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Quick Guide To Option Trading Levels

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by Gavin in Blog
September 4, 2020 0 comments

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While there are many different option trading strategies available, not all of them are accessible for every trader.

The reason being is that some of the trading strategies are very risky and require extensive experience to be able to trade them properly.

It is for this reason that brokers place limits on accounts, which are called ‘trading levels’ (They are also sometimes referred to as an ‘approval level’).

This article will provide a quick guide to what trading levels are, what their purpose is, how they are determined, and how a level can be increased.

Purpose of Option Trading Levels

As a derivative, there are many ways that options can be traded.

This includes different types of option trades (e.g. a covered call vs a naked write) as well as advanced strategies such as credit spreads.

Some types of trades and strategies are simple to understand and have low risk, while others are very complex and carry a high risk of loss.

In some situations, traders can even lose more than the cash spent on executing the trade.

In order to protect new options traders from engaging in high-risk trades without the proper experience or capital, brokers place limits on new accounts.

Bear in mind that brokers are not doing this because they want to look out for your well being – after all, they want you to trade as much as possible so that they can generate commissions.

The trading levels are in place to protect the brokers themselves from getting into trouble with authorities.

In the past, almost anyone could set up an account and start trading high-risk strategies immediately, with little or no experience.

Many of these novice traders blew up their accounts and then started to blame the brokers for allowing them to take on more risk than they were experienced or qualified for.

Authorities stepped in to try and stop these instances reoccurring, so now whenever a new brokerage account is created, the broker will conduct a risk assessment of the account holder.

Based on this risk assessment, as well as the amount of available capital to trade, account holders will be assigned to different trading levels that have access to trades with differing levels of risk.

So don’t be surprised if you’ve just opened an account and can’t trade your favorite strategy yet – read on to discover what the levels are and what you can do to raise your trading level.

The Option Trading Levels

For most brokers, they will have either four or five trading levels, with 1 being the lowest and 5 being the highest in terms of experience and accepted level of risk allowed (level 3 and 4 are sometimes combined).

The exception to this, are some brokers with level 0 (you are only allowed to trade stocks) and level -1 (your account has been suspended).

While this article serves as a general guide on the five levels used by most brokers, make sure you check with your broker as they may have slightly different classifications.

Each level builds on the previous level, so for example, a Trading Level 3 can do all the trades involved in Trading Levels 1, 2, and 3.

Trading Level 1

Trading level 1 is the lowest level and it typically only permits two types of trades – a covered call and a protective put, which are typically used in hedging strategies.

A covered call involves writing out-of-the-money call options on underlying stocks you own, while a protective put involves buying put options against underlying stocks you own.

In both cases, since these trades require the options trader to own the underlying stock, the risk here is minimal.

Trading Level 2

Trading level 2 adds the ability to buy call options and put options  and this is the level that most beginners are allowed to start with.

The key difference from level 1 is that at this level, traders are able to make directional bets.

Since they can only buy and not write options, a trader’s risk is limited to only the money used when buying the options.

Trading Level 3

Trading level 3 generally introduces the ability to trade debit spreads and is the first complex trade that beginners are introduced to.

This is due to the way risk is capped in debit spreads, despite the complexity in executing the trade.

With debit spreads a trader’s risk is limited to the cash paid when they execute the spread, making it a beginner-friendly but advanced trading strategy.

Trading Level 4

Trading level 4 is sometimes combined with level 3 and it introduces the ability to trade credit spreads.

A credit spread is like a debit spread, except that the trader executing the spread receives the premium.

Since calculating potential losses is more complicated than previous levels, inexperienced traders are exposed to potentially higher losses than they might otherwise have expected, making this a much higher risk level

Trading Level 5

Trading level 5 carries the highest risk as it allows traders to write calls and put options without having to own the underlying stock.

These types of trades expose account holders to the potential of unlimited losses, so they should only be traded by highly experienced options traders.

A key requirement of this level is that the account holder keeps cash as ‘margin’ in the account, which can be taken by the broker if the trade moves against the account holder.

Increasing Your Trading Level

If you’re ready to take on more advanced and high-risk strategies you’ll need to contact your broker as they will typically not upgrade your level automatically.

After contacting your broker asking for a new level, the broker will review your trading history and account size to see if you’re an eligible candidate.

Due to the margin requirement for trading level 5, you’ll only have access to this level with significant capital, typically in the hundreds of thousands of dollars.

Trade safe!
Gav.

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now