Option Approval Levels Explained

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Company Filings More Search Options. Before you can trade options, your broker must approve your brokerage account for options trading.

In an options agreement, you will need to provide information that will assist your broker in determining your knowledge of options and trading strategies, as well as your general investing knowledge and your financial ability to bear the risks of options trading.

Based on the information you provide, your broker will determine whether options trading is suitable for you and, if so, what types of options trading may occur in your account.

The information you will need to provide in an options agreement generally includes, among other things:. The information you provide in your options agreement allows your brokerage firm to determine which option trading levels, if any, you qualify for in your account.

These trading levels determine the types of option trades you can execute in your account. Broker-dealers generally offer 5 levels of option trading representing varying degrees of risk.

Level 1 generally represents the lowest level of risk, while level 5 generally represents the highest level of risk. The types of option trading that occurs at each level and even the number of levels may vary among brokerage firms.

You may ask your brokerage firm to provide you with a list and description of each option trading level it has available for its customers. Requirements for level 5 options trading account sure you read this publication and carefully consider the information in requirements for level 5 options trading account before requirements for level 5 options trading account begin trading options. This bulletin provides a general overview of the steps an investor must take to open an options trading account with his or her broker-dealer.

For more specific details on how to open an options trading account, investors should contact their broker-dealer. For additional information on options and the options marketplace, investors should consider reviewing the following:. Securities and Exchange Commission. Investor Alerts and Bulletins.

Information You Will Need to Provide The information you will need to provide in an options agreement generally includes, among other things: Trading Levels The information you provide in your options agreement requirements for level 5 options trading account your brokerage firm to determine which option trading levels, if any, you qualify for in your account. Additional Resources This bulletin provides a general overview of the steps an investor must take to open an options trading account with his or her broker-dealer.

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When you open your first option trading account or add option capability to an existing equities brokerage account , your broker assigns you an options approval level. Usually the levels run from Level One to Level Five. Your approval level determines which option strategies you are allowed to use in that account.

Here is a typical list of approval levels and the types of trades allowed:. Level 1 — Covered Calls, Protective Puts i. Level 2 — Level 1 items plus speculative call and put buying i. Level 3 — Level 2 items plus debit spreads i.

For example, bull call spreads, bear put spreads, long butterflies, long calendar spreads, long diagonal spreads. Level 4 — Level 3 items plus naked short puts and credit spreads i.

For example, bull put spreads and bear call spreads, iron condors, iron butterflies, put ratio spreads. Level 5 — Level 4 items plus positions involving naked short calls, including short straddles, short strangle, and call ratio spreads.

Having a low option approval level is a challenge since it shuts out many good option trading opportunities. As educated option traders, we would like to be able to use any option strategy that meets our own risk parameters. The first thing to do along this line is to get the highest option approval level that you legitimately can get. In your options account application, you will be asked what types of option trades you would like to do. I suggest you check all the boxes.

You will also be asked what the purpose of the account is. Check all the boxes here too, including speculation. If you only check the box labeled long-term investing , you will receive a low option approval level. Make sure to speak with a live representative and have that person clarify what they mean by experience. Find out if trading in option classes or simulated trading can be counted.

Let that person know what options education you have, as this might make a difference in marginal cases. Your broker may require several more months of trading experience before approving you for level three.

This is not uncommon. Or, it may be that in the type of account you have, level two is the highest level ever given. Well, the fact is that level two, or even level one, is not quite as restrictive as it appears if we use a little ingenuity. Using a fascinating property of options called Put-Call Parity and working entirely within the rules, with a level one or two account we can create positions equivalent of many Level 3 and even Level 4 strategies.

Very briefly, one of the key aspects of put-call parity is this: The amount of time value in a Put at strike x and a Call at strike x, of the same underlying and expiration, is equal after making adjustments for interest and dividends, if applicable. That leads to a set of equivalencies between options positions which we can exploit to construct many of the positions we want from the lower-level positions we are allowed to use. These are the notations we will be using:.

In the above translation, equals means yields the same profit or loss in all conditions. The amount of capital required for the two equivalent trades may be different, but the profit or loss is the same. Without going into too much detail about this, the five-cent difference is the adjustment to time value needed to compensate for interest.

Notice that no matter the eventual price of GLD, Position 1 always yields a result that appears better than Position 2 by exactly five cents. The Stock-plus-put combination is a synthetic long call. In this particular case, that gives us an alternative way to construct a position that we might want to do a long call in an account where we might not be allowed to do it an account with Level One approval.

That account can buy protective puts, but it cannot just buy single calls. Taking that example one step further, consider that the synthetic call from Position 1 can be combined with a short call at, say the strike. This short call would be a covered call because Position 1 includes shares of stock, so it is allowed in a Level 1 account.

The entire position now is exactly like a position containing a long call at the strike and a short call at the strike — in other words, a bull call spread. This is a debit spread normally requiring Level 3 approval, synthesized in a Level 1 account.

It will perform in all respects just like a bull call spread. Going yet another step, the covered short call that we added to the synthetic long call above could have been at any strike, including a lower strike an in-the-money strike. If we selected, say the strike for the short call instead of the , then the combined position would be the equivalent of a bull call spread. This, by the way, through the magic of put-call parity, is in turn the exact equivalent of a bull put spread — a credit spread normally requiring Level 4 approval.

We have synthesized a level 4 credit spread in a level one account. The same principal can be used to construct equivalents for, or in other words to synthesize , other types of positions as well.

This means that in a Level Two account, we can use the positions that we are allowed to use to synthesize most types of positions that normally require approval levels up to Level Four. Home Resources Lessons from the Pros Options: Options March 6, Options: Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever.

Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein.

Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.