Lessons from the Pros

Back to the Basics, Part 2

After filling up some loopholes with my previous article, Back to the Basics, I continue the discussion here with another commonly overlooked area of option trading – option level approval. Brokers assign to their clients, at the time when the account is being opened, 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. Figure 1 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.

Going through the list from the lowest to the highest; at the first 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 the QQQQ then a trader 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).

The next is Level 2, which 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 the new ones, which are 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, ETFs (exchange traded funds), or even indices. This level of approval is associated with the word speculation, at least in the broker’s viewpoint.

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 is known as uncovered selling or naked. (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, usually quite large. At this level short selling is possible as well as many different types of ratio spreads.

As a final word of caution, ever since September 11, a lot of things have changed in our country. It used to be that the brokers would take your word for it in terms of claiming the years of option trading and option knowledge. With the recent credit crunch and also the inability of brokers to verify the clients’ claims of knowledge and option trading, some brokers might require the clients to start at the lowest levels and after about six months they could increase the level based on the trading record.

In conclusion, I am often asked in my classes which level of approval I suggest. To such a question I answer back with rhetorical questions. I would ask: “How many car seats are in your vehicle?” The usual answer is four. Then I ask: “How many people are usually sharing the ride with you?” The answers do vary, but the point is that most likely the driver is alone. This then brings up the question “Why do we need four seats in the car if we are driving alone?” The answer is simple – just in case. If possible be approved for more than you need just in case you need it, and at least you will have an option to use it in the future. After all, option trading is all about having more choices and fewer limitations. An option trader must understand not only the strategies that he or she uses but also the rules involved in using the strategies within the confines of the brokerage account.

Good Trading.

- Josip Causic