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When you open an account with a brokerage for the first time, and you’re looking to do options trading, you might see different “levels” to sign up for. Though signing up for a different option level has no real immediate effect on your portfolio, it’s the actions you take after that could make or break you. And the last thing we want to do is get into options and lose a ton of cash. Today, we’re going to talk about what each of these levels are, and what you’re allowed to do or not do. When you’re signing up for options trading, you’ll see that there are three levels of options trading
.
LEVEL 1
You’re allowed to sell collateralized options.
Example
You can sell covered calls, where you hold 100 shares of stock that you’re selling the covered call. You can also sell cash-secured puts, where you have the cash available in your account to purchase 100 shares at the strike price of the put.
Basically, it means you can sell any option where the collateral, or maximum risk, is covered by something you already own. This collateral is already available in your account for the brokerage to use to fulfill your end of the bargain if you get assigned. That’s pretty much it!
LEVEL 2
Access to buying options. You can buy calls and puts in this level. The risk you run into is total loss of the premium you paid for. But generally, the risk is capped off at that point.
Example
So if you buy a call or a put for say $300 and it reaches expiration date out of the money, your maximum loss is that $300.
The reason why buying options is set at level two is because owning options is slightly more complicated to the user than selling options. You have to understand how exercising options works, and the challenges associated with holding long position options. You especially have to understand how short expiration options work, where holding them is an uphill battle since you need the price to move quickly in your favor by a certain amount of time.
LEVEL 3
Access to spreads
A spread is when you open two or more options positions against the same underlying stock.
This is a very complex topic so we’ll just go over the basics. A credit spread is when you sell an option closer to, or deeper, in the money and you buy an option of the same type further out of the money than the one you sold.
Call Credit Spread
A call credit spread is one where you sell a call and then you buy a call whose strike price is higher than the one you sold. This typically results in a net credit at the open of the position. The buy position, in effect, serves as the collateral. It’s like owning shares for a covered call or holding cash for secured puts. The difference is, you’ll also need extra cash to cover the gap between the spreads.
Conversely, a debit spread is one where you buy an option closer to (or deeper in) the money and you sell an option further out.
Debit Spread
Call debit spread is one where you buy a call and then you sell a call where the strike price is higher than the strike price of the call you bought. This results in a net debit at the open of the position because the call that you bought is more expensive than the call that you sold.
What is the Risk?
The maximum loss of a credit spread is the difference of the strike prices in the spread times a hundred. For example, if I sold a call for XYZ at a strike price of $100 and I bought a call for XYZ at a strike price of $105, my maximum loss is $500. The maximum loss of a debit spread is the difference between the PREMIUMS of the options at the point where the spread was set up. So if I bought a call for XYZ at a strike price of $100 for $500 and I sold a call for XYZ at a strike price of $105 for $350, my maximum loss is $150. Spreads are strategies designed to capitalize on market conditions while hedging potential losses.
These are just basic examples of spreads and it can get a little bit more complicated, which is why brokerages set this type of options trading at level 3. Some brokerages don’t even offer level 3 options trading because of infrastructure needed to handle spreads and the inherent risks and complexity in understanding them.
LEVEL 4
While the other options have limited risks involved, or the risks are fully collateralized, level 4 options trading gives way to trades that have unlimited or great risks. The type of options position that fall in this category is the selling of naked or uncovered calls and puts.
What is the Risk
If you sell a naked call, it means you do not have the shares on hand to cover the call you sold which means the risk is theoretically infinite.
Example
Let’s say that XYZ is selling for $100 per share, and I sold a naked call against it at a strike price of $105 for $500. If at expiration, XYZ reported some insanely amazing news which causes it to skyrocket to $300 per share, I would end up losing $29,500 because I have to buy 100 shares at $300. On the put side, if I had no cash in my account and I sold an uncovered XYZ put at a strike price of $100 and XYZ was caught committing financial fraud, like Enron or something, and dropped to $5 per share, my account would go negative $9500.
Selling uncovered options means that my account can actually drop below zero. Many brokerages do not even allow this tier of trading. Others may require users to be approved before engaging in level 4 trading. We generally do not recommend selling uncovered or unsecured options due to the amount of risk involved.
Conclusion
Keep in mind that when you sign up for an options tier, it doesn’t mean that you have to start trading at that level. It just means that you have ACCESS to trading those strategies. Approval time for each brokerage really depends on the brokerage itself. Sometimes it could take days, sometimes it’s immediate. Once you’ve gotten approval, congratulations! You now have access to engaging in one of wall street’s most lucrative money-making instruments.
If you’re new to options trading and investing and want to learn how to make some extra cash at home, you can sign up for a membership here. We'll show you all of the stocks we're investing in and coach you step-by-step on how to sell covered calls and cash-secured puts, aka the Wheel Strategy. I teach all of my exclusive members on how to easily make $800-$8000 a month just by using their phones for 5-15 minutes on a Monday morning. Learning this strategy has helped many people reach financial freedom, pursue their life passions, and spend more time with friends and family.