With options trading, brokers quantify different levels of risk exposure for different types of option plays and traders must be approved for each level, says Steve Burns of New Trader U.
The level is based on the risk that the broker is exposed to with potential open-ended unhedged short options. The option trader must have a correspondent hedge to limit the losses for any of his short option contracts or have the cash in their account to buy the stock if it goes in the money.
If an option trader doesn’t have enough capital for an option contract execution at expiration or the shares of a stock that is called from them or put on them, then the broker must step in to complete the transaction on the market. Brokers want to limit their risks and leave the risks primarily with the options trader.
Approvals for different levels of option trading are generally based on the experience the trader has in the markets, the size of their account, and their time with the broker as a customer.
Level One: Option Selling on Stock Positions
- Covered Calls
- Covered Puts
- Covered Rollouts
The first level of option trading is selling option premiums on existing shares of stock on an existing position. These option plays present no risk to the broker as they are hedged with shares. The worst-case scenario is that the short options go in the money by expiration and the shares are called by the option writer.
These are income-producing strategies for stock traders that also want to sell options on their positions. These plays can cap the upside profits for a stock trade or investment, but they can also create profits when they fail to go in the money before expiration. The risk on these option plays is in the stock position moving against the trader, the option premium will help reduce some of these losses when they occur.
Level Two: Buying Option Contracts (or Shares with Puts)
- Long Calls
- Long Puts
- Long Straddles
- Long Combinations
- Long Strangles
- Cash Secured Equity Puts
Level two option trading is simply buying option contracts limiting the risk of a trade to the price paid for the option contract. The most that a long option trader can lose is the cost of the contract, so the maximum risk is defined at entry. The danger with options versus shares is that options can be all-or-nothing bets and can expire, worthless, or lose a large percentage of value—like 50% or more—with a large adverse move against the option buyer. However, all risk is on the option trader, and none is on the option broker with long option positions.
The one exception to this level with short options is the cash secured put. A cash secured put is a short option that is opened at a strike price where the option trader wants to buy shares at and has the capital in their account to make the purchase. The option seller takes the risk of having the stock put on them at expiration. The option seller hedges their short put option with capital equal to the share purchase at the strike price. The worst-case scenario is the option seller gets to buy the stock at the price they wanted but it keeps falling lower leading them to buy at a loss.
Level Three: Multi-Leg Option Strategies
- Diagonal Call Spreads
- Diagonal Put Spreads
- Iron Condors
- Iron Butterflies
- Ratio Spreads
Level three allows options traders to take multiple leg option plays and create more complex strategies like spreads, iron condors, and iron butterflies as examples.
Spreads and more complex multi-leg option strategies require experience in option trading along with in-depth knowledge of how the option pricing model works and what affects option price moves. Level three option trading requires more capital for margin and using option hedges. Level 3 approves option traders for margin to use on their trades.
Allowing traders to use margin in their option trading account can increase risk on the option broker. So, the barrier for approval for level three requires vetting and approval before the margin is granted. The brokerage reviews their past option trades, and years of experience, and gives them a survey to complete. Brokers also have a minimum capital requirement for any accounts that want to qualify for level three option trading.
Level Four: Naked Options
- Uncovered Calls
- Uncovered Puts
- Uncovered Roll-outs
- Short Straddles
- Short Strangles
- Short Combinations
- Uncovered Ratio Spreads
Level four options consist of selling option contracts short with no hedge. Naked contracts are sold without a corresponding option hedge to limit losses or shares underlying the position. Short option contracts can be 100% profits on the premium of the contract if they expire out-of-the-money, but they can also lead to unlimited losses if the underlying stock has a huge adverse move against the option writer.
Level four options trading is only approved for the most experienced people in the market with long track records and high net worth. The risk of a naked option is both on the option writer which would need to add money for margin calls and if the trader could not cover it then the broker would have to settle with the clearinghouse of the option. If the broker was unable to settle, then the options clearing house would need to settle accounts with the long option traders on the other side of the trade.
Naked option plays have led to the ruin of many legendary option traders, money managers, and hedge funds. The tail risk events can take markets to price levels far beyond what anyone thought possible. With no hedge in place, the losses can be staggering quickly even becoming more than the value of their account or in extreme cases their entire net worth.
Option traders must understand the risk involved with trading options at any level and plan accordingly. Option traders need to be experts on the Black-Scholes option pricing model and position sizing to avoid the risk of ruin before they begin to trade options. The option market provides huge opportunities, but traders must manage the risk during their pursuit of profits.
Learn more about Steve Burns at NewTraderU.com.