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I'll preface this by saying that my experience in this field is limited, so bear with any abuses of terminology.

I understand the rationale behind FINRA's "Know your customer" and suitability rules for certain account privileges (e.g., trading options).

It seems as though the initial tier is only allowed to sell covered calls (which by my understanding require you to have multiples of 100 of the underlying ready to distribute to the buyer if necessary), but it would seem as though long puts and calls would be more "within reach" of those that are starting out (i.e., don't have $25,000+ to put down, and are likely only at risk of being OTM).

It's unclear to me why the system is set up this way. I know that these first two tiers are available with a cash account, so it wouldn't seem to be a margin requirement that dictates this "pecking order". Is this simply a set of stages through which people are traditionally initiated into these types of transactions, or is there a deeper rationale based on suitability?

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The different levels are somewhat related to levels of risk.

Writing a covered call is pretty low risk, in the sense that if I buy the stock but sell a call, I now have a lower cost for the stock, and however low the stock drops, I'm still slightly better off than the regular stock buyer. Covered call writing is often used to generate premium income from a stock portfolio, and less as a tool for speculation.

Buying a call or put is simpler in execution, but the risk of losing the entire amount spent (I actually avoid the word invested here) due to leverage involved isn't just a possibility — it can be pretty likely depending on the strike price.

Put writing and uncovered (naked) call writing can entail even higher risk relative to the premium received — consider extreme moves in the underlying to understand the potential losses involved.

The more sophisticated trades are presumed to take a bit more experience and tolerance for risk and each broker has its own set of criteria to allow the client to trade at each level.

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  • I was going to answer too, but yours covered most of the points I wanted to make, so I edited instead. I hope my edits are OK.
    – Chris W. Rea
    Commented Mar 21, 2014 at 12:19
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Option tiers are broker specific, according mostly to their business model and presumably within the bounds of FINRA Rule 2111 (Suitability).

The tier system can be as complex as E*Trade or as simple as none with Interactive Brokers.

The suitability is determined presumably by compliance presumably by the legal history of the rule. The exact reasoning is political, effected by the relevant party composition of the legislature and executive. The full legal history will have the judiciary's interpretations of legislation and policy.

Cash and margin rules are dictated primarily by the Federal Reserve and more precisely by FINRA and the SEC. This is the only distinction made by IB.

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