In order to trade options, your broker will undoubtedly require you to fill out an options application and assign you one of several option approval levels based on your needs, knowledge, and other factors, including net worth.
Often times people wonder why they must be approved for options trading even though they may "completely" understand the particular strategy they are trying to execute. The reason is that there can be substantial risks in options, especially from factors outside the strategy.
For example, most people believe that the most you can lose from a long call position is the amount of the premium -- the amount you paid to buy it. While it is true that a long call can never have negative value by itself, the mechanics of the options markets do allow for further losses if you do not understand them as shown in the following example.
Example:I actually witnessed this trade at a brokerage firm. A trader was long 20 calls at $4. In his mind, the most he could lose was $8,000, which was the total paid for the contracts. However, if an equity option expires 3/4 of a point or more in-the-money, the Options Clearing Corporation (OCC) will automatically exercise the option for you. On the last trading day, the customer thought the option would expire worthless, as it was slightly out-of-the-money. A small rally in the stock pushed it to just over 3/4 of a point in-the-money at the close. Because he did not close out the option or contact his broker with instructions to not exercise, the option was automatically exercised and the customer was long 2,000 shares on Monday morning. Unfortunately, the stock opened down 15 points on bad news and the customer sold the stock at a $38,000 loss ($30,000 from the 15-point decline and $8,000 for the cost of the option to acquire the stock!). |
This is a perfect example of how large losses can occur if you do not understand the strategies, risks and mechanics of the options markets, and exactly why your broker will require (or at least should require) you to fill out an approval form.
Once you are approved, your broker will assign you one of several option approval levels. While there is no official standard, the following list should serve as a general industry guideline as to the permissible strategies under each level. Check with your broker for specific details with their firm.
There are usually four option approval levels available through most brokerage firms. For whatever reason, option levels are generally ranked from 0 to 3 although some firms do use 1 to 4. Level 0 is considered to be a basic level and level 3 is the highest. The levels are cumulative meaning that, for any given level, all strategies below that level are acceptable too. For example, all strategies allowed under level 0 and level 1 will be allowed in under level 2.
Here is a list of the basic definitions and strategies allowed under each level:
Allows you to buy stock and write calls against it.
Allows you to buy puts but only for a specific stock and in the amounts you hold. For example, if you have 500 shares of INTC, you could purchase up to 5 put contracts to protect your position.
Note: Some firms will allow index puts to provide overall protection, especially for large accounts, where buying puts on each position would be cost prohibitive.
Allows the investor to sell puts if the stock is short in the account. Careful, a lot of brokers will tell you that short puts require level 3 but this is considered to be covered (by the short stock) which is why it is generally allowed in a level 0. If your broker does not sound sure, have them check with a manager.
This is generally the only level that will be approved for Individual Retirement Accounts (IRAs), but there are some firms that will allow level 1 in an IRA.
Allows the outright purchase of a call or put. Level 0 also allows the purchase of a put too but only for protective purposes. Level 1 allows you to speculate that a stock or index will fall.
Note: There is a strategy called a "rollup" where you sell one option and buy another. For example, you may be long 10 $50 strike calls and the stock is now trading at $60. One strategy is to sell the $50 strike to close and buy the $60 strike to open. You can send these orders as a spread to the market maker in hopes of a better deal; after all, it is a spread order as you are buying one option and selling another. But it is not a spread position, because once the order is executed, you will just be long 10 $60 strikes; there will be no short positions in the account. This is because one trade was to close and the other to open.
This is a very powerful strategy and one discussed in a later article. Just be careful if you use this strategy in a level 1 account, that your broker doesn't reject the trade becaues he thinks it's a level 2 transaction.
Allows the investor to buy and sell options as a basic spread position with limited risk. So, the basic bull and bear spreads and long calendar spreads (buy a far month and sell a near month) will qualify. You cannot have a short calendar spread (buy near month and sell far month) or do ratio spreads (such as buy 10 $50 strikes and sell 20 $60 strikes) as this would expose you to potentially unlimited losses.
This is the highest approval level and anything goes -- as long as you have the equity to do it. Here, the investor can sell a call or put with no corresponding long or short position, respectively, to cover. Short calendar spreads and ratio spreads are all approved.
Note: Many investors like the strategy of naked puts, as it is effectively a way to get paid to buy stock you like. In order to do this, level 3 is generally required. However, if you do not qualify for level 3 and have a lot of equity (usually $500,000 or more but entirely up to the brokerage firm) you may be able to get approved for "cash secured puts." The firm will hold cash to the side assuming you will be assigned. That way, the firm is protected under the worst possible circumstances. I just mention this here as many investors attempt approval for level 3 for the sole purpose of naked puts, and are disappointed if they do not get it. If this happens to you, you may want to check to see if the brokerage firm will allow cash secured puts.
If you are new to options, do not be concerned if your broker does not give you the desired approval level immediately. Often times they want to see some option trading history before increasing your approval level. For example, you may want to execute spread orders and need to be approved for level 2. Your broker may require you to start at level 0 or 1 and then increase you to a higher level in six months or so with a successful demonstration of option trading at the given level.
Please understand that option approval levels exist for a reason. If you are not immediately approved for your desired level, there are plenty of option strategies you can use with the level you receive.