Option Trading Approval Levels Explained

Option level approval is one of the commonly overlooked aspects of options trading. It is an inherently leveraged instrument and has counterparty risks. Therefore, brokers have developed different trading levels in order to limit their access to options trading.

Option Trading Approval Levels Explained
option approval letters

As options traders, you should understand different tiers of trading approval levels. Many new as well as experienced traders are unaware that there are certain trading level and how to evaluate which level they are currently at. You can become an efficient and successful trader by comprehending the trading level system and how brokers determine the trading level for the short position or long position margin account.

Option trading levels

Option level approval is one of the commonly overlooked aspects of options trading. It is an inherently leveraged instrument and has counterparty risks. Therefore, brokers have developed different trading levels in order to limit their access to options trading.

As options traders, you should understand different tiers of trading approval levels. Many new as well as experienced traders are unaware that there are certain trading level and how to evaluate which level they are currently at. You can become an efficient and successful trader by comprehending the trading level system and how brokers determine the trading level for the short position or long position margin account.

What is the purpose of creating option trading levels?

Several methods have been introduced so that options can be traded. These ways include different types of options trade, for instance, covered calls and naked write options. Moreover, advanced strategies such as credit spread are also included. Some strategies and types are easy to comprehend and carry less risk. Conversely, other types and strategies are pretty complicated and have the potential risk of harm and unlimited losses.

Moreover, in several situations, traders fall prey to loss more than they invest due to no experience. Hence, brokers have placed limits on new accounts to provide protection to beginner traders and prevent them from indulging in complicated and risky trades. These options trading levels not only protest traders but also broker them from engaging in trouble with authorities.

Now when a broker makes a new account, he will have to pass the additional risk assessment test held by the owner of the account. According to the risk assessment of the investor and capital to trade in the account, the account owner will assign different trading levels. It will have access to trades with different levels of risk.

If you are a new broker, do not get surprised if you open an account and cannot access your favorite trading strategy.

The options trading level

For the majority of brokers, there are four to five trading level. Among these trading level, level 1 is considered the lowest while level 4 is the highest regarding the experiences level and acceptable risk level. Except that, investor who gets level 0 are not allowed to trade, and trader with a -1 level means the trader side has been suspended.

options trading levels

However, here are four general trading levels used assigned to most brokers. Let's walk through it.

Covered Calls and Cash-Secured Puts - Level 1

Trading Strategies

  • Sell covered calls

  • Sell cash-secured puts

The first level is generally assigned for covered short calls as well as cash-secured puts which do not require a margin account. When shorting these options a trader will need to own the shares of stock or have the ability to buy the shares of stock. Basically, covered calls happen when the writer of options genuinely owns the shares for the option writing and has the ability to offer the typical delivery of the share if the stock price exceeds the predetermined strike price.

For instance, if a trader owns one hundred shares of stock the trader has the ability to sell one call option for a specified price. When the underlying stock rate crosses the covered call strike price, the holder will be assigned, which will result in selling the shares to the option buyer at the strike price of the option.

covered calls

On the other hand, a cash-secured put straightforwardly implies that the trader has the money in his pocket to purchase the shares at the strike price if the option gets assigned.

However, no potential risk associated with the broker connected to the covered calls and cash-secured puts because they can directly get or receive this share from the traders in return for the exercise rate. This level is specially assigned to inexperienced brokers to avoid fraud and mishaps. At this level, the trader does not have the ability to borrow money from the broker on margin.

Extended Options trading - Level 2

Trading strategies

This step is an incremental improvement over the previous level and allows buy stock options contracts. Here the trader is permitted to perform the level 1 strategies of covered calls and cash-secured puts. Level 2 options trading does present more risk for the trader but not too much to the broker. Brokers increase the barrier to buying long options for traders because of how quickly those options can go to zero.

Traders who know to trade simple logic may not be able to understand the effect and influence that option can have on a portfolio. It generally happens because of their inherent leverage when they are indulged in the comparison to traditional securities.

