Level 3 options trading

Level 3.

DEFINITION of 'Level 3'

Level 3 is the highest level of quotes provided by a trading service and gives the institution the ability to enter quotes, execute orders and send information. This level of service is restricted to NASD member firms that function as registered market makers. A level 3 quote allows a person to enter into best execution trades as prices are being updated in real time.

BREAKING DOWN 'Level 3'

To understand the reasoning behind level 3 its associated quotes, it is important to first understand the operations of the stock market. All publicly traded equities have a bid price and an ask price when they are bought and sold. The bid is the highest price an investor is willing to purchase a stock. The ask is the lowest price in which an investor is willing to sell a stock.

Each time a bid price or ask price is disseminated it is considered a quote. The U. S. stock market has three tiers of quotes: level 1, level 2 and level 3. Looking at these quotes allows an investor to see how a specific stock is performing over time.

Level 3 Quote.

All three levels of quotes build on top of each other. Level 1 quotes provides investors with the highest bid and the lowest ask prices for an individual stock. These types of quotes are the most common and is what private investors see when they request information from their financial services company. Level 2 quotes provide the same bid and ask information but also show the bid and ask prices for each individual market maker. This allows investors to identify the market maker with the lowest bid/ask spread, which is important for larger investors who conduct high volume and high frequency trades.

Level 3 quotes provide all the information and services of level 1 and level 2 quotes. In addition, level 3 quotes also grant an investor the ability to enter or change quotes, execute orders, and send out confirmations of trades. These types of quotes are reserved for registered brokers and financial institutions. Market makers, for example, participate in level 3 quotes, which allows them to execute customer orders.

Example of Level 3 Quotes.

All brokerages and financial institutions have best execution requirements on behalf of their customers. This means that they are required to provide their customers with the best stock price currently available. If a private investor, for example, wants to invest in Apple stock, he would see the level 1 bid and ask prices listed on his broker's online trading portal. When the investor initiates an order to purchase the stock, the broker uses level 3 quotes to give that investor the best possible price.

Options Accounts Trading Levels.

Options Accounts Trading Levels - Introduction.

What exactly are options accounts trading levels? What is the purpose of trading levels, how are they determined and how can you increase your trading level?

Options Account Trading Levels - Purpose.

The purpose of trading levels in options trading accounts are simply to control the risk of traders performing high risk trading without sufficient experience and funding. Derivatives trading, such as options trading, have been blamed by many who claimed that they did not understand the risks they were undertaking when they got burnt. When such options traders point their fingers at their brokers for allowing them to take on more risk then they are qualified or experienced enough to do so, options brokers get into trouble with the authorities. As such, all options brokers have since started a risk assessment of all new options account holders in order to determine the amount of risk they are suitable to undertake and since different options strategies have different levels of risk, trading levels were created based on the relative "riskiness" of each class of options strategies.

Indeed, the options account trading levels policy is a policy that not only protects new account holders from risk but also options brokers from litigation from disgruntled options traders.

Options Account Trading Levels.

Options brokers typically classify every options accounts into one of five levels as you can see in the picture above. More comprehensive options brokers such as Optionsxpress has level 0 for trading of stocks and funds only as well as a level -1 for suspended accounts. Each options broker may have slightly different ways of classifying an account and the kind of strategies allowed. We will go into some of the most common practises here. You should consult your options brokers on the specific criteria that they use.

Options Account Trading Level 1.

Trading level 1 typically allows you to only perform the Covered Call and Protective Puts options trading strategy. Both options strategies are more of a hedging strategy rather than speculative in nature as such options strategies require the options trader to own the underlying stock. A Covered Call is when you write out of the money call options on stocks that you own in order to hedge against a small drop in price on the underlying stock and a protective put is when you buy put options as protection on stocks that you own. At this level, options traders are not able to buy call options or put options without first owning the underlying stock.

Options Account Trading Level 2.

Trading level 2 allows you to buy call options or put options on top of what Trading Level 1 allows you to do. This is the level most beginners to options trading start at. At this level, options traders can only perform simple directional speculation by buying call options or put options without the flexibility of writing them or using them as part of a spread. Risk is therefore limited to the amount of money put towards purchasing the options.

Options Account Trading Level 3.

