What are options trading levels? Brokers implement levels on new trading accounts to protect new traders. Options allow you to trade big-name stocks with less money. However, there can be more risk involved. You need to understand the ins and outs of options trading if you want to be successful.
Before we discuss the details of all the different options trading levels, let’s briefly define options. Unlike individually trading the underlying asset, options trading allows you to make money without committing significant capital.
In options trading, the buyer has the right but not the obligation to buy or sell a specific underlying asset at a particular price and time. This underlying asset includes stocks, commodities, currency pairs, and even cryptocurrencies.
Why I Like Options: Less Risk (Sort Of)
Some strategies can be less risky depending on the trading level of options. Options trading can be complex. However, it’s often considered lower risk than stock trading for several reasons.
One key factor is the lower upfront financial commitment required in options trading than in stock trading. The price of buying an option (including the premium and trading commission) is typically lower than the cost of purchasing individual stock shares.
By using options, investors can also employ strategies to limit potential losses and manage risk more effectively. Various options strategies, such as protective puts or covered calls, can help mitigate risks associated with market volatility and unexpected price movements.
Why I Like Options: More Control With Less Money Required
Additionally, options trading allows investors to control a larger position with less capital than stock trading. For example, investing \$10,000 in options can allow a trader to control more shares than investing the same amount in stock.
Let’s consider an example to illustrate how options trading allows you to control a larger position with less capital than purchasing a stock outright.
Let’s say stock ABC is currently trading at \$100 per share. If you want to buy 100 shares of ABC, it would cost you $10,000 (100 shares * $100 per share). But you would only control 100 shares.
Enter options trading.
Options Trading Example
Instead of buying 100 shares outright, consider buying call options contracts. Assume ABC has a call option with a strike price of $100 and an expiration date of one month. One call option contract costs \$5 (500 premium per contract, assuming each contract represents 100 shares).
With the same $10,000 investment, instead of buying 100 shares of ABC, you could purchase 20 call options contracts (20 contracts * $500 premium per contract = $10,000). Each contract represents 100 shares, so you would control 2,000 shares(20 contracts * 100 shares per contract).
If ABC’s price rises to $110 per share, your options contract will gain value. Assuming the options contract has a delta of 0.5, for every \$1 increase in the stock price, the options contract would increase by \$0.50 (0.5 delta * \$1 price increase).
With the stock price at \$110 per share, your call options contract would now be worth \$5.50 (0.5 delta * \$10 price increase). Since you have 20 contracts, the total value of your options position would be $11,000 (20 contracts * $550 per contract).
In this example, your options position gained $1,000 ($11,000 – $10,000), while if you had bought the stock outright, your gain would have been $1,000 (100 shares * ($110 – $100) per share).
As you can see, utilizing options allows you to control a larger position (2,000 shares) with the same $10,000 investment as buying 100 shares outright. Options trading provides leverage, which can amplify potential gains while using a smaller amount of capital. How fantastic is that?!!!
5 Minute Takeaway: The Four Options Trading Levels
- Typically, there are four options trading levels.
- Level 1: Covered Calls is the basic level of options trading. Covered calls involve owning the underlying security and selling call options against it.
- Level 2: Long Calls and Puts involving buying call and put options
- Level 3: Spreads involve simultaneously buying and selling multiple options contracts on the same underlying asset with different strike prices or expiration dates.
- Level 4: Selling naked calls and Puts is the riskiest level of options trading and must be approached cautiously.
The Many Different Options Trading Strategies Available
Several options trading strategies, such as covered calls and protective puts, are considered less risky. On the other hand, others, such as naked puts and calls, can be regarded as high risk.
Traders must understand the options trading market and the various trading strategies to minimize risks and maximize potential profits.
Beware of the Danger of Options: Leverage
If you’ve read this far, you’ve probably figured out that trading options give you leverage—and lots of it. Because of this, the counterparty writing the options is put at risk.
Hence, brokers have developed a tiered system of option approval levels for traders, limiting their access to options trading.
The Tiered System of Option Approval Levels
Options trading levels are limits brokers impose on new accounts to regulate the type of options trading strategies the account holder can execute. These levels are typically determined based on the account holder’s trading experience, knowledge of options, and risk tolerance.
Traders have four levels of option approval, each providing access to different types of options trading based on their experience and resources. Likewise, options traders need to understand the various option approval levels and learn how to qualify to trade options at each option approval level.
The specific options trading levels can vary among brokers but generally follow a standardized tiered structure. Commonly, there are four levels of options trading.
