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Option Approval Levels Explained

Option level approval is a commonly overlooked area of option trading. When a person opens an account, the broker assigns them one of several option approval levels supposedly based on the option trader’s knowledge and needs.

In many instances, the students in the Options Trader courses I have recently taught did not know what level of approval they had, and a few students were unaware that the levels even existed.

I suggest that anyone who is uncertain of their option approval level contact his or her broker to find out which level of option approval their account has. It is possible to fill out additional paperwork and to have the level of approval bumped up. However, it does to take time to do it. Faxing the paperwork might expedite the process a bit.

Usually there are four option approval levels, generally ranked from one to four, the highest rank being the highest level of approval. The higher levels allow the trading of the strategies listed in the lower levels. For instance, Level 3 allows not only for spread trading, but also for going long on calls and puts which were included in Level 2. Thus, each level is cumulative.

At any rate, there is no official standard of what strategies could be traded at which level. The table below presents universal industry guidelines in terms of strategies commonly associated with each level. I have also added another column for abbreviation. I usually mark a long position with a plus in parentheses, while for a short position I use a minus sign. Calls are marked by “c” and puts by “p”.

Option Approval Levels
Option Levels Strategies Abbreviated
Level 1 Covered Call, Long Protective Puts Long Stock & (-c)
Level 2 Long call/put (+c) / (+p)
Level 3 Spreads {(+c) & (-c)}
{(+p) & (-p)}
Level 4 Uncovered or Naked (-c) / (-p)

 

Level 1

At the first option approval level, an option trader is permitted to do covered calls, as well as “long protective puts.” Now there is a catch to it; at this level a trader is not allow to buy any calls, but is allowed to buy puts only in the amounts he or she holds, and also only on the specific stock that he or she owns.

For instance, if a trader owns 100 shares of a stock, then they could purchase a single put contract and nothing more. By the way, this is generally the only level that most brokerages will approve for IRAs (individual retirement accounts).

Level 2

Option approval level 2 is an incremental improvement over the previous level. At this level, a trader is permitted to perform both strategies listed in Level 1, as well as going long on calls and puts.

At this level, one is allowed to perform the outright purchase of a call or put on either optionable stocks, exchange-traded funds (ETFs) or even indices.

This level of approval is associated with the word speculation, at least from the broker’s viewpoint.

Level 3

Option approval level 3 involves spreads regardless of whether they are diagonal, horizontal or vertical.

However, the same cannot be said for being long or short on a spread. If one is shorting a horizontal spread without sufficient funds in his or her account, the broker would automatically reject that order.

Once again, there is limitation on each of these different levels of option approval. Shorting something without ownership belongs to the next level.

Level 4

Option approval level 4 is known as uncovered selling or naked shorting. (I like to use the word “exposed” instead of “naked,” especially when I am talking about spread trading, which involves multiple positions, also known as legs. Occasionally, one of the positions could become uncovered or exposed, so if I say I have a “naked leg,” it does sound odd.)

Level 4 is the highest approval level and just about any option strategy could be performed at this level as long as the size of account is to the broker’s liking, which is usually quite large.

At this level, short selling is possible, as well as many different types of ratio spreads.

This article originally appeared on The Options Insider Web site.


Article printed from InvestorPlace Media, https://investorplace.com/2009/03/option-approval-levels-explained/.

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