This article has been reviewed by Sumeet Sinha, MBA (Emory University Goizueta Business School). Should you have any inquiries, please do not hesitate to contact at sumeet@finlightened.com.
Options Trading Levels
Options trading is divided into four levels (some brokers have 5, but generally there are 4 levels). Level 1 is the most basic, and Level 4 is the most advanced. A broker may progress an investor through levels i.e. grant them access to a higher level of options trading, depending on change in the investor’s profile and experience.
- Options Trading Levels
- Why Are There Multiple Options Trading Levels?
- What is Options Trading Level 1?
- What is Options Trading Level 2?
- What is Options Trading Level 3?
- What is Options Trading Level 4?
- Conclusion on Options Trading Levels
Why Are There Multiple Options Trading Levels?
Trading Stock Options is risky. Options provide leverage, that can make quick gains for the traders but can also make quick losses for them. Brokerages set up levels in options trading as a guardrail to prevent unsuspecting traders from placing trades they do not fully understand and potentially losing money.
- Options Trading Level 1 allows the traders to place more ‘secure’ and less risky options trades i.e. selling call and put option contracts while having a cover (we’ll see this in detail below).
- Options Trading Level 2 allows the traders to buy call and put options, i.e. place slightly riskier bets.
- More advanced and riskier options trades such as buying and selling spreads are enabled in Options Trading Level 3.
- Selling naked calls and naked puts are enabled at the highest Options Trading Level i.e., Level 4.
The broker decides what level a trader is suitable for based on investor profile and trading experience, appetite for risk, etc.
What is Options Trading Level 1?
In Options Trading Level 1, You can SELL Call Options and Put Options
1. Selling Covered Calls (or Writing Covered Calls)
What is a Covered Call?
Covered Call is the strategy for generating income by selling an option contract when you own the stock. Suppose, you own 100 shares of a stock, (say AAPL – Apple company’s stock). You can write a call option contract and sell it to earn a premium. Your shares, i.e. 100 shares per contract written, are locked against that contract as collateral.
Why Would You Sell a Covered Call?
You can sell covered calls to generate some premium as income. Let’s say that you own 100 shares of a company’s (for example AAPL) stock. The stock is trading at $125 per share. You believe the stock can go up to a maximum of $150 per share before January 2022.
Sell a Covered Call To Earn Premium
In the screenshot attached, the investor is selling a covered call (assuming they own 100 shares of AAPL).
The expiration date of the call option contract is Jan 21, 2022.
The Strike Price is $150 per share.
For selling the covered call, the investor can earn a premium of $10.83 per share i.e. $1,083 per contract.
You can then write a covered call on your 100 shares and earn some premium, say $1,000. Based on the price movement of the stock, your outcomes will be different. Let’s consider the scenarios below.
Case 1: What happens if the stock price goes above $150?
If the stock price goes above $150, the buyer of the call option contract you sold, will exercise their option. By exercising their option, they will get your 100 shares, and you will be paid $150 * 100 = $15,000. This is in addition to the $1,000 premium you receive for writing the contract.
Case 2: What happens if the stock price stays below the $150 mark?
Let’s say the stock price stays below the $150 mark by the contract expiration date (Jan 2022). In that case, you get to keep the full premium, and your 100 shares will be released back to you for trading as you wish.
2. Selling Cash Secured Puts (or Writing Cash Secured Puts)
What is a Cash Secured Put?
You have some cash in your brokerage account. You write a put option contract, committing to buy 100 shares at a fixed price, until a certain date. For example, You have $10,000 cash available, and you write a put on AAPL stock, committing to buy 100 shares of AAPL stock IF the contract buyer chooses to exercise their option before the expiration date.
Why would you sell a Cash Secured Put?
For writing this put option contract, you get some premium as income, and since it is a cash-secured put, your $10,000 ($100 per share *100 shares) is kept as collateral.
Apart from collecting the premium, selling put can be a good strategy to buy the stock at a lower price. The premium collected further lowers the effective price per share.
Sell Cash Secured Put To Earn Premium
In the screenshot attached, the investor is selling a cash-secured put (assuming they have $10,000 cash in their brokerage account).
The expiration date of the put option contract is Jan 21, 2022.
The Strike Price is $100 per share.
For selling the cash-secured put, the investor can earn a premium of $5.65 per share i.e. $565 per contract.
Why would anyone buy a put contract from you? Because it gives them a certainty that no matter how much the AAPL stock price falls, they can sell the shares to you at the fixed price of $100 per share, according to the contract. It’s a risk mitigation strategy for them.
Case 1: What happens if the stock price falls below $100?
If the stock price falls below $100, the investor who bought the put option contract you sold, will exercise their option. They will sell their 100 shares to you @$100 each. You will be given 100 shares, and the collateral of $10,000 will be used for the purchase.
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However, you get to keep the premium you receive for writing the contract.
Case 2: What happens if the stock price stays above the $100 mark?
If the stock price stays above the $100 mark by the contract expiration date (Jan 2022), you get to keep the full premium, and your collateral of $10,000 will be released back to you.
