Brokerage firms offer two basic types of accounts: cash and margin accounts. Options can be traded in either account type. However, options trading strategies will be more limited in a cash account compared to a margin account. The most appropriate account type is based on the type of option trading you plan to do.
No new brokerage account automatically has authorization for options trading. A separate application and financial disclosure must be submitted to the broker to add options trading to the account. The brokerage firm reviews the option trading application and approves the account for a specific options trading level. Brokers use trading levels one through five, with higher levels allowing riskier, more complicated option trading strategies. A cash brokerage account would receive no higher than a level 3 options authorization.
Cash Account Limitations
Options trading in a cash account will be limited to options strategies with levels of risk which can be exactly calculated when a trade is entered. The basic strategies of buying puts or calls plus covered call writing will be allowed in almost any option authorized cash brokerage account. Options spread trading -- the simultaneous buying and selling of puts or calls with different strike prices -- may be allowed in the cash account of a more experienced investor. Cash secured put selling is an additional strategy that does not require a margin account.
Margin Account Strategies
Trading options in a margin account allows the trader to implement trading strategies where the potential loss cannot be calculated in advance. The availability of a margin loan protects the trader and broker against excessive losses if a strategy goes wrong. Strategies, such as selling puts or calls, where the trader collects option premium and must fulfill the contract obligations if the buyer chooses to exercise an option, are the types of strategies that must be traded in a margin account.
Cash or Margin
The most common reason to trade options in a cash account is if the account is an individual retirement account. IRA accounts must be cash accounts and cannot be set up as margin accounts. Another reason to use a cash account is to start with an account balance below the margin account minimum of $2,000. To have a wider choice of options trading strategies, a trader may be better served by using a margin brokerage account for options trading.
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