Options trading in 4 levels of complexity explained
With options trading, brokers quantify different levels of risk exposure for different types of options play and traders must be approved for each level. The level is based on the risk the broker is exposed to with potential open uncovered short options. The options trader must have matching coverage to limit losses from one of his short option contracts or have the money in his account to buy the stock if it goes in the money.
If an options trader does not have enough capital to execute an option contract at expiration or the shares of a stock that is called or bet on them, then the broker must step in to complete the market transaction. Brokers want to limit their own risk and leave the risk primarily to the options trader.
Approvals for different options trading levels are usually based on the trader’s experience in the markets, their account size, and time spent with the broker as a client.
Level 1: Selling options on equity positions
The first level of options trading involves selling an option premium on existing stocks on an existing position. These options games pose no risk to the broker as they are hedged by stocks. In the worst case, short options go into the money at expiration and the stock is called by the option seller.
These are income-generating strategies for stock traders who also want to sell options on their positions. These games can cap the upside profits for a stock trade or investment, but they can also create profits when they fail to enter the money before expiration. The risk on these options games is in the position of the stock moving against the trader, the option premium will help reduce some of these losses when they occur.
Level 2: Purchase of option contracts (or shares with puts)
Level 2 options trading is simply buying option contracts limiting the risk of a trade to the price paid for the option contract. The maximum a long options trader can lose is the cost of the contract, so the maximum risk is set at entry. The danger with options versus stocks 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 contrary move against the option buyer. . However, all risk is on the options trader and none on the options broker with long option positions.
The only exception to this level with short options is the guaranteed cash put. A cash secured put option is a short option that is opened at a strike price where the options trader wants to buy stock and has the capital in their account to make the purchase. The option seller takes the risk of having the stock placed on him at expiration. The option writer hedges his short put option with capital equal to the stock purchase at the strike price. In the worst case, the option seller can buy the stock at the price he wanted, but it continues to fall, causing him to buy at a loss.
Level 3: Multi-leg options strategies
Level 3 allows options traders to take multiple sets of options on their legs and create more complex strategies like spreads, iron condors and iron butterflies as examples.
Spreads and more complex multi-leg options strategies require experience in options trading as well as an in-depth knowledge of how the option pricing model works and what affects option price movements. Level 3 options trading requires more capital for margin and the use of option hedges. Level 3 approves options traders for the margin to be used on their trades.
Allowing traders to use margin in their options trading account can increase the risk on the options broker. So, the approval barrier for Tier 3 requires verification and approval before margin is granted. The brokerage reviews their past options trades, years of experience, and gives them a survey to complete. Brokers also have a minimum capital requirement for all accounts that wish to qualify for Tier 3 options trading.
Level 4: naked options
Level 4 options involve selling short option contracts without hedging. Naked contracts are sold without corresponding option coverage to limit losses or the actions underlying the position. Short options contracts can generate 100% profit on the contract premium if they expire out of the money, but they can also result in unlimited losses if the underlying stock has a huge move against the issuer. of the option.
Level 4 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 seller of the option who would have to add money for margin calls and if the trader couldn’t cover it the broker would have to settle with the clearing house of the options. options. If the broker was unable to settle, the options clearinghouse would have to settle accounts with the long options traders on the other side of the trade.
Naked options games have led to the ruin of many legendary options traders, money managers and hedge funds. Extreme risk events can take markets to price levels far beyond anyone thought possible. With no coverage in place, the losses can quickly be staggering, even exceeding their account value or, in extreme cases, their entire net worth.
It is crucial for options traders to understand the risk involved in options trading at all levels and plan accordingly. Options traders should be experts in the Black-Scholes options pricing model and position sizing to avoid the risk of ruin before beginning to trade options. The options market offers huge opportunities, but traders must manage risk in their quest for profits.
Image created by Holly Burns