Why You Need To Rethink What You’ve Previously Learned About Options Trading!
Brokerage firms establish options level approvals which determine which strategies a particular trader is allowed to deploy. This can range from trader to trader based upon things like how much experience you report as having as an options trader…what your objective is…and sometimes even the amount of capital you have in your account.
But when it all boils down to it, these option approval levels are really more to cover the butts of the brokerage firm as they assess THEIR risks more so than YOURS.
When you learn of these levels and the strategies that can be used at each level, the assumption is that you’re taking on more risk and therefore becoming more speculative the higher up in options approval that you go. However, rally, it’s the risk to the actual firm that’s first (and foremost) considered when creating these option levels.
Every broker can vary a bit what they allow at each level, but for the most part…here’s what you can generally see at each level.
Option level 1: Covered calls, and sometimes cash-secured puts or protective puts
The firm views this level of risk (to them) to be small because you’ve put up the stock or cash to fully secure the risks. So in the case of a covered call, you can sell a call and take in income for every 100 shares of stock that you’ve got in your account. The sold call is “covered” by the stock that resides within the account.
Some allow cash-secured puts which means that you’ve got the funds already in the account to presently cover your put. And sometimes protective-puts are also allowed, which are where you’re buying a put to try to protect against some downside risk in the stock that you presently hold in that account. So the risks to the firm at this level is almost non-existent because you’ve really covered the risks and that’s why newer options traders and even some retirement accounts (IRAs) can be granted this options approval level.
Option level 2: This level is fairly conservative too Long option strategies like buying calls or buying puts. Your maximum risk is the amount you’ve put into the option contract. So if you bought a call contract for $200, then $200 (plus the commission cost) is your risk. This requirement is a bit higher because it requires a bit more knowledge if you decided to exercise an option and acquire the actual shares…AND it’s also higher because these options can easily erode in value on the trader and many novice traders don’t realize that. So they want there to be a step-up in knowledge/awareness when trading options level 2, yet that’s a level that’s fairly easily obtained.
Option level 3: Buying/selling spreads (where a combination of calls, puts or both are bought or sold at the same time). This is where margin approval is also required on the account (which is why most retirement accounts won’t be approved for this level. I think some savvy traders with very large, liquid accounts may occasionally be an exception to that rule, but your broker could tell you for sure). Since there are various strategies (that are beyond the basics of options) that have various leanings (bullish, bearish or neutral strategies), these tend to require a higher level from your broker.
Option level 4: Naked calls/naked puts – This is where calls or puts are sold, without there being any underlying position within the account BUT the broker has to feel that the trader can bring in any needed funds to meet the risks. And some of these strategies can carry unlimited risks. So lots of experience and larger accounts tend to be the ones granted this level.
Okay, this is all from YOUR BROKER’S PERSPECTIVE. Now let me tell you how many pros think about all of this:
The Pros See It Differently Than Your Broker Does
While a covered call may be considered to be a conservative strategy, some pros don’t like it because it’s a capital-intensive strategy, which means more overall dollars are at risk in the position than some other strategies that could produce a similar outcome.
For instance, I would either HAVE TO buy or presently own $5,000 in stock (100 shares of a $50 stock) to sell a call and bring in, let’s say $100 of income on those shares. OR…I could sell a naked put for $100 (taking in the same income) and not have to initially put up the money for the shares (even though I’d need to have it available in case I were assigned the shares). But by selling the put, it doesn’t INITIALLY require me to put up as much money, yet the covered call does and yet still has the objective of getting paid income.
Now some would say, yeah but selling a naked put is risky because your $50 strike put could go to zero if the company went bankrupt and you’d have to buy $5,000 worth of stock that was now essentially worthless (minus the amount of income taken in from the sold put, really making it $4900).
So if I’d just owned the stock outright, the stock could just as easily go to zero and not get any income for it. Or, I could sell a covered call against my stock and the shares could still go to zero and I’d keep the income from the call. In the end, they carry similar risks but the broker KNOWS their butt is covered in the case of a covered call and they may not be in the case of the sold put (because they’re counting on you to be able to make good on any funds needed). Yet your risks are about the same EXCEPT that you initially don’t have to put up as much money in the case of the sold put to obtain the same income objective AND except for the fact that more puts expire worthless than calls expire worthless. Yep, the CME (Chicago Mercantile Exchange) did a study on it and found that even more puts expire worthless than calls.
Therefore, over long periods of time (via many, many trades) you’d be more likely to have puts that you sold to expire worthless than calls. And when you sell a call to take in income, you want the option contract to erode in value and even become worthless. That way you get to keep all or most of the money/income near or at expiration. Yet selling puts are level 4 and buying a covered call is level 1.
Selling options generally have a higher probability of working out than options bought.
Also, initially selling options have a higher statistical odds of working out (being profitable) than do buying options. The buyer of options (level 2) has a much lower probability of success because they have to get the direction right, the volatility right and have that all happen before the contract erodes in value on them. Therefore, time is NOT on the option buyers side. Yet it is on the option seller’s side (which in most cases is options levels 3-4). Time IS on the side of the option seller. And if the seller of the option is smart, they only initiate sold calls/puts that expire in 60 days or less (because they know that the time erosion is fierce in the last 45 days or so until expiry). And that steep erosion is on their side and against the option buyer. So they gain an edge.
