The Different Options Trading Levels

If you are getting started with options trading, you may have seen that your broker has several options trading levels, each with their own strategies. Reaching higher levels as an options trader gives you more flexibility with how you trade options and may potentially profit from stock price movements but may also come with greater potential risk of losses. Some traders want every options trading choice, while others prefer to only have the basics. Understanding how each options trading level works will help you determine which level makes sense for you.

Making Sense of the Trading Levels

Options trading levels help manage certain risks by giving new traders an opportunity to start with less complex options trading strategies. Every investment strategy carries risks, but Level 1 options trading strategies are generally less risky when compared to than Level 4 options trading strategies. You can start as a Level 1 options trader and potentially move up as you gain more experience. Some brokerage firms quiz you on options trading to assess your level, while others raise your level after you’ve had enough experience trading at the first level.

4 Options Trading Levels

You can’t start trading options upon opening a brokerage account. Every trader must apply to trade options and specify which level they want. Level 1 options trading is typically the most common for new applicants. While you may get approved for Level 4 options trading on the first try, you may have to trade options at other levels before receiving Level 4 privileges. In general, these are the available options trading levels.

Level 1: Covered Calls and Cash-Secured Puts

Level 1 lets you access covered calls and cash-secured puts. These strategies are generally less risky when compared to other advanced strategies and can be good for beginners. If you want to sell a covered call, you must have 100 shares of the underlying company. If you have a $50-per-share cost basis for 100 shares and sell a covered call with a $55 strike price, you have to sell your shares at $55 per share at expiration if the stock hits or exceeds $55 per share. If not, you get to keep the premium. Having the underlying shares before selling the call limits your losses and lets you get immediate income through the premium. However, there are two big risks of this strategy. Losing money if the stock price declines below the breakeven point and the opportunity risk of not participating on the upside in case of a large stock price rise past the strike price of the call option.

Level 2: Long Options

Level 2 trading lets you access long puts and calls. Puts are contracts that gain value when the underlying stock’s price decreases, while calls gain value when a stock experiences bullishness. The premium and strike price contributes to the investor’s break-even price point. If a trader buys a long call with a strike price of $75 and pays a $2 premium, that trader needs the stock price to reach $77 to break even. Anything above $77 represents a profit.

Some investors sell out of their long positions before the expiration date if the option has gained in value. As an option gets closer to its expiration date, it will lose value, especially if it is far out of the money. Traders need stock prices to move in their direction to compensate for an option contract’s time decay.

Level 3: Option Spreads

An options spread involves trading multiple options contracts of the same company. The strike prices and expiration dates vary depending on the trader’s objective. Traders using bull spreads will purchase a long call with a lower strike price. The trader will then lower the net cost by simultaneously selling a call with the same expiration date but a higher strike price.

An options trader lowers their cost for initiating the long position but also caps their

upside. Potential profit is limited to the difference between the long call strike price and the short call strike minus the net debit paid. A bull spread is one of the many spreads you can use once you become a Level 3 options trader.

Level 4: Naked Contracts

Naked contracts are the highest level of options trading because of the risks. Only the most experienced options traders should use naked call contracts. These contracts are like covered calls and cash-secured puts but without the protection of having the underlying assets. .These traders can sell uncovered calls and puts to earn the premiums. A trader will have to raise enough funds before the expiration date to purchase 100 shares for a

naked call if it's exercised. Naked puts are risk defined when compared to naked calls. A naked call's theoretical risk is unlimited since there's no cap to how high a stock price can rise. A naked put 's potential loss is also substantial, but limited to the strike price minus the premium received if the stock goes to zero.

How To Apply for Options Trading

Each brokerage lets its clients apply for options trading. You will have to complete an application before accessing any options trading level. After filling out basic information and answering questions about options trading and your investment goals, your brokerage firm will assign an options trading level for your account. If you want a higher level among other requirements, you must first demonstrate your ability to trade options at your current level.

Choosing the Right Level

Brokerage firms establish options trading levels based on experience level and risk tolerance. Incurring more risk creates the opportunity for potentially higher returns, while lower levels provide less complex and more risk defined strategies. If you are just getting started with options trading, the first level can be a great starting point. This level gives you the opportunity to learn the basics. As you get better with options trading and feel more confident, you can reach out to your broker and request to trade at a higher level.

Deciphering the Complexities of Options Trading

Experience is a good teacher, but it's good to build up your knowledge and start with a low level if you decide to pursue options trading. Understanding the available trading strategies at each level will help you acquire additional flexibility that aligns with your financial goals.

Frequently Asked Questions About Options Trading Levels

What is the best options trading level?

It depends on your risk tolerance and options trading experience. Level 1 options trading are generally less complex and the strategies are risk defined. Level 4 is generally better for people who have high-risk tolerances and are advanced option traders.

Which options trading level has more strategies for novice traders?

The first level is a great way to get started because traders at this level can only use covered calls and cash-secured puts. Be aware that each has their own risks. The risks for the covered call was covered above. For cash secured puts, the big risk is getting assigned and the stock price potentially falls drastically.

What options trading level is generally considered a starting point for beginners?

You should start at the first level to become familiar with how options trading works.