If you’re just getting started with options, you might have learned the hard way about the different levels of trading.

That could happen, for example, if you tried to place a spread order only to be informed by your trading platform that you’re not approved for Level 3 options trading.

Huh? What does that mean?

In this guide, I’ll answer that question.

Different Levels of Options Trading

Let’s start with the basics: there are five different levels of options trading. They’re identified by the numbers 1 through 5.

As you move up the levels, you get more permissions. Higher levels give you new permissions plus permissions to do everything granted by lower levels.

For example, if you’re cleared for Level 2 options trading, you can do everything that people cleared for Level 1 options trading can do. In addition to that, you have the permissions granted to Level 2 options traders.

Why are there different levels? For a couple of very good reasons.

First, they protect you as a trader. The last thing you want to do is make a mistake as a novice investor and watch your life savings get sucked away because you entered a complex option trade without understanding the risks.

Second, they protect your broker. If you go deep into debt on bad options trades and can’t pay the money you owe, your broker is on the hook.

So options trading levels exist for your benefit as well as your broker’s.

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And yes, you have to get approved for each level. Your broker will want to evaluate your experience with trading options as well as your financial position before granting you higher levels of approval.

Next, let’s look at the different levels of options trading.

Level 1

It’s usually easy to get approved for Level 1 options trading. That’s because it only gives you permission to write covered calls against stocks you own.

If you’re unfamiliar with writing a covered call, it’s a strategy that allows you to sell someone the right to buy your shares for a specific price (called the “strike price”) at some point in the future.

Sometimes, people who’ve seen a nice unrealized gain in stocks that they own will hedge themselves by writing covered call options instead of just selling the shares.

Level 2

With Level 2 options trading, you get permission to write covered calls and buy options.

If you’re bullish on a stock, you can buy call options instead of buying the stock.

If you’re bearish on a stock, you can buy put options instead of shorting the stock.

Investing in call options and put options can be lucrative. However, you have to watch out for time-decay.

Options have a tendency to lose value over time, all other things being equal. That can happen even if the underlying stock moves in your favor.

This video provides valuable tips concerning options approval levels.

Level 3

Level 3 options trading is probably what landed you on this page. It gives you permission to do everything in the first two levels plus debit spreads.

Debit spreads are options strategies that result in a net debit in your account. That debit is the maximum amount that you can lose in the trade.

A credit spread is a strategy that puts money in your account right away. You can’t place credit spread orders with Level 3 options trading.

If you’re unfamiliar with spreads, they’re multi-leg options orders. That means you’re placing multiple trades within a single order.

For example, you might buy an option contract for a stock while simultaneously selling an option contract for that same stock at a different strike price.

Why would you do that? To protect yourself in case the trade doesn’t go your way.

That kind of trade, by the way, is called a vertical spread.

With Level 3 options trading, you can place spreads such as:

• Bull call spreads
• Bear put spreads
• Long butterflies
• Long calendar spreads
• Long diagonal spreads

Level 4

Level 4 is the highest level of options trading with some online brokers.

With Level 4 options trading, you can do everything in the first three levels plus credit spreads.

As stated above, credit spreads are multi-leg orders that give you an immediate credit to your account.

Yes, there are options strategies that give you cash up-front. Don’t get too excited about that, though, because you could still take a big loss if the trade goes the wrong way.

How do you get a credit to your account? That happens when you enter a multi-leg order that involves selling as well as buying options. In the case of a credit spread, you earn more from selling the options than you pay for buying the other options. So you get cash right away.

If the trade goes south, you’ll have to buy back the options you sold at a higher price than you earned from selling them. That’s how you take a loss with a credit spread.

You can also sell “naked” options on equities at Level 4. That’s when you sell an option even though you don’t own (or you’re not short) the underlying stock.

That’s a risky strategy because if the underlying stock moves against you, you’ll have to buy back the shares at a major loss.

Level 5

This level varies from broker to broker. Undoubtedly, though, it’s the highest level you can achieve.

Usually, you’ll get permission to do everything in the first four levels plus write uncovered options in indexes.

In other words, if you want to write a naked put option on the S&P 500 Index ETF, you can do that with Level 5 options trading.

How to Move From Level to Level

First of all, don’t be in a hurry to get to Level 5. If you’re just getting started with options trading, you really don’t need to be writing naked puts on SPDR.

Again: these trading levels exist for a reason. Think of them as friends and not enemies.

You should have no trouble getting approved for Level 1 options trading. That’s especially true if you’ve traded stocks for awhile.

Consider getting a Level 1 clearance and using the covered call strategy to hedge yourself when you’re ready to sell stocks you own. That will give you some experience with options that you can use when you apply for a higher level.

And yes, experience does matter. Your broker will ask you about your experience with trading options. Answer honestly.

Additionally, your broker will ask you about your objectives when it comes to trading options. Usually, you’ll have several boxes that you can check off. In this process, a good broker is crucial.

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If you believe you’re ready for higher levels of trading and you know what you’re doing, feel free to check all the boxes. That will help you achieve a higher level.

Of course, your broker will also look at the overall value of your account. If you’re going for Level 4 or higher, you’ll need margin.

Get a margin account if you don’t have one and you’d like to trade credit spreads or sell naked options.

If you do everything suggested here and still only get approved for Level 2 options trading, take a look at your application and account to identify the red flags. Maybe you just need more experience, more cash, or more margin.

Keep growing your asset value and learning about options. Eventually, you’ll get a higher level of approval.