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The world of options trading can be quite complex, with many different types of trading strategies available.
There are many benefits to using options, such as hedging against risk exposure in underlying securities and increasing return. There are 4 levels of options trading and each level has its types of options, each level being approved for certain traders due to the different levels of risk associated with each level.
The first level of options trading is defined by the selling of option premiums on, for example, existing shares of a particular stock—trading covered calls. This is generally the level those with limited trading experience in options turn to first.
Level 1 of options trading is considered to have limited risks of standardised options, as the options are hedged with shares, with the biggest problem that a trader could face is the short options entering in-the-money by the expiration date and the shares are then called from the options writer. There are 5 elements within level 1 of options trading, which cover the following options strategies:
The trading elements that are found in level 1 options trading are used for those with an investment objective of producing income: if the trader wants to sell options in their open position. Although they can limit the profits for a stock trade, on the upside, they are able to generate a profit if they do not go in-the-money before the expiration date. Not only does this level have the lowest risk, they are also the simplest of options. For example, a contract can give you the right to sell your stock at a pre-agreed upon strike price.
The second level of options trading is defined as buying option contracts that limit the risk of a trade in relation to the price that is paid for that particular options contract. The main aspect that is associated with the second level of options trading is that it limits the risk of a particular trade. Level 3 mainly deals with buying calls, buying puts, and selling secured puts.
The worst-case scenario when dealing with level 2 options is the trader can lose the cost of the contract, which is already defined the moment the trader enters the contract. The risk is that the options can be a situation of all or nothing and there is a chance the options can expire without having any worth. Despite this, all of the risk that comes from a trade is on the options trader and not with the options trader when dealing with long option positions. The following are the elements that are within the second level of options trading:
This is also a level that the majority of individuals start at due to its ease and low barriers to entry. The reason for this is that traders are only able to execute directional speculation with call or put options. Essentially, the loss of the trader is only limited to the amount of capital that they have invested into the options.
The third level of option trading includes all of the elements in level 1 and level 2, with the added benefit of being able to trade debit spreads. Debit spreads is an options trading strategy that allows investors to execute more complex trade strategies with multiple leg options such as long strangles and long straddles.
Debit spreads are typically made from short and long options and the risk that is associated is limited by the amount of capital that is spent on the spread. Though the risk is limited to the capital, level 3 options trading does require capital for using a margin account and option hedges, such as:
Unlike level 1 and level 2 in options trading, the barriers to entry when it comes to trading level 3 options are much higher.
The fourth level, also known for buying and writing naked options is the highest level of options trading. Buying and writing naked contracts has the highest levels of risk associated with them among all levels of options rating. Both parties are exposed to elevated levels of risk, the option traders and the brokers.
Although level 4 of options trading has the highest level of risk, they also offer traders the highest possible returns among all 4 levels. This is since option traders are able to sell option contracts short without hedging. Short contracts can theoretically have unlimited losses if the underlying stock moves against the option writer. The following are examples of level 4 option trades:
Although the allure of trading level 3 and level 4 options can be attractive to many individuals who have just started trading, many investors and traders start at level 1 or 2 and then work their way up the levels. It is often recommended that traders start at lower option trading levels and less capital.
As with all investing, beginners are encouraged to perform all their due diligence before investing, especially when trading with level 3 and level 4 options and past performance does not guarantee future results.
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