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. 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 brokers typically classify every options accounts into one of five levels as you can see in the picture above. Trading level 1 typically allows you to only perform the Covered Call and Protective Puts options trading strategy.
Trading level 2 allows you to buy call options or put options on top of what Trading Level 1 allows you to do.
Trading level 3 allows you to trade debit spreads on top of everything level 1 and 2 allows.
Trading level 4 allows you to put on credit spreads which put cash into your account the moment they are performed.
Trading level 5 allows you to write call and put options without first owning the underlying stock.
The two main factors that determine your initial trading level are your experience and your networth.
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. First of all, options brokers typically do not upgrade account trading levels automatically.
Data and information is provided for informational purposes only, and is not intended for trading purposes.
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".
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.
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. 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.
This is where you get to "play banker" to other options traders who are speculating through call and put options buying.
The more experienced an options trader, the lower the percieved risk to yourself and your broker.
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.
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. Each options broker may have slightly different ways of classifying an account and the kind of strategies allowed.
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 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. 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.
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. 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.
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. 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. At this level, options traders are not able to buy call options or put options without first owning the underlying stock. This is how a lot of beginner options traders lose a fortune and should only be performed by experienced options traders. 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.
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.
On top of that, writing options requires a significant amount of cash as "Margin" which denies most small retail traders.
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.
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