Brokerage Levels and Option Risk

This article originally appeared on The Options Insider Web site.

In this article, I will scrutinize the risk associated with trading different option strategies against the four levels of brokers’ approval. (For more on the four different levels of options approval, see Option Approval Levels Explained.)

My intention is to demystify the myth of the true reason behind the different levels of brokers’ approval. Are they truly in place to protect us, the traders, from the risk in the option market, or are they in place to protect the brokers?

Let’s embark on the journey of finding it out.

A Figure is Worth a Thousand Words

One of the easiest ways to present the information that I will be discussing is with the chart below.

In the first column, I have included the abbreviation. I usually mark a long position with a plus sign in parentheses, while for a short position I use a minus sign. Calls are marked by “c” and puts by “p”. In the case of a long stock, I used “LS”.

The second column names the strategy, while the third one assigns to it the option level of approval by the broker, which I discussed in Option Approval Levels Explained.

The fourth and fifth columns are the most essential ones, because they deal with the risk perspective: broker’s versus ours. And the last column presents the trader’s reward.

Abbreviated	Strategies	Level	Brokers’ risk	Trader’s risk	Trader’s reward
LS & (-c)	Covered Call	1	None	Unlimited	Limited
(+c) / (+p)	Long Options	2	None	Limited	Uncapped
(+c&-c)/(+p&-p)	Spreads	3	None	Limited	Limited
(-p)	Naked put	4	Unlimited	Unlimited	Limited
(-c)	Naked call	4	Uncapped	Uncapped	Limited

Covered Call

The covered call is most often misunderstood for being the most conservative option strategy out there. This is true from the broker’s viewpoint, because the investor owns the stock on which he or she is selling the calls and, consequently, receives the premium for it.

If the call expires worthless, then the investor keeps the stock as well as the premium.

However, if the stock plummets, the limited premium that the investor has received is very small protection from the southbound move. The investor’s loss could be substantial, while the broker’s loss and risk is non-existent.

Long Call/Put

This strategy involves outright purchase of calls or puts. The most an option trader could lose is the amount the trader has invested in buying of the premium.

In the case of a long call, the stock could go down to zero or even get de-listed, yet the trader can lose only what was invested — not a penny more. Meanwhile, the broker has received his commission and has absolutely no risk.

Spread Trading

Spread trading is my favorite strategy. I tend to call it “being a net premium seller.” Being a net premium seller, in my eyes, means being a seller of premium regardless of whether the final outcome is a credit spread or debit spread.

As long as I am being protected and unexposed, I am considering myself a net premium seller. The key thing is to be covered or protected by another option rather than by the stock.

I have been beating the drum more for spread trading than for any other strategy because, in my humble opinion, it is the least risky option strategy.

For those who need a refresher on when it is financially better to do one type of spread over another, read my article on Debit Spreads Versus Credit Spreads.

The main reason why I like spread trading is that I have clearly defined risk and reward. No other option strategy gives me such comfort as this one. Meanwhile, the broker has no risk.

Naked Short

The fourth strategy is selling uncovered puts and the fifth one is selling of naked calls. As it can be observed in Figure 1, it is only with these last two strategies that the broker gets true exposure to the option market risk.

Please observe that I have purposely used two different terms “uncapped” and “unlimited” in Figure 1, which linguistically mean the same thing in order to point out a slight but essential difference. Before I lay out where the difference is, let me point out why naked put selling is less risky than naked call selling.

When a trader sells a put, the trader actually wants the sold put to expire worthless, which means the stock (underlying) should go up.

But what happens if the trade goes in the opposite direction? How low can the stock go down? To zero. Zero is the cement floor; the stock cannot possibly go into the negative territory below zero.

Hence, I used the word “unlimited” in italics when indeed it means only “theoretically” unlimited, for it is zero that creates the limitation.

Now let us flip a coin and talk about the naked call. Had a trader sold a naked call and it had gone sour, how far can it go up? Is there a “cement” ceiling? No. The stock can take off to the moon, and that is why naked call selling is considered the highest option risk-taking strategy.

It is only in selling of the naked calls that the risk to the option trader, as well as to the broker, is uncapped. (By the way, naked call selling on the indices is the worst of the worst. It is off the chart. It is not on Figure 1 and not a part of this discussion.)

One Final Note

As a final note, observe that in the case of covered calls and naked puts, I have used the terms in italics. Why? Because any well-informed option trader knows that the risk profile graph for covered calls and naked puts are identical. Both strategies have unlimited risk, yet at the same time, limited reward.

Hence, it is from the broker’s point of view that covered calls hold the lowest ranking in terms of risk, which explains why the selling of covered calls requires only the lowest level of option trading approval.

As a side note, not every brokerage company has the same requirements; some more specialized in option trading are more progressive and they do recognize that by the risk profile graph, there is absolutely no difference between the selling of a naked put and covered call.

From the brokers’ perspective, it is with naked puts that they have a greater chance of loss, for if the trader cannot fulfill his or her obligation of selling puts, then they are on the hook. The way brokers protect themselves is by not giving this level of approval to everyone.

In conclusion, I have presented to you the facts. Draw your own conclusion based on what you have read. Are the different levels of option approval in place to protect us, the traders, or are they in place to protect the brokers, or possibly both parties?

As Alexander Elder said in his best-selling classic, “Trading for a Living,” “The brokers laugh all the way to the bank.”

Tell us what you think here.

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