What is Options Trading Level 2?
In Options Trading Level 2, You can BUY Call Options and PUT options
You could write the call and put options and collect premium, against the collateral of cash (in case of writing put options) or shares (in case of writing call options) in Options Trading Level 1. In Options Trading Level 2, you get to be the person at the other end of the transaction, i.e., you can buy call options and put options.
Please note, your privileges of level 1 are also retained i.e. you can still write options if you are approved for Options Trading Level 2.
1. Buying a Call Option
Why Would You Buy a Call Option?
You are bullish on a stock, and believe that the stock price will move up in the next few months (or weeks, or days – you can choose an expiration date accordingly). Instead of buying 100 shares the traditional way, you choose to buy a call option at a fraction of the cost of 100 shares. In case the stock price goes up, you get to benefit from the ‘power’ of holding 100 shares i.e. you are leveraged inherently.
For example, a stock is trading at $125 per share. You buy a $150 call option with Jan 2022 expiration date by paying a premium of $1000 because you believe the stock price will go above $150 + $10 (premium paid per share).
Case 1: What happens if the stock price goes above $160?
If the stock price goes above $160, say to $180, you make $20 per share in profit, i.e. $2,000.
Case 2: What happens if the stock price stays below $150?
You lose the premium ($1000) you paid. All of it! That’s the risk of loss associated with buying a call option.
Case 3: What happens if the stock price stays between $150 and $160?
You lose money. For example, if the stock price stays at $155, you can salvage ($160-$155) $5 per share or $500 from your call option. So, that is a loss of 50% on your initial $1000 investment to buy the call option.
2. Buying a Put Option
Why Would You Buy a Put Option?
You are bearish on a stock, and believe that the stock price will go down in the next few months (or weeks, or days – you can choose an expiration date accordingly).
To bet on the downward direction, you can buy a put option. In case the stock price goes down, you get to benefit at a leverage of 100 shares.
For example, a stock is trading at $125 per share. You buy a $100 put option with a Jan 2022 expiration date by paying a premium of $500 because you believe the stock price will fall below $100 – $5 (premium paid per share) = $95.
Case 1: What happens if the stock price goes below $95?
If the stock price falls below $95, say to $80, you make $15 per share in profit, i.e. $1,500.
Case 2: What happens if the stock price stays above $100?
You lose all the premium ($500) you paid. That’s the risk of loss associated with buying a put option.
Case 3: What happens if the stock price stays between $95 and $100?
You lose money. For example, if the stock price stays at $97, you can salvage ($97-$95) $2 per share or $200 from your put option. So, that is a loss of 60% on your initial $500 investment to buy the put option.
What is Options Trading Level 3?
In Options Trading Level 3, you can trade Options SPREADS such as Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Straddles, and Strangles.
What are Options Spreads?
Options Spreads are complicated financial instruments as they involve buying and selling a combination of multiple call options and put options on the same underlying security (example AAPL stock) with variation in strike prices and/or expiration dates.
Trading Options Spreads require access to a margin account from the broker. Spreads can be refined and finetuned per investor’s taste to suit their chance of profit and risk tolerance. The following are the basic spread strategies:
- Call Spreads – any option spread involving a combination of just call options can be considered a call spread.
- Put Spreads – any option spread involving a combination of just put options can be considered a put spread.
- Bull Spreads – any option spread that aims to benefit from the rise in stock (or underlying security) price is considered a bull spread.
- Bear Spreads – any option spread that aims to benefit from the fall in stock (or underlying security) price is considered a bear spread.
- Vertical Spreads – any option spread that has options with the Same Expiration Date, Different Strike Prices.
- Horizontal Spreads – any option spread that has options with the Same Strike Price, Different Expiration Dates.
- Diagonal Spreads – any option spread that has options with Different Strike Prices, Different Expiration dates.
What is Options Trading Level 4?
In Options Trading Level 4, you can write NAKED Calls and NAKED Puts.
What is a NAKED Call?
If you remember from Level 1, an investor has to put their 100 shares as collateral to sell a call (hence called covered call), in level 4 an investor can write a call WITHOUT owning the 100 shares. That is called writing naked calls (or naked call options).
As you can imagine, selling a naked call option carries a lot of risks. In case the stock price soars, the seller of the naked call has to procure the shares from the market at a (much) higher price and sell it to the call option buyer at the (lower) strike price.
What is a NAKED Put?
If you remember from Level 1, an investor has to put cash as collateral before they can write a put contract. In Level 4, an investor can write put options WITHOUT putting cash as collateral. This is called writing naked puts (or naked put options).
Writing naked calls and puts requires access to a margin account from the broker. While writing covered calls and cash-secured puts, there is a cap on losses an investor can make, writing naked calls and naked puts can theoretically run into INFINITE losses. Understandably, writing naked calls and puts are made available in Options Trading Level 4 to seasoned investors only.
Conclusion on Options Trading Levels
We hope you found this guide on Options Levels useful, and we trust this will help you adjust your options trading strategy accordingly.
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