Stock trading volumes set new records in 2021 as millions of people started investing for the first time. Many new and experienced investors are beginning to dabble in options as a way to increase their leverage, generate income, or hedge against risk. But unlike stocks, you need special permission from your broker to trade options.
That’s because options are riskier than stocks. For example, a long call option loses all of its value if the underlying stock fails to reach the strike price before the expiration date. And, if you write a naked call and don’t have the cash to deliver the stock, your broker may liquidate some of your other stock positions at considerable expense.
Let’s look at how brokers use option trading levels to manage these risks and what you should know about them.
Brokers manage their risk with option trading levels—here’s what you need to know about them.
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What Are Option Trading Levels?
Brokers manage risk with a three to five-tier rating system covering various options strategies. For example, Robinhood uses a three-tier system, whereas Fidelity uses a five-tier system. Sadly, because the brokers don’t use a universal system, they become even more confusing when making comparisons. The lowest tiers permit the least risky options strategies, whereas the highest focus on more risky and complex options.
Basic options strategies, such as covered calls, are available to nearly everyone. Some brokers may require a minimum asset level or years of experience. But if you want to use advanced strategies, you must complete a form detailing your knowledge, trading objectives, and experience. Then, the broker will evaluate these factors and your overall account to assign an options trading level that defines the strategies you are permitted to use.
Example of a covered call strategy that involves minimal risk. Source: Wikipedia
Level 1
Level 1 strategies involve risk levels similar to owning a stock since a trader either owns the underlying security or cash to buy it as collateral. For example, you might write a call option against an existing stock that you own to create a covered call. Level 1 strategies have defined risk levels and limited loss potential.
- Covered Calls
- Covered Puts
- Buy-Writes
- Unwinds
- Covered Rollouts
Level 2
Level 2 strategies don’t have any counterparty risk, but they involve a significant risk of loss. While covered call losses are limited to the decline in the underlying stock, a long call option that expires worthless results in a complete loss of your investment. As a result, brokers want to ensure that Level 2 traders are prepared to lose their entire investment.
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- Long Calls
- Long Puts
- Long Straddles
- Long Combinations
- Long Strangles
- Cash-Secured Equity Puts
Level 3
Level 3 strategies can result in losses that exceed the initial investment, meaning that they require margin accounts. If you lose a lot of money, the broker is left to cover any excess losses. Brokers also want you to be aware of other margin account features, such as interest payments, margin calls, and other adverse events that may happen.
- Spreads
- Diagonal Call Spreads
- Diagonal Put Spreads
- Ratio Spreads
Level 4
Level 4 strategies involve the potential for unlimited losses. For example, while option spreads have limited losses, buying a naked call option opens the door to limitless losses since the underlying stock could rise indefinitely. As a result, brokers want to ensure that traders using these strategies understand the significant risks.
- Naked Calls
- Naked Puts
- Naked Rollouts
- Short Straddles
- Short Combinations
- Short Strangles
- Naked Ratio Spreads
Choosing the Right Level
Everyone trading options should understand the different option approval levels and how to qualify for each level.
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Brokers provide you with a form where you detail your options knowledge and trading experience. While it’s easy to lie about your experience, you’re only hurting yourself if you try risky strategies that are unfamiliar to you. So instead, it’s best to tell the truth and work your way up the approval ladder over time as you gain knowledge and experience. These rules are in place to protect you and your broker.
As you gain experience, you may request higher trading levels or wait for them to be automatically assigned by the broker. Also, remember that you may need certain account features to qualify for higher trading levels, such as a margin trading account or a minimum balance that the broker would like to see in order to approve a new level. Keep in mind, some option strategies aren’t allowed in retirement accounts. Brokers also use Trade Levels to ensure compliance.
Finally, you may only need certain levels to execute the strategies that you use. For instance, long-term investors who use covered calls and buy-writes to generate extra income may only need a Level 1 account, so they don’t have to worry about obtaining higher approval levels. Having the appropriate level in place also protects you from placing a mistaken trade. Selling 100 calls instead of 1 is a common mistake avoided when your account has the correct trade level. Higher levels are typically reserved for active traders.
The Bottom Line
Options are riskier than stocks due to their inherent leverage and counterparty risks. To manage these risks, brokers assign traders different levels that govern the strategies they can use. These options trading levels are set based on your knowledge and experience, as well as your account attributes (e.g., margin approval, balance, etc.).
Covered calls are a great low risk strategy for new option traders. The Snider Investment Method is a comprehensive covered call strategy that can help you decide what stocks and options to target and manage positions over time. You can also use our free covered call screener to find opportunities or manage positions with Lattco, our innovative trading platform.
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