Long options can result in traders losing all their money very quickly. Level 1 options trading is mainly for shorting options which is the least risky strategy for the broker and trader because of how likely options go to zero.

options value and time decay

Options spreads – Level 3

Strategies of trading options

  • Credit Spreads

  • Buying calls as well as puts

  • Long straddles/strangles

  • Cash secured puts

  • Covered calls

Option approval level 3 involves buying and selling spreads regardless of considering whether they are horizontal, diagonal, or vertical. However, the trader is required to use a margin account which can increase the risk of a margin call. Having the reach or rights to margin trading means that traders can lose more money than the amount inside their accounts. The ability to lose everything and more make this new level particularly dangerous for those traders who don't completely understand.

put credit spread

However, option spread requires a thorough and deep understanding as well as know-how with options trading. Because they utilize a wide range of options with many different potential sales and purchases at different places in time according to the strike price of the underlying security progresses throughout the option spread.

Hence, full rights to the margin needed and are essential for spread trading is saved for the level of a trader with previously proven abilities in options trading. However, there are limitations on each of these levels of options strategies. Limitation to something without ownership belongs to the underlying position or next level.

Naked Calls and Puts - Level 4

Strategies of trading options

  • Selling uncovered call option and puts

  • Short selling/straddles

Option approval level four is the highest approval level, and at this level, any option strategy can be performed as long as the size of the account is in the broker's favor. However, it revolves around the purchase of short call options and short protective puts that are basic options on the margin with the highest potential risk.

short straddle

Only the experienced, seasoned, and knowledgeable option investors get access to this highest option approval levels and buying puts. In a tiered system where the levels are implied, this level is the most complex level to understand as a trader and a broker. In order to achieve this level, there are specific requirements, including a few years of this sort of options trading experience with a healthy account balance. Generally, it should be in the six figures range.

Which options trading level is the best?

Level 1 is the best option approval level as it does not require margin. It allows the trader sells covered calls and cash-secured puts. All of these options sold are backed up by the proper amount of capital or stock.

How to know what level you are currently at for trading options?

It is the most frequently asked question because it is natural to wonder which trading level you are working at. However, if you want to know about the level of approval you are trading at, there are some options to determine it.

First of all, you can check your brokerage account and figure out what trade options are available to you and what you can access.

Secondly, you can also reach out to your broker directly online or by phone and ask about your level. They can tell you about your option approval levels.

Robinhood option trading levels below show that this user is a level 3 which is the highest level this broker gives. To find this level the trader must to their "account settings" and then hit "investing."

trading levels on robinhood

Accessing the levels of options approval

Brokerages offer the new investors a form on which they are supposed to mention their experience as well as knowledge regarding options trading. After that, the broker will utilize this information along with the underlying shares to determine the accounts option approval level.

However, the brokers have created a sound vetting system. Moreover, the traders are directed to be truthful when detailing their experience and knowledge about this sort of trading. Hence, the trader can get the proper and deserving level of trading options.

These levels are as crucial to brokers as to traders and are designed especially for traders' benefit and underlying security. Therefore, it is crucial to collect the legit information regarding options trading before getting into the tricky as well as risky strategies.

Afterward, the trader can acquire experience by practicing trading at their assigned level. Then they request a higher level of access. Once you become a pro at your level, then wait to get access to a higher trading level automatically.

What should one do to climb to the next level of option contract?

Whatever level you are on, whether it is 1, 2, or 3, if you want to climb to the upper level, it will require some proactivity on your part. Sometimes, your account automatically upgrades after a while because of the amount of capital and the age. However, you will likely ask your broker to upgrade your account to the next level in most cases.

If you are planning to reach out to your blocker, provide him with a legit reason to upgrade your account. Moreover, if you have demonstrated consistency and wisdom in your trade, you have a higher chance to get approval for the higher approval level.

levels of trading on robinhood

On the other hand, if you do not have enough experience or you do not maintain enough capital in your trading account, the broker may reject your request. For the majority of brokers, six figures in your account are the primary requirement.

However, if you do not agree with your brokerage's reasoning to not upgrade your account, you are allowed to look for a different brokerage that can approve your account to upgrade to the next level.

Conclusion

Setting the option approval level is the best step taken by brokers to induce underlying security. These levels hold significance and are vital for mitigating risk. These levels are advantageous for both sides. On the trader's side, the levels can help protect novice traders as well as inexperienced traders from getting into the trades that are too complex strategies and highly risky. On the other hand, on the broker's side, the approval tiers help ensure that qualified traders receive access to margins. It will protect the brokers from getting themselves indulged in traders who do not have the potential to pay back a margin call or particular stock.

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