What are Options Trading Levels?


As you probably know at this moment, there are many different option trading strategies, with different profile risks. Some with limited risk; others with unlimited risk. Not all of the options strategies are available for every trader. The reason is that some of the trading strategies are very risky, like the unlimited risk ones (naked Call selling), and require extensive experience and "knowledge of what a trader is doing" ...

For this reason, options brokers place limits on accounts, which are called ‘trading levels’ (sometimes referred to as "approval levels"). Due to the high leverage in these financial instruments, brokers have developed a system of option approval levels for traders that limits their access to options strategies.

There are 4 options trading levels, each of which allows additional access to additional options trading strategies based on the experience and cash amount available of the trader. It is very important for options traders to understand these options trading levels, and to learn how they can qualify to trade options at each approval level.

Level 1 – Covered Calls & Cash-Secured Puts

The first option trading level is for covered calls and cash-secured puts. In essence, both are hedging strategies for the stock owner. Covered calls occur where the options seller actually holds the shares for the options being sold, and can thereby provide physical delivery of the shares if the share price exceeds the strike price (or under assignment of its owned shares). There is no risk to the broker in a covered call, as they can simply take the share from the trader’s account in exchange for the exercise price.

A cash-secured put simply means that the trader has the cash on hand to buy the shares at the given strike in the event of the exercise of the put. As the price of the purchase is fixed at the strike price, there is no risk that the change in the security’s price will exceed the ability of the trader to pay.

Level 2 – Long Options (Options buying)

This level allows the trader the possibility to trade options without owning the stock. It is said the trade can buy naked options. While there is no counterparty risk to the broker involved in buying options, there is the risk that the option could expire worthless, which would mean a complete loss for the trader. This is the level that most beginner options traders are allowed to start with.
The key difference from the previous level is that at this level, traders are able to make "pure" directional bets.

Brokers limit access to option buying to level 2 to ensure that the trader fully understands the concepts involved in options trading, such as time decay and the mechanics of exercising an option.


Level 3 – Option Spreads (Vertical Spreads and its relatives - Butterfly spreads, Iron Condors)

The next options trading level opens access to trading spreads and the need of qualifying for trading on margin. Access to margin trading means that traders can create positions whose value exceeds that of their total account, which would leave the broker at risk (it needs to cover any difference in case of loss).

Options spreads require a more advanced understanding and familiarity with options trading. They use a combination of options, often with some sold options and bought at different strikes or expirations. Risk analysis of the position will often need an understanding of the Greeks. Access to margin trading required for options spread trading is reserved for traders with a proven understanding of options trading.

Level 4 – Naked Calls & Puts

Option trading level 4 allows the sale of short calls and short puts, which are options sold also under a certain margin requirement.  These strategies involve very high risk due to the potentially unlimited risk. When a naked Call is sold, there is an infinite potential loss... especially in volatility instruments like VXX, this strategy should be avoided at all cost. Imagine the VXX price is at $20 and he sells a naked call at $22, expecting to capture the premium due to VXX price drag... next day, a pandemic is slowing the economy, and volatility spikes with consequent VXX price move up to $60... this trader is now with a very big loss!

The ability to sell naked calls and puts provides access to the riskiest options trading strategies, such as naked straddles, strangles, or naked calls and puts. Since the final settlement cost of a written option can be many times the initial premium earned, only the most knowledgeable options traders have access to this option trading level.


How to access these Option Trading Levels?

Whether you are at levels 1, 2, or 3, and you want to go to the next level, it will require action from your side. Sometimes, your account may be increased to a higher level, but probably each trader usually needs to interact with the broker to elevate his account to the next level. There's no specific way to guarantee an increased trading level with your broker. But this would be entirely at the discretion of your brokerage firm. If you had a solid trading history with them and a reasonable amount of funds on the account, then you would probably stand a good chance of being upgraded.

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.

Conclusion

Trading levels are vital for mitigating risk for both sides, the trader and broker. On the trader’s side, the options trading levels protect beginner traders from entering into trades that are too complex and risky. On the brokerage’s side, the approval scale helps ensure that experienced traders receive access to margin and are knowledgeable enough to control their position risks.