Options trading levels are a system put in place by brokerages to regulate the amount of trading that can be done by traders. The levels are divided into different tiers, with each tier having its own specific requirements for trading. The levels are designed to help prevent traders from taking on too much risk and to ensure that traders have the necessary knowledge and experience to handle the level of trading they are engaging in.

Trading levels are important because they help to ensure that traders are not taking on too much risk. They also help traders to build their knowledge and experience as they progress through the different levels. By starting at a lower level and working their way up, traders can gain a better understanding of the options trading market and learn how to make more informed trading decisions.

The level you are assigned determines what types of trades you are allowed to take part in. Specific details may vary from broker to broker, but they tend to follow the same rules. 

There are generally four different levels of options trading, each with its own specific requirements. These levels are:

• Level 1: Covered Calls
• Level 2: Long Calls and Puts
• Level 3: Spreads
• Level 4: Advanced Options Strategies

Level 1 Covered Calls

The first level is very restrictive, in fact, it only allows you to sell to open options contracts under strict conditions. In the first case, you can do what is known as a covered call. This means you are going to sell a call option that is covered, meaning it is backed by 100 shares of stock. In other words, you have to own the shares of stock before you can sell a covered call. As we will see, many people who own shares of stock use covered calls to earn monthly income from their investments. 

Level 1 traders can also sell to open a protected put. A protected put is an option that is backed by the cash needed to buy the shares of stock should the option get exercised.

While a protected put has the benefit of providing financial security should the option be exercised, it requires a large amount of capital in your account. It turns out there are other ways to sell puts with relatively low risk, so it’s hard to imagine many people selling protected puts. 

To qualify for Level 1 options trading, you will need to have a margin account with your broker, and your account must be approved for options trading.

Level 2 Long Calls and Puts

A level 2 trader can buy and sell long calls and puts. Level 2 traders cannot engage in advanced trading techniques like spreads. Moreover, they are not officially allowed to enter into strangles and straddles, although they can do them indirectly by purchasing options on an individual basis. 

Most readers are probably hoping to be at least a level 2 trader. Becoming a level 2 trader requires you to submit to an interview process by the broker. The good news is that the “interview” is done via computer these days, and it is pretty easy to get approval as long as you know what to say. The two main things you need to be aware of before undergoing the interview is that the broker will want to know your investment goals and time horizons. Your answers will need to assure the broker that you understand how options work. 

Firstly, they are going to ask you if your goals are long-term capital appreciation or short-term profits. Even if you have a stock portfolio or IRA you are managing for your retirement, you need to tell the broker your investment goal is to make short term profits. Secondly, they are going to ask if you are interested in speculating or investing. You need to tell them that you are interested in speculating. That means that you are buying financial securities with the hopes of selling them for a profit in 1 year or less. Again, what your real goals are overall is not important – you need to tell the broker what they want to hear if you are planning on trading options. 

To qualify for Level 2 options trading, you will need to have a margin account with your broker, and your account must be approved for Level 2 options trading.

Level 3: spread

If you have not done any options trading, you are probably going to have to spend a few months at level 2 and buy and sell some options before you are approved for level 3. Level 3 opens up some new possibilities for you. As a level 3 trader, most brokerages are going to allow you to engage in certain options strategies that help minimize risk and increase the odds of profit. You will be able to sell options even without cash or owning the stock – as part of one of the pre-defined strategies. The strategies that level 3 traders can use include credit and debit spreads, straddles, strangles, and more complicated trades like an iron condor. Some of these strategies involve the simultaneous sale and purchase of options, and they can even involve call and put options simultaneously. Many brokers set them up for you and will give you the estimated profit and loss in each case. 

To qualify for Level 3 options trading, you will need to have a margin account with your broker, and your account must be approved for Level 3 options trading.

Level 4: Advanced Options Strategies

Level 4 is the highest trading level at most brokerages. This allows you to engage in any type of options trading, including selling “naked”.

This means that you can sell options which are not backed by any cash or collateral. However, that is not strictly accurate, as brokerages require a margin account to engage in that type of trading. In order to open a margin account, you must deposit $2,000 cash.

Then, the broker uses a formula to determine the fraction of capital you must have in your account to cover a trade. Keep in mind the money is never spent, it is kept in the account as insurance. While a “protected put” might require you to put $10,000 in your account, for a “naked put” you might only need $1,500. The specifics depend on the specific strike price, underlying stock and other conditions. 

Level 4 traders also have access to more advanced trading strategies. These include using multiple legs and special strategies such as a “butterfly” or iron butterfly.  Each additional level of trading gives access to anything a lower level trader can do, so a level 3 trader also has the powers of a level 1 and level 2 trader. For junior traders, it is best to trade some options in a straightforward manner at level 2, before moving up to advanced levels.

To qualify for Level 4 options trading, you will need to have a margin account with your broker, and your account must be approved for Level 4 options trading.

To increase your options trading level, you can start by gaining experience with the lower levels of options trading. As you gain more experience and build up your capital, you can then apply for a higher level of options trading with your broker.

It’s important to note that each broker may have slightly different requirements for each level of options trading. So, it’s always a good idea to check with your broker to understand the specific requirements they have in place.