In the previous article in this guide, we discussed the importance of choosing the right online options broker. Signing up with a broker is a necessary step you must take before you can actually begin trading options, and doing so isn't always particularly straightforward. For one thing, deciding which one is right for you can be tough because of the huge range of them that exist.
Once you have selected an appropriate options broker for your requirements, you then will typically have to go through a fairly lengthy approval process before your account will be opened and ready to use. You have to go through this process so that your broker can carry out a risk assessment and decide what trading level, or approval level, you should be assigned.
Trading options isn't as simple as just signing up with a broker and then making whatever trades you want; the risks involved in certain trades and strategies means that brokers have to be responsible and only allow individuals to make trades that are suitable for them. For example, a complete beginner with a small amount of starting capital wouldn't be allowed to start using complex strategies with unlimited risk exposure.
Trading levels are essentially how brokers control the level of risk that their customers, and themselves, are exposed to. On this page we explain these levels in more detail, covering the following:
- The Purpose of Trading Levels
- How Trading Levels are Assigned
- What Each Trading Level Allows
- Increasing your Trading Level
The Purpose of Trading Levels
The purpose of trading levels, also known as approval levels, is essentially to provide a form of protection to both the broker and the customer. Options brokers are regulated and have a duty to look out for the best interests of their customers, which gives them a form of obligation to ensure that their customers only take risks in which they have sufficient experience and funds for.
It isn't entirely uncommon for investors and traders to employ high risk strategies when they don't really know what they are doing and don't have the necessary capital. If things go horribly wrong the broker is potentially liable, so they assess their customers and assign them trading levels so that they can only ever carry out transactions which are commensurate with their experience and their funding. By doing this, both the customer and the broker are protected from excessive exposure to risk.
How Trading Levels are Assigned
When you sign up with an options broker, you will usually have to provide detailed information about your finances and previous investments that you have made. You will typically be asked a series of questions that will help the broker understand your level of knowledge and risk tolerance.
Your application will then be reviewed by the compliance department and they will determine what trading level you should be assigned based on the information you have provided. In some cases, you may be required to provide verification of certain aspects of your application.
Essentially, brokers concern themselves with two main factors when assigning you your initial trading level: your relevant experience and your overall financial position. Experienced investors that can demonstrate they have a solid knowledge of options trading will usually be assigned a higher level because there is an assumption that they know what they are doing.
Those with a high net worth or a large amount of starting capital will also tend to be given a high trading level too. There'
s no standardized formula for calculating what level is assigned, and the criteria can change from one broker to another.
What Each Trading Level Allows
Most options brokers assign trading levels from 1 to 5; with 1 being the lowest and 5 being the highest. A trader with a low trading level will be fairly limited in the strategies they can use, while one with the highest will be able to make pretty much whatever trade they want.
In the same way that brokers all have their own methods for assigning trading levels, they also usually have slightly different ways of classifying trading strategies. Because of this, there isn't a definitive list of what strategies each trading level allows at every broker; this is something that you must find out directly from your options broker. We can, however, provide a rough idea of what you can usually do at each level.
With a trading level of 1, you'll probably only be able to buy and write options where you have a corresponding position in the underlying security. For example, if you owned stock in Company X then you would be able to place a buy to open order for put options on Company X stock. This would give you the right to sell your stock at an agreed strike price and the only additional risk you would be exposed to is the amount of money it costs to use those options.
You would also be able to place a sell to open order on call options on Company X stock, giving someone else the right to buy your stock at an agreed price. Even though you would technically make a loss if Company X stock went up in price and you were forced to sell it below market value; there's no additional exposure risk because you already own the stock.
A trading level of 2 would typically allow you to also buy call options and put options without having a corresponding position in the underlying security. You would only be able to buy options contracts if you had the funds to do so which means there isn't a huge amount of risk involved. The worst case scenario is that the contracts expire worthless and you lose the funds invested, but you couldn’t lose any more than your initial purchase. This trading level is usually the lowest one assigned.
Trading level 3 would usually allow the writing of options for the purposes of creating debit spreads. Debit spreads are options spreads that require an upfront cost and your losses are usually limited to that upfront cost. Although debit spreads involve writing options without a corresponding position in the underlying security, the losses are limited by having multiple positions on options contracts based on that same underlying security.
For example, you could create a debit spread by writing call options on a particular stock and buying call options on the same stock. Again, there's not a huge amount of risk associated with these trades, but the higher trading level is required due to the additional complexities of creating spreads.
For the creation of credit spreads, where you receive an upfront credit and are exposed to future losses if the spread doesn't perform as planned, you would normally need an account with trading level 4. This is because potential losses are more difficult to calculate. Trading level 5, being the highest, would basically give you the freedom to make whatever trades you wanted. You would, however, usually be required to have a significant amount of options margin in your account.
Increasing your Trading Level
There's no specific way to guarantee an increased trading level with your broker. Some brokers may review your account periodically and automatically increase it if appropriate, but this is quite rare. You would usually have to contact your broker directly and request an upgrade, but this would be entirely at the discretion of your brokerage firm. If you had a solid trading history with them and a reasonable amount of funds on account, then you would probably stand a good chance of being upgraded.
