Options are derivative contracts that have values based on individual stocks, exchange-traded funds or stock market indexes. Options are short-term contracts with a wide range of different contracts trading against each stock, fund or index. Options can be used to set up conservative investment strategies or aggressive trading strategies.
When an investor or trader opens an account with a stock broker, the account is not authorized for option trading. Adding option trading privileges requires the completion of additional paperwork and disclosures. The documentation includes details about the investor's previous investment and trading experience. The brokerage firm will add option trading privileges to an account after the paperwork has been reviewed and the broker knows the investor understands the risks of trading options. Option trading authorization can be added to cash, margin and IRA brokerage accounts.
When a brokerage account is given options trading privileges, the account is also assigned an options trading authorization level. Most brokerage firms have five levels of option trading authorization. The levels put a limit on the option trading strategies that can be used in the account. An account at level 1 is only authorized to trade using the most conservative option strategy. An account with level 5 authorization can use any option combination trading strategy.
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Beginner Option Authorizations
Novice traders and IRA accounts are usually given level 2 trading authorization. Level 1 allows an account to just make covered call trades. Level 2 adds the ability to buy put or call contracts. These option strategies limit the amount a trader can lose. Level 3 trading adds the additional strategies of cash-secured puts and spread strategies with stock options. All of the strategies in levels 1 through 3 can be accomplished in a cash or IRA account. They all have limited downside risk to the trader.
Advanced Authorization Levels
Level 4 and 5 trading authorization include option trading strategies requiring a margin account. A brokerage margin account allows the trader to borrow money from the broker to pay for a portion of a trade. Option strategies in these levels expose the trader to large losses if the trade does not work. Strategies included in levels 4 and 5 are naked selling of puts or calls, uncovered straddles or combinations. Level 4 allows these strategies with stock options. Level 5 allows using index options in the same advanced strategies.