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Options Trading: The Most Important Piece of Advice for Beginners

By , Money Morning •

Here it is. The most important piece of advice I have for anyone thinking about options trading.

Don't let the red tape hold you back.

A lot of experienced and sophisticated investors shy away from anything that involves paperwork.

They think they're not qualified or ready, or simply that it's not worth the trouble.

Don't be one of them.

Yes, you will have to fill out an options application with your broker, but it's easy.

In fact, you had to file a similar form just to open your trading account in the first place. Now, if you want to upgrade your account to be "options approved," it's just another small step away.
Admittedly, the application may look intimidating at first glance. It is full of disclosures, legal qualifications and the kind of small print that is worrisome.

Yet the purpose of the application is simple enough.

Your broker just wants you to state that you know enough about options to make your own trading decisions.

And not to worry... It's not a quiz.

The disclosures are designed to gauge your level of experience. But their real goal is to let the brokerage firm off the hook in case things go terribly wrong. Of course, that's not going to happen to you.

But if a broker lets anyone trade without at least appearing to check them out first, they could be liable for your losses. And no one wants that.

Because options are by definition speculative, the New York Stock Exchange (NYSE), Financial Industry Regulatory Authority (FINRA), and National Association of Securities Dealers (NASD) all have rules and policies about "suitability."

That's the real reason you have to go through this (very small) hoop.

So you'll fill out the application. They file it away into the "just in case" drawer and you're ready to trade.

What's on the Options Trading Application?

The options application will ask some questions you would expect: Name, address, employment and employer name, annual income and all sources of income. They also want to know your net worth and liquid net worth, marital status and number of dependents.

Then there are a few questions you might not expect.

Like about your "affiliations."

Are you a member of a stock exchange, or do you hold 10% or more in stock of any publicly traded companies? Most likely not.

You will also be asked to identify both your stock trading and options trading experience: Knowledge level, number of years actively trading, average number of trades per year, and the average dollar amount of trades.

So the application has a few surprises, but nothing difficult to complete.

The biggest time-consumer are the pages of disclosures and qualifiers, about options trading risks, margin accounts, and financing disclosures - all of which you are required to acknowledge and sign off on.

Once you send in the application, the brokerage reviews it and assigns you to an "options approval" level. The level defines your ability to take risks based on knowledge levels and experience.

The Four Levels of Options Trading Accounts

While terminology varies among brokerage firms, there are always four levels of options trading:

Level 0 -- At this basic level, you are not allowed to do very much. You can write covered calls and protective puts, and not much more.

Level 1 -- You can do everything in level 0, plus buy calls or puts and open long straddles and strangles.

Level 2 -- Now you're getting somewhere! Here you can do everything in the previous two levels, plus open long spreads and long-side ratio spreads. (And no, there is no VIP lounge or mileage bonus for getting to this level.)

Level 3 -- This is for the big dogs. At this level, you can enter into just about any kind of options positions. This includes all of the other level trades, plus uncovered options, short straddles and strangles, and uncovered ratio spreads.

Your broker is going to assign a level to your options trading account based on what you say on the application, and (although they don't tell you this) based on the amount of cash you put into your account when you open it.

You need at least $5,000 to trade on "margin" (and options trading requires a margin account), and the more you start out with, the better your chances for landing in the higher levels.

Remember, this is all designed to cover the brokerage risks of letting you trade options. The higher the level, the higher your risks.

But remember, the higher your level, the higher their risks - especially if you lose a lot of money and then hire a lawyer to sue, claiming you didn't know what you were doing.

Now, is your brokerage firm actually going to investigate your claims about knowledge and experience levels? Probably not.

But again, they do want you to fill out the form so they cannot be held responsible, just in case your lawyer later tries to claim you were allowed to trade above your experience level. Should it ever go to trial, the application is potentially your broker's "Exhibit A." It is designed to make sure they don't lose that lawsuit.

So, just like that, we're ready to trade options.

In our next installment, we'll start by nailing down a few simple options trading concepts.

That's why I hope you'll continue to read this series. In the weeks to come, you are going to learn:

  • The complete options "lingo" and what each term means for you.
  • How to read an options listing.
  • What you need to know to structure a winning options trade.
  • The ins and outs of basic options trading strategies.
  • And much, much more....

And don't worry, once you nail down the language I'm going to talk about next week, you're most of the way there!

[Editor's Note: I've seen firsthand over the years just how little people understand about options.

That's why we had Michael create an exclusive investor's guide for you called "The Power of Options."

It's ready for you today if you'd like to read ahead. It could be the most important thing you read all week.

The best part is we are giving it to every single subscriber for free.

It's a guide created purely as a service for our readers. I hope you enjoy it. To access your free investors guide, click here. ]

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