March 13, 2003

Option Account Approval Levels
by John Brasher, Publisher

Want to trade options, maybe write some covered calls or create some Barefoot Calls? Regular stock brokerage trading accounts are not approved for options or futures trading. So if you want to trade options, even simple option trades like buying calls or writing covered calls, your first step is to get your account approved for options trading. You have to ask; it isn't automatic. Your broker will want an options application from you.

With your application in hand, the broker will assign your account an option approval level based on several factors, such as trading experience, sophistication, knowledge of options and of course, net worth.

Be aware of all your options...

Options carry risks, and the less knowledge and experience you have of how options work the more likely you are to suffer a needless loss. The brokerage firm is fairly adept at protecting itself with margin and other requirements. However, the firm can only protect a trader from his or her stupidity or inexperience to a limited extent. And believe it or not, your broker does not want to see you get hosed in a trade. For example, did you know that if you are long (meaning that you bought) stock options and the options are $0.75 or more in the money at expiration, the Options Clearing Corporation (OCC) will automatically exercise the option for you? Of course, the exercise will not occur if you have given your broker contrary instructions. The point is that you have to be aware of such requirements and be paying attention, or a loss could occur. What if that option was automatically exercised for you and the stock then dropped the following Monday morning on the open? You could suffer a significant loss.

When your account is approved for options trading, it will be assigned one of several possible option approval levels. Understand that option approval levels are not standardized, and each brokerage firm decides for itself what strategies are allowed in each level. You should check with your firm to learn how they handle approval levels. There typically are 4-6 approval levels, and they usually begin with Level 0 (which allows no options trading) or Level 1. When you reach a particular level, you can do all strategies in that level and levels below it. Unless you are a novice trader, you can usually get approved at a level that allows covered call writing.You can request a higher level - argue your case, as it were - at some firms. Frequently, the solution is to enlarge your account by putting more cash or stock in it, but account size alone will not entitle you to an approval level requiring sophistication clearly beyond your experience. That is, firms want to see you grow into more advanced (riskier) trades. If you've written two or three covered calls, don't expect your firm to allow you to write butterfly or ratio spreads!

The following chart outlines how optionsXpress, one of the leading online brokers for options trading, does it.

Level 0
Allows trading of stocks, bonds and mutual funds, meaning long positions (no shorting). Allows no options at all.

Level 1
Allows covered call writing, which means to buy stock and write call options on it.

Allows short sales of stock.

Some firms will allow protective puts at this level, which are puts you buy against a long stock position to protect against a decline in the stock's price. But a speculative purchase of puts would not be allowed.

Level 2
Allows you to buy put and call options that are not protective in nature, but speculative.

Allows covered put writing, which means to short stock and write puts on the stock. These are not separate positions, but a unified trade, because the short put covers the short stock.

Level 3
Allows you to create debit spreads, which involves buying a call (or put) and selling another call (or put) with a different strike price. Because the trade costs you money, it is known as a "debit" spread. The "spread" is the difference between the strike prices of the two options. The most you can lose on a debit spread is the amount of the debit you paid. The debit spreads are the bull call and bear put spreads.

Level 4
Allows you to create credit spreads, which involves buying a call (or put) and selling another call (or put) with a different strike price. Because the trade nets you money and therefore requires no cash investment on your part, it is known as a "credit" spread - the credit is the amount you net. The "spread" is the difference between the strike prices of the two options. This is frequently riskier than a debit spread, because you can lose the full amount of the spread, less the net credit you received. If the spread is $5 and your net credit was $1, you can lose $4 ($5 - $1) on the trade. The credit spreads are the bear call and bull put spreads.

Allow you to sell naked puts, a relatively risky trade, since the stock theoretically could decline to zero, and the stock could be sold ("put") to you at the put strike price.

Level 5
Allows you to sell naked calls, a very risky trade, since the stock's price theoretically could go to, well, infinity. Suppose you wrote the 30 Call when the stock is $28 and the stock zipped up to $100 at the time of option expiration? You certainly would be called out at the $30 strike price but would have to go into the market and buy the stock at $100. If you can't write the check, your brokerage firm would have to cover the trade out of its capital.

Allows the writing of naked index puts and calls.

Allows exotic opton strategies like ratio spreads.

Final Thoughts
After a few months and some option trades, you can usually get moved up to a higher level. But if you want to write credit spreads or naked options, approach your firm with more cash, since the exposure to you (and them) is paramount in their thinking. In many instances ou can secure the risk to yourself and the firm with more cash.

Good luck and good trading!