Because of the natural leverage in options and counterparty risk in writing options, brokers have created a tiered system of option approval levels to limit traders’ access to options trading.
These four option approval levels allow further access to various options trading based on the trader’s experience and resources.
Options traders need to understand the various option approval levels and learn how to qualify to trade options at each option approval level.
Level 1 – Covered Calls and Cash-Secured Puts
The first level is aimed at covered calls and cash-secured puts.
Covered calls happen when the writer of the option holds the shares for the written options and provides the shares’ physical delivery if the share price surpasses the strike price.
For instance, a trader sells a call option for one single share of company B at a strike price of $10. When the share reaches $11, the call owner exercises their option, then one share is handed over in exchange for $10 from the call owner.
The broker is under no risk in a covered call, since they can take the shares from the trader’s account, trading for the exercise price.
A cash-secured put indicates that a trader has the cash ready to buy shares at the given strike to complete the put exercise. Since the purchase price is fixed at the strike price, there is no risk that a change in the security’s price will surpass the trader’s ability to pay.
Level 2 – Long Options
Level 2 dives into access to options buying.
Even though there is no counterparty risk to the broker buying options, there still is risk of the option expiring worthless. This translates as a complete loss for the option owner.
To guarantee that the trader thoroughly understands the concepts involved in options trading, brokers limit access to option buying to level 2, such as a reduction of value and actual mechanics of exercising an option.
Traders used to trading simple securities could potentially misunderstand the impact options have on a portfolio due to their natural leverage compared to conventional securities.
Level 3 – Option Spreads
Option approval level 3 unlocks access to trading spreads, including the essential margin trading required. This special access to margin trading indicates that traders can create positions with value exceeding their total account. This leaves the broker to cover any discrepancy in the case of excess loss.
A spread requires an extensive comprehension and experience with options trading. Spreads use multiple different options, with multiple potential sales and purchases at other points in time, contingent on how the price of a security advances throughout the spread.
This granted access is only reserved for traders with a proven level of competence in options trading.
Level 4 – Naked Calls & Puts
Option approval level 4 comprises the sale of short calls and short puts. These are options sold on the margin when possible settlement costs are unlimited.
Because the final settlement cost of written options can be many times larger than the initial premium earned, just the most proficient and seasoned options traders have access to this 4th option approval level.
The capacity to sell naked calls and puts grants access to the riskiest options trading tactics, such as naked straddles, strangles, or naked puts and calls.
This is the most difficult level to achieve since brokers like to see several years of options trading experience and a healthy account balance in the six figures range.
Accessing Option Approval Levels
Brokerages provide new traders with a plan that allows them to present their options trading experience and knowledge. Brokers often use the information and the account’s specifics to assign an option approval level to the new trader’s account.
Brokers have developed an advanced vetting system. Traders should be honest when describing their knowledge and expertise in options trading so brokers can assign the proper option approval level.
Option approval levels are just as much for the trader’s benefit as for the broker’s. It is crucial to accumulate the necessary knowledge and experience of options trading before striving for more intricate and risky strategies.
Traders should gain knowledge and experience by trading at their approved level before petitioning for or pursuing a higher tier of access to be correctly assigned.