How to Get Started with Level 2 Options Trading

After you’ve started learning about trading options, you may find yourself exploring level 2 options trading. Whether you're a newbie or a seasoned trader, this guide is packed with valuable insights and practical tips for your options trading strategy. You’ll learn about how to use level 2 options strategies, interpret level 2 market data and assess risk tolerance. 

What Is Level 2 Options Trading?

Level 2 options trading allows investors to buy and sell call and put options on stocks and exchange-traded funds (ETFs). Call options allow the buyer to buy the underlying asset at a specific strike price by an expiration date, while put options allow the buyer to sell the underlying asset at a strike price by expiration. 

Compared to level 1 options trading, which only lets investors sell covered calls and cash-secured puts, level 2 options trading differs because it allows for more flexibility to add strategies. However, it requires further understanding of options, and options buyers can lose their entire investment if the option expires worthless. Selling options also increases risk. Still, level 2 options trading can offer the potential for profit if the underlying asset moves in the desired direction.

What Is Level 2 Market Data and How Does It Work?

Level 2 market data is a type of market data that displays the complete bid and ask prices for a particular security. It also shows the orders' size and origin. This data type is also called market depth, as it reveals the liquidity and demand for a security at different price levels. Level 2 market data can be beneficial to traders because it aids in identifying trading opportunities, assessing the strength of a stock and executing trades more efficiently. To access level 2 market data, subscribe to a data feed from an exchange or a third-party provider.

How to Read Level 2 Market Data

You can read level 2 market data by viewing the order book, which displays bid and ask prices and sizes at different levels for a particular security. The order book is typically presented as a table or a chart, with bid prices and sizes on the left and ask prices and sizes on the right. The highest bid price and lowest ask price represent the best bid and offer (BBO) or the national best bid and offer (NBBO) if the data is from multiple exchanges. Additionally, the order book indicates each order's market maker or source.

By analyzing level 2 market data, you can determine the supply and demand for a security at different price levels, as well as the market's liquidity and depth. You can also identify trading opportunities, including price gaps, support and resistance levels and trends. The goal is to execute trades more efficiently by selecting the best price and size for your order.

How Is Level 2 Different from the Other Options Levels? 

Level 2 differs from the other options trading levels with respect to the strategies and risks involved. Depending on the broker, there are usually four or five levels, tiered according to risk, with level 1 being the lowest and level 4 or 5 being the highest. Each level provides access to varying types of options trades and margin amounts.

Read more: Level 2 vs Level 3 Options Trading: Which Is Better?

3 Basic Options Strategies You Can Use in Level 2

Options trading at level 2 includes level 1 strategies along with the ability to buy options. Here are four options strategies you can employ:

1. Long Call

A long call option allows the buyer to purchase a specific stock at a fixed price (strike price) within a given timeframe by paying a premium. If the stock price climbs above the strike price, the buyer can exercise the option to profitably buy the stock at a lower cost. 

For instance, you want to buy 100 shares of Company ABC, priced at $150, expecting it to exceed $160. Instead of investing $15,000, you buy one ABC 160 call option for $5 per option contract, which equates to 100 shares, paying $500 ($5 x 100). If ABC's stock climbs to $170 before expiration, you can exercise the option and purchase the shares at $160, earning a profit of $500, which is (($170 - $160 -$5) x 100). If the stock price drops to $140, you lose only the $500 premium, much less than buying the shares outright, which would result in a loss of $1,000 ($150 - $140 x 100).

2. Covered Call

A covered call option involves selling a call option on a stock you own. By selling the option, you receive a premium but limit your potential profit and risk losing money if the stock price drops. Traders use this options strategy to generate income or reduce risk. 

Assuming you bought 100 shares of Company XYZ (XYZ) at $300 per share. You fear it won't go higher in the next month but don't want to sell. Instead, you can sell one XYZ 310 call option expiring in a month for $10 per contract for 100 shares, receiving $1,000 ($10 x 100). If XYZ stays below $310, the option expires worthless, and you keep the premium. If it exceeds $310 and the buyer exercises the option, you sell the shares you own at $310 each, earning a profit of $1,000 on the stock and $1,000 from the premium received. However, you miss out on further stock appreciation.

3. Long Put

A long put option allows the buyer to sell a stock at a predetermined price within a specific timeframe. This strategy is used when the buyer expects the stock price to decrease below the strike price. It offers limited profit potential but also limits the risk to the premium paid. 

Assuming you believe that the Company AAA stock price will drop below $750 from $800. Instead of shorting, which exposes you to unlimited risk if the price rises, you buy one AAA 750 strike put option for $20 per option contract. If the stock falls to $700 before expiration, you can exercise the option and sell 100 shares at $750 each, resulting in a profit of $3,000 ($750 - $700 - $20 x 100). 

However, if the stock price rises to $850, the option expires worthless, and you only lose the premium of $2,000. This approach mitigates the risk compared to shorting the stock outright.

How to Get Level 2 Options Approval

To trade level 2 options, follow these steps to obtain approval from your broker. 

• Start by logging into your brokerage account and accessing the settings or account management section. 
• Locate the options trading section and select the appropriate option, such as "enable" or "apply." 
• Next, complete a comprehensive questionnaire that covers personal information, financial status, investment experience, trading goals and risk tolerance. Provide accurate and honest responses as they determine your eligibility for options trading. 
• Submit the application and await the broker's approval, which can take a few days or weeks. Once approved, you'll receive a confirmation email or notification, allowing you to begin trading level 2 options on your brokerage platform. You can be denied this level of approval and most firms do not allow naked short put options on level 2.

Understanding Level 2 Options Trading and Market Data

Level 2 options trading offers more flexibility and strategies than level 1. It allows investors to purchase call and put options on stocks and ETFs, but higher risks are involved. Additionally, level 2 market data provides a comprehensive view of bid and ask prices, order sizes and origins, allowing traders to assess market liquidity and identify opportunities. These tools are valuable for investors seeking advanced options trading strategies and deeper market insights.

Frequently Asked Questions