level.
Conclusion
As you can see, trading levels are vital for mitigating risk.
On the trader’s side, the levels can help protect novice and inexperienced traders from entering into trades that are too complex and risky.
On the brokerage’s side, the approval scale helps ensure that qualified traders receive access to margin. This protects the brokerage from exposing themselves to traders who cannot pay back a margin call.