Options trading is not gambling, but to help you think about it…think of the options seller as “the house” and the options buyer as the gambler. Does the gambler have a chance to win? Sure! However, much of the time, the house wins because they have the long-term edge and that’s why…the lights stay on in Vegas.
In a similar way, the option seller generally takes in smaller, yet more regular premiums relative to the times when they have to pay out. They get paid to take upon risk. Where the option buyer has to pay to take upon risks. Also, the fact that implied volatility tends to be higher than historical volatility…it means that the contract is typically a little over-priced, which benefits the seller of the contract and not the buyer. And in the final days to weeks of the contract, the seller gains a huge edge as the time-value in the premium erodes big-time.
Certain level 3 strategies are some that have the highest probability of win-to-losing trades.
Some spreads, like credit spreads, are high probability trades. They tend to have success rates of 70-90% of them winning. So it generally pays you to be a seller of these vertical call or vertical put spreads (credit spreads) because you’re a net seller of options and therefore take in a premium because the contract you sold brings in more than the option you buy (pay out for). Time erosion works in the favor of the trader in this strategy and the credit spread trader just has to figure out where the stock WON’T go rather than where it will go.
For instance, right now as I’m writing, Microsoft (MSFT) is trading for around $105 per share. If I believe that MSFT WON’T go to $110 or higher, then I could sell a $110 strike call and buy a $115 strike call.
Microsoft can trade up (to just shy of $110) or it can trade sideways or it can trade downward and in all of those scenarios, I’d make money. Yet if I had to make a directional call (like the call or put buyer), then I ONLY make money if the price moves in my direction, moves enough in my direction and does it well before the time erosion starts to eat away at my gains. As the buyer, I’ve also got to be sure to buy when the volatility is low and sell when it’s high. Can you see how being a buyer is a bit more difficult job than being the seller? Yet being a buyer is options level 2 and in most cases, the seller is level 3 or 4.
Fewer dollars at risk in the market
Also, spread trades generally require less up-front capital than buying the stock outright or buying the stock and then doing a covered position. So many pros feel that since they have fewer dollars at risk in the market and can make a larger percentage return than if they’d owned the stock outright, they view this as being less risk.
Now some may say, “Yes, but an option eventually expires and the stock can be held forever”. True. However, many options have time frames that go up to 2-3 years. And buying those long time frames is still typically cheaper than buying the shares outright. And if the options trader wasn’t right in their assumption of what should happen in their stock during that long time frame, then they probably shouldn’t be trading options.
Remember, don’t confuse options trading with long-term investing. The beauty of owning shares outright in a solid company that was bought cheaply is that all I have to do is to be patient and in most cases I’ll reap some level of profit on down the road. With the option, time is a factor…but if you’re smart, you buy FAR more time than you feel you’ll need if you’re the option buyer and if you’re the option seller, you keep your expiry short (30-60 days max) so that you stand the best chance for the time erosion facet in the option to kick-in to a great degree and heighten your odds of being successful.
How to increase your odds of success as a buyer or seller of options
So if I felt that a stock would make the move I felt is should make within two months, then I’d buy 6-9 months of time. If I felt the option would need six months to do what I felt it should do, then I’d buy 12-18 months of time. Remember, most “market calls”, even if you’re good, take a bit longer than you think they will. So you want to account for that. And you’re not likely going to shoot yourself in the foot by buying more time, but you may in buying too little time until expiry.
Therefore, when buying an option I think about how much time I think it will need and then I tack on some more time for me to be off a bit in my timing and then I add another 60 days to that in order to dodge the bulk of the time erosion on the contract. The deeper I go in-the-money, the more the option trades more like the stock would and the intrinsic value of the option is greater which leaves less of the option’s price for time erosion (the extrinsic value).
If I’m buying, I want to buy an in-the-money or at-the-money option to heighten my odds of success because a buyer’s out-of-the-money option has a slim chance of winning and it’s why they’re priced so cheap. (I refer to them as lottery tickets).
If I’m a seller, I want to sell an out-of-the-money option with little time (30-60 days) until expiry in order to put the odds in my favor.
If you’d like to learn more about options trading and even get SIX trading strategies, then you can check out my e-book (link below). It’s probably the easiest-to-understand options book you’ll ever read.
If you already know something about options but you want to increase your odds and better learn how to make an option trade more like a stock, yet without as much capital tied up as in owning the stock…then you can check out my Options Report. You can get it by making a $100 donation to my PayPal account, by clicking here or by directly sending it to my PayPal address, which is my email: email@example.com
Additionally, if you’d like to figure out how to get paid (essentially get “free money”) by selling a dog of a stock that you’ve owned, and even how to potentially recoup some of those former losses with the new-found money…then you can check that out in the same options report mentioned above, at the same link. Once the donation is made, I’ll typically have the report emailed out to you (in Word doc form) within 24-48 hours of the contribution.
Okay, I hope this article has helped to really rethink how you think of options risks and probabilities of success as it relates to these options approval levels. As you’ve seen here, there’s a big difference between the risks to the brokerage firm and what sometimes may be your own personal risks or odds of success.
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