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Options Accounts Trading Levels
Options Accounts Trading Levels - Introduction
The very first thing that stands in the way of a beginner to options trading is the long risk compliance form that needs to be filled out when opening an options account. After the form is filled out and the account started, they are usually greeted with the shocking and frustrating realization that they are unable to perform most of the sexy options strategies that they have learnt due to insufficient "Trading Level" or "Approval Level".
What exactly are options accounts trading levels? What is the purpose of trading levels, how are they determined and how can you increase your trading level?
Options Account Trading Levels - Purpose
The purpose of trading levels in options trading accounts are simply to control the risk of traders performing high risk trading without sufficient experience and funding. Derivatives trading, such as options trading, have been blamed by many who claimed that they did not understand the risks they were undertaking when they got burnt. When such options traders point their fingers at their brokers for allowing them to take on more risk then they are qualified or experienced enough to do so, options brokers get into trouble with the authorities. As such, all options brokers have since started a risk assessment of all new options account holders in order to determine the amount of risk they are suitable to undertake and since different options strategies have different levels of risk, trading levels were created based on the relative "riskiness" of each class of options strategies.
Indeed, the options account trading levels policy is a policy that not only protects new account holders from risk but also options brokers from litigation from disgruntled options traders.
Options Account Trading Levels
Options brokers typically classify every options accounts into one of five levels as you can see in the picture above. More comprehensive options brokers such as Optionsxpress.com has level 0 for trading of stocks and funds only as well as a level -1 for suspended accounts. Each options broker may have slightly different ways of classifying an account and the kind of strategies allowed. We will go into some of the most common practises here. You should consult your options brokers on the specific criteria that they use.
Options Account Trading Level 1
Trading level 1 typically allows you to only perform the Covered Call and Protective Puts options trading strategy. Both options strategies are more of a hedging strategy rather than speculative in nature as such options strategies require the options trader to own the underlying stock. A Covered Call is when you write out of the money call options on stocks that you own in order to hedge against a small drop in price on the underlying stock and a protective put is when you buy put options as protection on stocks that you own. At this level, options traders are not able to buy call options or put options without first owning the underlying stock.
Options Account Trading Level 2
Trading level 2 allows you to buy call options or put options on top of what Trading Level 1 allows you to do. This is the level most beginners to options trading start at. At this level, options traders can only perform simple directional speculation by buying call options or put options without the flexibility of writing them or using them as part of a spread. Risk is therefore limited to the amount of money put towards purchasing the options.
Options Account Trading Level 3
Trading level 3 allows you to trade debit spreads on top of everything level 1 and 2 allows. Debit spreads are options strategies which you actually need to pay cash to put on while credit spreads give you cash for putting them on. An example of debit spread is the Bull Call Spread where you write an out of the money call option on the call options that you bought. Debit spreads are typically made up of both long and short options. Risk is limited to the amount of money paid towards putting on the spread. Even though risk is limited in this sense, it is a lot more complex than simple call options and put options buying and requires more knowledge on the part of the options trader.
Options Account Trading Level 4
Trading level 4 allows you to put on credit spreads which put cash into your account the moment they are performed. An example of such an options strategy is the Short Butterfly Spread. Such options strategies are not only a lot more complex to execute and exact potential losses can be complex to calculate for beginners as well, leading to unexpected loss amounts.
Options Account Trading Level 5
Trading level 5 allows you to write call and put options without first owning the underlying stock. This is where you get to "play banker" to other options traders who are speculating through call and put options buying. Such positions again exposes you to unlimited risk which means that losses accumulate indefinitely when things go bad. This is how a lot of beginner options traders lose a fortune and should only be performed by experienced options traders. On top of that, writing options requires a significant amount of cash as "Margin" which denies most small retail traders.
Main Factors Which Determine Your Initial Trading Level
The two main factors that determine your initial trading level are your experience and your networth. The more experienced an options trader, the lower the percieved risk to yourself and your broker. This is why there are a whole lot of questions like how long you have been trading and the kind of instruments you have been trading in every risk assessment form when opening an options trading account. Similarly, the richer you are, the more losses you can afford to take and hence the lower the risk to yourself and your options broker.
Most options brokers would not require verification or proof of the information provided and has led to a lot of beginners making false claims in order to qualify for a higher options account trading level.
How To Increase Your Options Account Trading Level
First of all, options brokers typically do not upgrade account trading levels automatically. When you think you are ready for a higher level or that you think you ought to qualify at a higher level, you need to call up your broker to discuss the matter with them. Typically, your options broker would look at your past trading record as well as your account size in order to decide if you should be placed at a higher trading level. However, since level 5 naked options write requires nothing more than a large fund size in order to satisfy margin requirements, you should be able to discuss for a level 5 account placement as long as you have that kind of cash in your account, typically USD$200,000 and above.