Options Trading Levels: Level 1 - Covered Calls
Covered calls are the basic level of options trading. Covered option calls, or covered calls, are a trading strategy for lower-risk options. The strategy is “covered” because the investor already owns the underlying stock, which can potentially mitigate risk. By selling call options, the investor collects premiums from the buyers of those options. The premium from selling the call options can help offset potential losses if the stock price decreases or remains stable.
In a covered call, the trader who owns the underlying stock sells call options on that same stock. It involves holding a long position in an asset (such as a stock) and writing (selling) call options on that asset.
The trader may be required to sell the stock in a covered call strategy if the call options are exercised. If the stock price rises above the strike price of the call options, the buyer may choose to exercise the option, and the investor will be obligated to sell their shares at the predetermined strike price.
Neutral or mildly bullish traders typically use the covered call strategy. It allows them to generate additional income from the premiums received from selling call options while still participating in potential price appreciation up to the options’ strike price.
It’s important to note that while covered calls can provide income and potential profit, risks are still involved. If the stock price rises significantly above the strike price, the investor may miss out on further gains as they will have to sell their shares at the strike price.
Level 2 - Long Calls and Puts
At this level, the account holder can trade long calls and put options in addition to covered calls. Long calls give the holder the right to buy the underlying asset, while long puts give the holder the right to sell it.
The level 2 long calls and puts options strategy employs more advanced trading techniques involving buying a call and put options. Investors typically use this strategy with a moderately bullish or bearish outlook on a particular stock or security.
A long call option is an options contract that gives the holder the right, but not the obligation, to buy the underlying asset at a specified price (known as the strike price) on or before the expiration date. By purchasing a long call option, the investor hopes that the underlying asset’s price will rise above the strike price, allowing them to exercise the option and profit from the price difference.
On the other hand, a long put option is an agreement that allows the holder to sell an underlying asset at a specific price (also known as the “strike price”) on or before the expiration date, but they are not required to do so. Investors who purchase long-put options expect the asset’s value to decrease below the strike price so they can profit from selling it at the higher strike price.
These are Level 2 strategies because they involve advanced trading techniques beyond basic options buying and selling. Level 2 options trading requires more knowledge, experience, and ability to analyze market trends and make informed predictions about the underlying asset’s movement.
Level 3 - Spreads
Spreads are an intermediate options trading level that involves using combinations of different options contracts to create specific risk and reward profiles. Furthermore, spreads involve simultaneously buying and selling multiple options contracts on the same underlying asset with different strike prices or expiration dates.
Some popular option spreads include vertical, horizontal, butterfly, condor, calendar, and credit spreads. Bullish Bears offers fantastic options trading courses that explore different strategies. And better yet, they’re free. Click here for our Options Trading Basics course.
Level 4 - Selling Naked Calls & Puts
Without a doubt, these strategies (i.e., naked options writing, short straddles, and iron condors) have the highest level of risk.
When selling naked calls, you don’t own the underlying stock. Hence, there’s the risk of unlimited loss since there’s no limit to how high a stock’s price can go. Furthermore, the primary risk of naked calls is that the seller may be obligated to sell the underlying asset at the strike price if the option is exercised. Since there is no limit to how high the underlying asset price can rise, the naked call seller potentially faces unlimited losses if the price surpasses the strike price.
Selling naked puts is also risky, but maximum loss can be reached if a stock falls to zero. Similarly, the risk of naked puts is that the seller may be required to buy the underlying asset at the strike price if the option is exercised. If the asset price declines significantly, the seller could face substantial losses.
Another risk when writing naked options is the potential for adverse market movements. If the market moves against the writer’s position, they may incur losses due to changes in the underlying asset’s price or other market factors.
The Broker Calls the Shots
It’s important to note that brokers may have different criteria and requirements for approving each level of options trading. Traders interested in accessing higher levels may need to meet specific account sizes, trading activity, or financial suitability requirements, which vary by broker.
Options Trading Levels Final Thoughts
It’s important to note that options trading also carries risks. Risk includes the potential loss of the entire premium paid for the option if it expires out of the money.
Understanding options trading levels, strategies, and risks is essential before trading. There’s a reason why people love options trading. You trade large-cap stocks with less money. It’s a great way to build a small account when you know what you’re doing.
Options are a great way to limit risk. As a result, you protect your profits. So, learn the ins and outs of options trading. And watch your account grow.
Frequently Asked Questions
Level 1 options trading refers to selling covered calls. Level 2 options trading refers to trading long call and put options.
A risky trading strategy where the trader sells naked calls and puts.
It involves trading spreads in which the trader simultaneously buys and sells multiple options contracts. These contracts are on the same underlying asset with different strike prices or expiration dates.
Level 5 naked options write requires at least USD 200,000 in your trading account to satisfy margin requirements.
Some brokers assign trading levels up to 5.
