Level 2 vs. Level 3 Options Trading: What’s the Difference

Options trading has many layers. Some traders buy calls and puts and stop there, while others get into more complex strategies like iron condors and straddles. To create less confusion, options trading brokers have levels that identify what you can and cannot do with your account. Knowing which trading strategies you want to use will help you decide which options trading level works for you. This article will examine the differences between Level 2 and Level 3 options trading.

What Are Options Trading Levels

Options trading levels act as guardrails that help traders become more familiar with options before embracing complex trading strategies. Options traders get assigned levels from 1 to 5. Level 1 is the most restrictive level, while you can perform any options trading strategy at Level 5. The highest level doesn’t make sense for every options trader. Most traders will have enough flexibility at Levels 2 or 3, depending on their preferred options trading strategies.

What Is Level 2 Options Trading

Level 2 options trading is the first step up you can take. Most traders begin at Level 1, where they can only sell covered calls, but some start at higher levels.

Strategies You Can Execute in Level 2

Every time you level up, you get to keep the same features. Going from Level 1 to Level 2 still gives you access to selling covered calls. In addition to keeping that Level 1 capability, Level 2 options trading opens the doors to new strategies. You can buy calls and puts, something you couldn’t do before. Level 2 options traders can also sell cash-secured puts, the put version of covered calls.

How to Get Approved for Level 2

Each options trading broker has different requirements that you have to meet for Level 2 options trading. These tips will increase the likelihood of success:

• Open a margin account: Some brokers require that you trade with margin before upgrading your account to Level 2. Other brokers do not have this requirement.
• Build your portfolio: Traders with larger sums of cash in their portfolios tend to have an easier time upgrading to Level 2. Investing more money each month can help you become a Level 2 options trader sooner. You should check your broker’s requirements and set goals around them.
• Keep trading: Traders with more experience can get a Level 2 account sooner. It can also help if you get started with a Level 1 account to build experience.

Advantages of Options Level 2

Options Level 2 accounts have several advantages over Level 1 accounts:

• You can buy calls and puts: This options trading strategy has the highest potential return if you get the timing right.
• You can sell cash-secured puts: Some traders use these puts to lower their cost basis for a favorable stock. Traders wait for a stock to reach what they believe to be a fair value or don’t buy it at all. The trader makes money along the way.
• You can use the options wheel strategy: This options strategy involves buying 100 shares and selling a covered call. After the call gets exercised, the trader uses the cash position to sell cash-secured puts until it gets exercised. Then, the cycle repeats with a covered call on the 100 shares. Level 2 options trading lets you implement this strategy.

Limitations of Options Level 2

While a Level 2 account is an upgrade from only selling covered calls, Level 2 options trading has some shortcomings. Here are some limitations to keep in mind:

• You cannot use more complex strategies: If you want to use butterflies, condors, debit/credit spreads, and other complex strategies, a Level 3 options trading account is better. 
• You can only sell options if you have the right collateral: Level 2 options trading does not let you sell naked calls and puts. You have to own 100 shares for a covered call or enough cash to buy 100 shares if you use a cash-secured put. The Level 2 options trading requirement makes it more difficult to get started with these strategies.
• Fewer hedges available: Traders can buy a put to protect their shares or a call to protect a short position. However, you get more hedging abilities as you level up. You don’t have to be a hedge fund to get useful hedging capabilities, but you can use more hedges if you upgrade beyond Level 2.

What Is Level 3 Options Trading

Level 3 options trading is a leg up from Level 2 options trading that enables more complex trading strategies. Most options traders will have everything they need at this level. The strategies get more complex, but you won’t get to access the riskiest options trading strategies (naked calls and puts).

Strategies You Can Execute in Level 3

Level 3 options trading lets you do far more than buy calls and puts. Here’s the list of options trading strategies you can use with Level 3 options trading.

• Long strangles: Traders can buy a call and put with the same strike price and expiration date. This strategy rewards a sharp price movement in either direction.
• Long straddles: Traders can buy a call and put with different strike prices. The call has the higher strike price of the two, which results in lower premiums. The strategy also rewards a sharp price movement in either direction.
• Vertical spreads: Vertical spreads involve buying an option and selling another option in a corresponding move. Both options are of the same type — call or put — and have different strike prices. A credit spread leaves you with a net premium, while you have to pay a net premium to initiate a debit spread.
• Iron condors: This strategy involves trading two calls (one long and one short) and two puts (one long and one short). Long iron condors realize a gain if the stock stays within a small range while losses are capped. Each option has the same expiration date.
• Iron butterflies: This strategy involves four options contracts, just like an iron condor, but it only uses three strike prices. Traders who use the iron butterfly hope a stock’s price will remain stable.
• Two-legged options trades: A two-legged options trade involves two options of the same type. Some traders sell a short-term put and then buy a long-term put. Other trades sell a long-term call and buy a short-term call. These options have the same strike price.

How to Get Approved for Level 3

The strategies for getting approved as a Level 3 options trader are the same as the ones for getting approved as a Level 2 options trader. If you get started with a Level 2 account, it’s easier to get approved for a Level 3 account in the future. Traders may have to expand their search for an options broker to find more generous requirements. 

Advantages of Options Level 3

Level 3 trading has several advantages over Level 2 accounts.

• Benefit from low volatility: Iron condors and butterflies give traders more ways to benefit from low volatility. 
• Easier access to hedges: Selling covered calls can also help you profit from a flat market, but you need 100 shares as your hedge. You do not need that type of collateral to hedge your positions as a Level 3 options trader.
• More strategies: Vertical spreads, two-legged options trades and straddles become available if you upgrade to a Level 3 options trading account. That’s just the tip of the iceberg.

Limitations of Options Level 3

Before you commit to a Level 3 options trading account, you should keep these limitations in mind:

• You cannot trade naked calls and puts: Most traders do not need to get involved in these options trading strategies. They are riskier and typically reserved for traders with the most experience. But if you see yourself selling naked calls and puts in the future, a Level 3 options trading account won’t be enough.
• More isn’t always better: A Level 3 account gives you more strategies, but not everyone thrives with more choices. Some traders may benefit from sticking with the simplicity of Level 2 options trading, but others can benefit from the additional choices.

Leveling Up Your Options Trading 

Levels 2 and 3 options trading offer more capabilities than the first level. You can use more complex strategies as you reach higher levels. Most options traders will find what they need in the second and third levels. These levels let you get a lot out of options trading without getting involved with selling naked calls, a strategy reserved for the most experienced traders.

Frequently Asked Questions