Most investors know that the right broker and sufficient knowledge are crucial factors for success in options trading. However, many are less familiar with options trading levels—another factor that impacts trading performance. What are options trading levels? How are they assigned? Can one choose their trading level, and how? Let’s answer these and other relevant questions in this article.
What Are Options Trading Levels?
Options can be much more complex than stocks because of the inherent leverage and counterparty risks. Brokers, who are strictly regulated, are responsible for ensuring investors take on risks commensurate with the experience level and capital those investors possess.
Options trading levels, also known as approval levels, constitute a mechanism designed to protect investors from excessive losses and brokers from consequent liability.
The idea behind trading levels is that investors execute only trades that suit their experience and ability, not riskier ones. Thus, how you trade options does not just depend on the trading platform you use but also on the trading level you are assigned.
Understanding the Different Options Trading Levels
There is no universal system with clearly defined elements of trading levels as every broker has its own methods for assigning trading levels. While following the general guideline based on widespread practice, you must check with your broker how they define the various trading levels.
Interestingly, most brokers assign levels from 1-5 where 1 is the lowest indicating limited stock trading, while 5 is the highest indicating wider probabilities.
Trading Level 1
Level 1 has a risk similar to investing in stocks. Typically, the only trades allowed at this level are covered calls and puts options. These are hedging strategies where you own the underlying stock, so the risk is minimal.
Trading Level 2
Level 2 adds slightly greater risk through the ability to make directional bets. The trades typically allowed at Level 2 are long calls and long puts, that is, buying a call and put options without any underlying security. As the investor is only buying the option in either case and not writing it, the most money risked is the original investment.
Trading Level 3
Level 3 ups the complexity by allowing investors to write options to create debit spreads. A debit spread requires an upfront expense, with the risk limited to the loss of this amount. Some beginners with reasonably high options knowledge can also attempt this level as the losses are capped.
Trading Level 4
Level 4 allows investors to write credit spread and, in some cases, may be combined with Level 3. Credit spreads differ from debit spreads, where the premium goes to the trader executing the spread. The main reason credit spreads are categorized under higher risk is the complexity of calculating potential losses and the exposure to higher losses.
Trading Level 5
All trading strategies are allowed in Level 5, including writing naked calls and put options. Since one could lose more than the initial investment, brokers allow only highly experienced options traders with a notable requirement of having a margin account.
How Are Options Trading Levels Assigned?
When you sign up with an options broker, you need to answer a series of questions on your investing experience, understanding of options, risk tolerance, and more. The broker’s compliance team will then evaluate your filled form and ask you to provide verification for some of your answers. Finally, they will take a call on the level to be assigned to you.
The process does not mean that you can’t influence the options trading level you get. While the specific criteria for level assignment can vary from one broker to another, the compliance team is generally concerned with two factors: your relevant experience and your financial position.
If you demonstrate strong options trading knowledge, you will likely be assigned a higher level it is vital to be truthful at this stage instead of feigning knowledge to qualify for a high level. Similarly, a large starting capital or high net worth will likely mean a high trading level.
Besides knowledge and financial wherewithal, other factors also come into play while assigning trading levels. Higher trading levels often require additional account features, such as a margin trading account and a minimum balance.
You may also favor certain strategies that simply don’t require a high level. For example, long-term investors often limit their exposure to covered calls, which is possible with Level 1.
Choosing the Right Options Trading Level
As the above section makes it apparent that no options trading level is without risks. The right level for you depends on factors specific to you. Remember that with most options brokers, you can request reassignment to a higher level after gaining some experience. Many brokers reevaluate their clients’ approval levels periodically, so you may move to a higher level automatically.
The bottom line is that you must begin with an options trading level that you are completely comfortable with, try out different strategies to gather experience, and then move to the next level.
If you have absolutely no experience with to trade options, Level 1 may be the best choice for you. Most beginners, however, begin with the slightly riskier Level 2.