Trading level 3 allows you to trade debit spreads on top of everything level 1 and 2 allows. Debit spreads are options strategies which you actually need to pay cash to put on while credit spreads give you cash for putting them on. An example of debit spread is the Bull Call Spread where you write an out of the money call option on the call options that you bought. Debit spreads are typically made up of both long and short options. Risk is limited to the amount of money paid towards putting on the spread. Even though risk is limited in this sense, it is a lot more complex than simple call options and put options buying and requires more knowledge on the part of the options trader.

Options Account Trading Level 4.

Trading level 4 allows you to put on credit spreads which put cash into your account the moment they are performed. An example of such an options strategy is the Short Butterfly Spread. Such options strategies are not only a lot more complex to execute and exact potential losses can be complex to calculate for beginners as well, leading to unexpected loss amounts.

Options Account Trading Level 5.

Trading level 5 allows you to write call and put options without first owning the underlying stock. This is where you get to "play banker" to other options traders who are speculating through call and put options buying. Such positions again exposes you to unlimited risk which means that losses accumulate indefinitely when things go bad. This is how a lot of beginner options traders lose a fortune and should only be performed by experienced options traders. On top of that, writing options requires a significant amount of cash as "Margin" which denies most small retail traders.

Main Factors Which Determine Your Initial Trading Level.

The two main factors that determine your initial trading level are your experience and your networth. The more experienced an options trader, the lower the percieved risk to yourself and your broker. This is why there are a whole lot of questions like how long you have been trading and the kind of instruments you have been trading in every risk assessment form when opening an options trading account. Similarly, the richer you are, the more losses you can afford to take and hence the lower the risk to yourself and your options broker.

Most options brokers would not require verification or proof of the information provided and has led to a lot of beginners making false claims in order to qualify for a higher options account trading level.

How To Increase Your Options Account Trading Level.

First of all, options brokers typically do not upgrade account trading levels automatically. When you think you are ready for a higher level or that you think you ought to qualify at a higher level, you need to call up your broker to discuss the matter with them. Typically, your options broker would look at your past trading record as well as your account size in order to decide if you should be placed at a higher trading level. However, since level 5 naked options write requires nothing more than a large fund size in order to satisfy margin requirements, you should be able to discuss for a level 5 account placement as long as you have that kind of cash in your account, typically USD$200,000 and above.

Option Approval Levels Explained.

A breakdown of option approval levels one through four.

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”.

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).

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.

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.

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.

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

©2017 InvestorPlace Media, LLC.

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OPTION APPROVAL LEVELS.

The Option approval level dictates what types of strategies you can employ in your Schwab account. In order to see the trading level your account is approved for look in the header of the Account Details window.

Option Trading Approval Levels.

Allows you to place:

All of Level 0 plus:

Cash Secured Equity Puts (CSEP)

All of Level 1 Plus:

Diagonal Call Spreads.

Diagonal Put Spreads.

Ratio Spreads (long side heavy)

All of Level 2 Plus:

Uncovered Ratio Spreads.

If you decide that you would like to apply to upgrade your option trading level, please complete a new Option Trading Application Option Trading Application. Schwab will evaluate your application and send a confirmation of the option trading strategy approved for your account.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Multiple leg options strategies will involve multiple commissions. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Call your local Schwab office or write Charles Schwab & Co., Inc. 101 Montgomery Street, San Francisco, CA 94104 for a current copy.

Copyright ©Charles Schwab, & Co., Inc. 2008. All rights reserved. Member SIPC. (0007-7048)

Trading Levels at Options Brokers.

In the previous article in this guide, we discussed the importance of choosing the right online options broker. Signing up with a broker is a necessary step you must take before you can actually begin trading options, and doing so isn't always particularly straightforward. For one thing, deciding which one is right for you can be tough because of the huge range of them that exist.

Once you have selected an appropriate options broker for your requirements, you then will typically have to go through a fairly lengthy approval process before your account will be opened and ready to use. You have to go through this process so that your broker can carry out a risk assessment and decide what trading level, or approval level, you should be assigned.

Trading options isn't as simple as just signing up with a broker and then making whatever trades you want; the risks involved in certain trades and strategies means that brokers have to be responsible and only allow individuals to make trades that are suitable for them. For example, a complete beginner with a small amount of starting capital wouldn't be allowed to start using complex strategies with unlimited risk exposure.

