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.

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:

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).

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.

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.

Why Should You Consider Level 2 Options Trading?

Level 2 options trading gives traders insight into market dynamics. It allows for more informed decision-making. Unlike standard trading, Level 2 shows details about the order book. It displays both bids and asks at different price levels. This information can reveal market sentiment and potential price movements in advance. By using this advanced strategy, investors can assess supply and demand more effectively. They can also identify emerging trends and find opportunities that traditional trading might miss. This guide will outline the key benefits of Level 2 options trading. It aims to enhance trading strategies and improve performance in financial markets.

Enhanced Market Insight

Level 2 options trading provides real-time data on bid and ask prices. This information goes beyond what is available on Level 1. It shows market depth and liquidity. Traders can view how many shares are offered at different price levels. By analyzing this data, traders can identify potential support and resistance levels more accurately. This improved insight helps them make more informed decisions. As a result, traders can achieve better trading outcomes.

Improved Execution Timing

Level 2 data offers a key advantage in gauging market sentiment. It provides real-time information, enabling traders to react quickly to price movements. This is especially useful in volatile markets, where prices can change dramatically in a short time. By using Level 2 data, traders can find the best entry and exit points. This allows them to take advantage of price changes and increase their profits.

Strategic Advantage

Level 2 trading allows traders to use advanced strategies. These include market-making and scalping. Such strategies depend on understanding supply and demand dynamics in the market. With better insight into order flow and liquidity, traders can take advantage of small price changes more effectively. This approach increases the potential for profit. It also enhances the trader's understanding of market mechanics. As a result, traders can navigate complex trading environments with greater confidence.

Considerations Before You Start Level 2 Options Trading

Before starting Level 2 options trading, it's important to understand several key factors. Level 2 trading offers deeper insights into the market. It provides real-time data on orders and prices beyond basic bid and ask offers. However, a well-informed approach is necessary. Your risk tolerance, trading strategies, and market conditions matter. A solid understanding of options mechanics is also crucial for successful trades. Additionally, having a clear trading plan and continuing your education about market trends are essential. As you prepare for Level 2 options trading, considering these factors will help you build confidence and make informed trading decisions.

Understanding Market Depth

Level 2 trading requires a good understanding of market dynamics. You need to know how to interpret bid/ask spreads and order sizes. Different levels of orders can impact pricing and liquidity. For instance, knowing how many shares are available at various price points can help you anticipate price movements. This can aid in identifying key support and resistance levels. Having this foundational knowledge is essential for making informed trades. It allows you to navigate market complexities with confidence.

Risk Management

Level 2 trading carries increased risk. This risk can amplify both profits and losses. It is important to create a strong risk management strategy that fits your trading style. This should include setting stop-loss orders to reduce potential losses. You also need to know your overall risk tolerance to avoid overexposing your capital. Be ready for higher volatility and unpredictability that often come with options trading. A clear risk management plan will help protect your investments and improve your trading discipline.

Choosing the Right Platform

Not all trading platforms offer comprehensive Level 2 data. It is important to research and choose a brokerage that provides reliable and detailed Level 2 quotes. Look for platforms that include user-friendly analytical tools. These tools can help you make better decisions. The right platform can improve your trading experience. It allows you to react quickly to market changes and analyze trends effectively. Ensure that the platform meets your trading needs and offers the resources necessary for successful Level 2 options trading.

Frequently Asked Questions