If you have ever tried to make an options trade, and your broker rejected it, you might have the wrong Options Level.
In this article we will cover how to navigate the four levels of options trading approval and become a more knowledgeable and effective trader. Understanding these levels helps traders manage risk and brokers assess which trades clients can execute.
Options trading involves tiers of approval to safeguard both the broker and the trader. Brokers offer margin, amplifying the potential risks and rewards. To mitigate risk, brokers employ approval levels based on the Financial Industry Regulatory Authority (FINRA) Rule 2090, also known as the Know Your Customer (KYC) Rule. This system ensures traders are matched with trading options that align with their experience and financial capacity.
Here is an Overview of the Four Options Trading Levels
Traders begin at Level 1, primarily dealing with covered calls, a low-risk strategy suitable for beginners. This level requires traders to own the underlying stocks or have enough capital to cover potential losses. As traders gain experience and demonstrate knowledge of options trading, they can advance to higher levels, unlocking more complex and potentially riskier strategies.
Level 2 introduces buying calls, puts, and selling secured puts, allowing traders to speculate on price movements without significantly increasing broker risk. These strategies offer a clear risk-reward balance, with the trader’s maximum loss limited to the premium paid for the options.
Level 3 traders access more sophisticated strategies like spreads, requiring a deeper understanding of options mechanics and significant capital. This level involves using margin to create trades, with brokers closely monitoring trader qualifications and minimum capital requirements.
Level 4, allows for buying and writing naked contracts, presenting the highest risk and reward. This level is reserved for highly experienced traders with a thorough understanding of market dynamics and the financial resilience to cover potential unlimited losses.
The Different Options Levels and Their Strategies
Options trading approval levels determine the type of option orders a trader can submit (or otherwise open), with each level granting access to different strategies and risks.
- Level 1:
- Long calls, long puts
- Selling covered calls. For each 100 shares of a stock, you can sell one call contract. Buy 100 shares of ABC at $10 and sell one call at the $11 strike.
- Suitable for new traders with minimal risk.
- Level 2:
- Everything in Level 1
- Enables selling secured puts. If you have $1000 in buying power, you can sell one $10 strike put contract on ABC. This is because your broker will hold the “max loss” position as collateral. If ABC goes to $0, your counter party can exercise and collect $1000 from you. This is why the broker holds this aside for you until expiration day or exercise.
- Level 3:
- Everything in Level 1 and Level 2
- Enables complex option selling strategies like credit spreads, debit spreads, calendar spreads and their more complex combinations (e.g., iron condors).
- Level 4:
- Everything in Level 1 and Level 2 and Level 3
- Enables selling naked contracts on margin.
- For example, you could have sold a $200 call on NVDA for $500 and have it get exercised for -$70,000 (a realized loss of $-69,500). If you have Options Level 4, and the capital in your account, your broker will allow you to do this. This is not recommended and not necessary for 99.99% of all options traders.
- This represents the highest risk level with potential for unlimited losses.
Each level builds upon the previous one, offering more trading strategies and risks. Traders progress through these levels based on experience, knowledge, and account requirements set by their brokerage. It is important to take a step back and consider the intent of this regulation: to protect you. With each increased Options Level you are granted, you are increasing your chances of volatility in your portfolio. One wrong trade could trigger a margin call, forced sale, or make you lose more than you had invested.
Requirements for Accessing Options Trading Approval Levels
To access different options trading approval levels, traders must meet specific criteria set by their brokerage. Keep in mind, these are KYC (know your customer) regulations and are designed to protect you and the broker.
- Level 1:
- New accounts start here until you apply for a higher level. When you create your account with the broker, you will likely have to check a box to select options. If no other level is indicated, you will end up with Level 1.
- Level 2:
- Traders may need to open a margin account and build a portfolio of potentially $2000 to qualify. Brokers need to know there is enough liquidity in the account to satisfy an potential requirement or risk.
- Level 3:
- Your broker is going to want to make sure you have the in-depth knowledge of option mechanics and substantial capital, income and familiarity with strategies, risk and reward.
- Brokers may want to know if you are investing, speculating or trading.
- Level 4:
- Usually requires traders to have significant experience and expertise in options trading.
- A broker may require a more lengthy account history, a higher account balance, and a greater scrutiny of your financial circumstances before enabling this ability in your account.
- Your broker doesn’t want you to blow up your account, and they don’t want to end up with a negative net liquidation value – because then you owe your broker and they will have to collect.
Additionally, some brokerages may have age requirements, such as being at least 21 years old for access to Level 2-4 option trading. Traders progress through these levels based on their experience, financial standing, trading objectives, and knowledge of options trading. Meeting these criteria is crucial for gaining approval to engage in various options trading strategies at different levels of risk and complexity.
How to Apply for Options Level Two, Three or Four
To apply for Level 2, Level 3, or Level 4 options trading approval, the process typically involves interacting with your brokerage platform and meeting specific criteria. Here is how to likely upgrade your Options Level:
- Log into your account and navigate to the “Account” or “Settings” section.
- Look for the “Options Trading” subsection and select “Enable.”
- Answer a series of questions regarding your experience, trading objectives, and financial status.
- Your responses will determine the level assigned to you; if it’s not what you expected, you can reapply after addressing any issues.
The specific requirements and application processes may vary between brokerages. Generally, eligibility for these levels is determined by factors such as trading experience, account type (e.g., margin account), financial standing, and self-reported information related to trading objectives and knowledge. It’s essential to follow the guidelines provided by your brokerage platform and ensure that you meet the necessary criteria to apply for higher options trading approval levels
The Regulations around Options Levels:
Regulatory oversight of options trading in the United States is managed by various bodies such as the Commodity Futures Trading Commission (CFTC), Securities and Exchange Commission (SEC), and Financial Industry Regulatory Authority (FINRA) Rule 2090, also known as the Know Your Customer (KYC) Rule. These regulatory bodies establish rules and regulations governing options trading to ensure market integrity, investor protection, and compliance with established guidelines.
At the same time, these regulations limit your rights as a free market participant.
While there isn’t a specific law that dictates the creation of the four levels of options trading, these levels are part of brokerage policies aimed at managing risk and ensuring that traders have the necessary experience and knowledge to engage in different types of options strategies. Traders progress through these levels based on their qualifications, financial standing, and understanding of options trading principles.
The Conclusion on Options Trading Levels
To determine your current approval level, review your brokerage account’s available trades or directly inquire with your broker. Advancing to the next level requires proactivity, a solid track record of wise and consistent trading, and sometimes a significant capital holding. If dissatisfied with your broker’s assessment, exploring other brokerages that may offer a higher approval level is an option.
Option trading levels play a crucial role in balancing risk, protecting both inexperienced traders from overly complex trades and brokers from undue exposure. This system ensures that traders have access to strategies that match their experience and financial capacity, promoting a safer trading environment.
The question is: what options level are you on?