Trading levels are essentially how brokers control the level of risk that their customers, and themselves, are exposed to. On this page we explain these levels in more detail, covering the following:

The Purpose of Trading Levels How Trading Levels are Assigned What Each Trading Level Allows Increasing your Trading Level.

The Purpose of Trading Levels.

The purpose of trading levels, also known as approval levels, is essentially to provide a form of protection to both the broker and the customer. Options brokers are regulated and have a duty to look out for the best interests of their customers, which gives them a form of obligation to ensure that their customers only take risks in which they have sufficient experience and funds for.

It isn't entirely uncommon for investors and traders to employ high risk strategies when they don't really know what they are doing and don't have the necessary capital. If things go horribly wrong the broker is potentially liable, so they assess their customers and assign them trading levels so that they can only ever carry out transactions which are commensurate with their experience and their funding. By doing this, both the customer and the broker are protected from excessive exposure to risk.

How Trading Levels are Assigned.

When you sign up with an options broker, you will usually have to provide detailed information about your finances and previous investments that you have made. You will typically be asked a series of questions that will help the broker understand your level of knowledge and risk tolerance.

Your application will then be reviewed by the compliance department and they will determine what trading level you should be assigned based on the information you have provided. In some cases, you may be required to provide verification of certain aspects of your application.

Essentially, brokers concern themselves with two main factors when assigning you your initial trading level: your relevant experience and your overall financial position. Experienced investors that can demonstrate they have a solid knowledge of options trading will usually be assigned a higher level because there is an assumption that they know what they are doing.

Those with a high net worth or a large amount of starting capital will also tend to be given a high trading level too. There'

s no standardized formula for calculating what level is assigned, and the criteria can change from one broker to another.

What Each Trading Level Allows.

Most options brokers assign trading levels from 1 to 5; with 1 being the lowest and 5 being the highest. A trader with a low trading level will be fairly limited in the strategies they can use, while one with the highest will be able to make pretty much whatever trade they want.

In the same way that brokers all have their own methods for assigning trading levels, they also usually have slightly different ways of classifying trading strategies. Because of this, there isn't a definitive list of what strategies each trading level allows at every broker; this is something that you must find out directly from your options broker. We can, however, provide a rough idea of what you can usually do at each level.

With a trading level of 1, you'll probably only be able to buy and write options where you have a corresponding position in the underlying security. For example, if you owned stock in Company X then you would be able to place a buy to open order for put options on Company X stock. This would give you the right to sell your stock at an agreed strike price and the only additional risk you would be exposed to is the amount of money it costs to use those options.

You would also be able to place a sell to open order on call options on Company X stock, giving someone else the right to buy your stock at an agreed price. Even though you would technically make a loss if Company X stock went up in price and you were forced to sell it below market value; there's no additional exposure risk because you already own the stock.

A trading level of 2 would typically allow you to also buy call options and put options without having a corresponding position in the underlying security. You would only be able to buy options contracts if you had the funds to do so which means there isn't a huge amount of risk involved. The worst case scenario is that the contracts expire worthless and you lose the funds invested, but you couldn’t lose any more than your initial purchase. This trading level is usually the lowest one assigned.

Trading level 3 would usually allow the writing of options for the purposes of creating debit spreads. Debit spreads are options spreads that require an upfront cost and your losses are usually limited to that upfront cost. Although debit spreads involve writing options without a corresponding position in the underlying security, the losses are limited by having multiple positions on options contracts based on that same underlying security.

For example, you could create a debit spread by writing call options on a particular stock and buying call options on the same stock. Again, there's not a huge amount of risk associated with these trades, but the higher trading level is required due to the additional complexities of creating spreads.

For the creation of credit spreads, where you receive an upfront credit and are exposed to future losses if the spread doesn't perform as planned, you would normally need an account with trading level 4. This is because potential losses are more difficult to calculate. Trading level 5, being the highest, would basically give you the freedom to make whatever trades you wanted. You would, however, usually be required to have a significant amount of options margin in your account.

Increasing your Trading Level.

There's no specific way to guarantee an increased trading level with your broker. Some brokers may review your account periodically and automatically increase it if appropriate, but this is quite rare. You would usually have to contact your broker directly and request an upgrade, but this would be entirely at the discretion of your brokerage firm. If you had a solid trading history with them and a reasonable amount of funds on account, then you would probably stand a good chance of being upgraded.