An Investor's Guide to Options Trading Levels

Thursday, February 25, 2021 4:27 PM | Neal Farmer

The combination of $0 commissions at most brokerage firms downtime from the pandemic and those stimulus checks has prompted millions of people to start investing for the first time.

Many of those new investors, as well as many more experienced investors are also dipping a toe into the options market for the first time. However, unlike stock trading, options trading requires your broker to enable special permissions on your account, and even after you're approved to trade options, what you're allowed to do can still be limited.

This tiered system is designed to protect investors from taking on risks they can't afford, don't understand, or both. Each broker has their own system of defining these levels and approving investors to use them, but there are similarities between them.

Most trading platforms have between three and five tiers for options trading. Level 1 requires the least amount of experience and the highest level typically reserved for experienced options traders with healthy account balance. Robinhood, for example, uses a three-level system while Fidelity uses a five-tier system but both have a similar progression in what strategies traders are allowed to use. The breakdown for the levels, no matter the platform, typically goes from least amount of risk to most risky positions.

Level 1

The first options trades investors are allowed to make are covered positions such as covered calls and cash-secured puts. In a covered call, the investor owns the stock and sells a call option against that position. Since he already holds the stock, and thus can deliver the shares should the call option be exercised, the investor is only really taking on the risk of the stock falling, which stock investors should be familiar with. A cash-secured put has the same basic risks and rewards as a covered call, but the investor holds cash instead of the stock while the trade is open. Both of these positions offer very little risk to the broker and the investor's risk is very similar to vanilla stock ownership.

Level 2

Level two trades are what allow investors to actually buy options contracts and go long either calls or puts. There is no risk to the broker in these trades, as options cannot be purchased on margin, but investors can experience a total loss of their investment if the contract expires worthless. Thus, investors need to know a little more about how options work than in level 1.. Typically, if an investor cannot afford to purchase the underlying shares when a contract is expiring, the broker will recommend selling the option contract. Alternately, if the option expires in the money, the shares can be bought on margin, giving the investor a chance to sell them. Investors may not need much or any previous experience with options to reach level 2 but traders at least need to show they know how an option contract works and that they understand the higher degree of risk compared to stocks.

Level 3

Once investors reach level three, they are usually allowed to trade options spreads. There are many different kinds of options spreads that traders can make. At this level, credit and debit spreads are allowed, although if you are not trading in a margin account, you may need to hold cash to cover losses on credit spreads. Investors can have up to four legs of a spread such as an iron condor or iron butterfly. The total maximum loss for spreads is fixed and are often lower than a simple long position depending on the trade. However, investors need to have a much stronger understanding of options for these positions as they are far more complicated and involve multiple contracts. Additionally, the investor decides when they want to exercise in a level 2 long position but half of the positions in spreads are reliant on what another party might do. Investors can also hold positions with different time horizons and/or different strike prices.

Margin accounts are allowed at this point as collateral for these positions. Each broker has their own margin requirements that may differ from the minimum set by regulators. Trading on margin drastically increases risk for both the investor and broker and thus are reserved for these higher options levels where the trader has shown a deep understanding of options trading.

Level 4+ Positions

The highest levels of options trading allows investors to sell uncovered calls and puts as well as short straddles. These options are sold on margin and have a massive amount of risk. Uncovered calls have an unlimited maximum loss as the stock price can keep rising and the seller will have to buy the shares at market price and sell to the buyer at the predetermined strike price once the contract is exercised. Uncovered puts are slightly less risky because there is a set maximum loss that is reached if the underlying stock reaches a share price of $0. Short straddles are the riskiest because any volatile movement either up or down can lead to huge losses for the investor.

Brokers leave access to this trading for investors with extensive knowledge and experience of options trading and a strong account balance that can handle significant losses since brokers are exposed to tremendous risk if the trader can't cover their losses.

Wrapping Up

The options trading levels are set in place to protect investors and their brokers due to the risks associated with options. Requirements for each level can be found by respective brokers with some maybe carrying more or less requirements than necessary. Options provide great investment opportunities but inexperienced investors probably shouldn't be looking to do anything too complex as their first foray into the options market.

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