Some extra money in the bank, check. Brokerage account, check. Interest in diving into options, check!
Approval to use certain options strategies, che-, wait, you need that?
Yes. Trading options is inherently riskier than simply buying and selling stocks. They are not only riskier for the investor, but also the brokerage. Because of this, regulators and brokerages (especially in the US), set limits on what types of options strategies you can use. These limits are known as levels, and there are typically four.
The higher the level, the more trading privileges you have. But, with more trading privileges comes more risk. So brokerages want to make sure that you have both the experience and capital to protect you and them from what could be catastrophic losses.
Here we’ll explain what the purpose of the levels, what the levels are specifically, and how they are set in the first place
What you’ll learn
The Purpose of Trading Levels with Options
Options are a rather exotic way of trading, full of various strategies. And depending on the strategy used, you expose both yourself, and your brokerage to different levels of risk.
Risk can be thought of as your maximum loss. Sometimes your maximum loss is capped, meaning it would be impossible to lose a certain amount on a trade. And other times you can even expose yourself to infinite loss.
Based on these different levels of risk, regulators and brokers put strategies into different categories of risk based on an investor’s experience trading, employment status, income, and investment goals.
Investors use various methods to protect themselves against risk, some simply steer clear of riskier strategies, and some follow alerts for options trading to save themselves both time and stress.
The Four Options Trading Approval Levels Explained
Both the criteria and the quantity of trading levels will vary across different options trading brokerages. Most brokers however will feature four different levels of options trading, each with their own permissions. The following is a breakdown of those four primary categories.
Level 1: Covered Calls and Cash-Secured Puts
The first options trading approval level involves covered calls and cash-secured puts.
A covered call is when an investor writes, or sells a call, while also owning corresponding shares of the underlying security. This means that if the contract is assigned to the investor, they can provide the shares.
This is advantageous to the brokerage because it poses no risk to them, as the investor already owns the shares that would need to be delivered to the investor in the case that the option is exercised.
Cash-secured puts work in a similar way, but just the reverse. Whereas with a covered call you would need to provide shares if the option is exercised, with cash-secured puts you would be responsible for buying the shares. As a result, you would need to have enough capital to cover the trade in the event that the contract is assigned.
This requires the investor that is setting up a cash-secured put to have enough capital to purchase 100 shares of the underlying security. Which, again, poses no risk to the brokerage.
Level 2: Call and Put Options
Level 2 opens the door for investors to purchase, or long options.
With long calls and puts, investors can start to see more of the risks involved with trading options, while also having a finite max loss, meaning risk is capped. You can only lose as much as the initial amount invested, which gives traders some peace of mind.
Perhaps the most dangerous aspect of trading long calls and puts is the effect of time decay, and then the options expiring worthless.
Time decay works like ice cream in the sun. Where the value, or premium of your option is the ice cream, and time decay is the heat from the sun, which melts the ice cream. Notably, as time progresses, the decay becomes exponentially greater. The image below will help elucidate this concept.
The other risk that becomes apparent when purchasing options is leverage. While leveraged positions can increase capital quickly, it can also shed capital quickly.
Lastly, this level allows investors to experience what it is like to exercise a contract, should they choose to do so.
Level 3: Options Spreads
Options spreads are a significant step-up in terms of risk, and they are more complex than the types of strategies used in options trading levels 1 & 2. Spreads involve trading multiple different types of options, with different expiration dates, all at once! This includes short and long calls, as well as short and long puts.
To give you a basic idea of how many moving parts there can be with spreads, a box spread, for example, involves four options contracts. Where you would buy one put and one call, and sell one put and one call.
Further, spreads are riskier for both the investor and the brokerage. Trading levels 1 & 2 pose no risk to the brokerage, but level 3 allows you to margin trade, which means that the brokerage can lend you money, allowing you to purchase more shares than you can normally afford. This means that if the trade(s) goes south, it is the brokerage’s responsibility to supplement any loss you are not able to cover.
Because of the complexities of spreads, it is crucial that investors have a solid grasp of the concepts involved in trading options before they are approved for level 3.
Level 4: Naked Calls and Puts
We saw in level one that you can write, or sell calls and puts, but you need to have either cash on hand, or the corresponding shares to protect both yourself and the brokerage in case you are assigned the option.
Naked calls and puts are when an investor sells a call or a put, but does not need to have the shares or cash set aside to protect against assignment. This exposes investors to a whole new level of risk: unlimited. Yes, naked calls can feature infinite losses.
This is because there is nothing to protect the position, it is unhedged. Many investors have evaporated all of their capital, and all of their gains they have accumulated over many years, as a result of this risk.
In the example below, we can see where an investor loses $139,985.82 on naked Tesla (TSLA) calls.See the total profit/ loss since open in the bottom right hand corner. Notably, the investor lost over $60,000 in a single day.
After seeing this, it becomes pretty apparent why an investor needs to be seasoned, and is typically approved after they have years of options trading experience, with a significant amount of capital that they can afford to lose.
How Do Brokers Assign Trading Levels?
Brokers assign or approve traders for trading levels based on a number of factors. Each brokerage will be a little different, but in general there are some key factors almost all of them will look for.
First, they want to make sure you have sufficient trading experience, so they’ll ask you how long you have been trading options. Sometimes this can mean you need a few years of experience before you’re approved for something like level four.
Second, a brokerage will ask about your financial status. Namely, what is your annual income and your net worth.
Lastly, they’ll probably ask you what your investment objectives are. Specifically, are you looking for safety, income, or capital gains. What they’re trying to assess here is how aggressive you want to be, and how much time you’re willing to dedicate to investing.
Below is an example of the types of questions stock brokerages might ask in order to determine whether or not the investor has the risk profile needed for options trading. Keep in mind that there is no ‘industry standard set of questions
Based on an investor’s answers to such questions, brokerages will typically assign what they deem as an appropriate level of options trading permissions. In addition to general questions however, some brokerages might directly ask investors which level of options trading they are requesting:
The Different Tiers of Options Trading: FAQs
Now that you have a thorough understanding of the criteria behind basic permission levels set by brokers in options trading, let’s quickly review some frequently asked questions.
Are options levels the same across different brokers?
No, options levels are not the same across different brokers. While there are similarities, each brokerage has their own way of setting up their levels. Some brokerages, such as Robinhood, don’t even have four levels.
How can I obtain options trading approval letters?
With most brokerages, in order to obtain approval for an options level, you would need to submit an application. You will need to provide information such as your employment status and financial info, as well as your investment goals. It is then left up to the brokerage to approve your application or not.
What are the four levels of options trading?
Typically, the four levels of options trading are as follows:
- Selling calls and puts, while at the same time having enough capital, or shares to provide should the call or put be assigned to the writer.
- Buying calls and puts.
- Spreads – box spreads, debit and credit spreads.
- Naked calls and puts – selling a call or put without insuring yourself in the case of assignment.
Does Robinhood have four levels of options trading?
No, Robinhood does not have four levels of options trading. Instead, it has two levels. Level 2, “Basic Options Strategies”, allows investors to buy and sell calls and puts. Level 3, “Advanced Options Strategies” allows investors to trade spreads, butterflies, and iron condors.