Day traders commonly trade commodity futures, currencies, or stocks. However, an alternative to each of these is to trade options. The usual reason for trading options is to leverage trading capital or to hedge risk or both. Can options (Call/Put) be day traded? How does one go about doing this? Why and when should a day trader consider options instead of trading commodity futures, currencies, or stocks directly? What are the risks? Are the benefits worth the risks?
What Are Options (Call/Put)?
Options are contracts that one can trade on the Chicago Board Options Exchange or CBOE. There are two types of options, calls and puts. A call contract gives the buyer the right to purchase the underlying asset at a set price until the expiration of the contract. The buyer can do so no matter how high the market price goes. A put contract gives the buyer the right to sell the underlying asset at a price specified in the contract no matter how low the market price falls. In each case, the seller of the contract is obliged to sell or buy in return for which they receive a premium up front. The buyer pays the premium for the opportunity that the contract offers and is not obliged to do anything unless it provides a profit.
Understanding the Fundamentals of Options Trading
It is important to understand the fundamentals of options trading if that is how one wants to day trade. An important consideration for a day trader who is interested in options trading is the time value of an option. Sellers receive a premium for taking on the risk that a stock, currency, or commodity future price will not go up or down over a specific period of time. Buyers pay a premium in the hope that the price will do the opposite of what the seller expects. The closer it gets to expiration of an option contract the less likely it is that an out-of-the-money option will become profitable. This is critical for the day trader who is only expecting to hold an options position for several hours.
Options Day Trading – The Risk vs Reward
Just like when a day trader trades stocks, currencies, or commodity futures directly, they are looking to profit from changes in price. In the case of options, it is the value of the option contract. The contract value is driven by current price and market expectation. Sellers of options, on the average, make more money than those who buy. This is because most options expire worthless. The risk of just selling calls and puts is that from time to time the market changes drastically and takes the option price with it. This can cause a trader to lose all of their trading capital and even have to replenish their margin account in the space of a few hours. Thus, most options traders hedge their trades with purchases to offset potential losses from selling options.
Analyzing Time Frame and Volatility When Day Trading Options
Like with directly trading commodity futures, currencies, or stocks, options day trading profits come from identifying when volatility will provide profit opportunities. A benefit of using options is that the trader can purchase the opportunity to make a profit and limit their loss potential. Times like when the Federal Reserve is about to announce interest rate decisions are when stocks or an index like the S&P 500 can be volatile. With options, a day trader can stake out a potentially profitable position and know that their risk is limited to the premium they are paying.
Strategies for Successful Day Trading of Options
Successful day trading comes from having more profits than losses and profiting more often than losing. It also comes from limiting potential losses. Options traders commonly use vertical spreads to lock in profits if the market moves as expected while limiting downside risk. For example, with a bear call spread, The day trader expects an asset to fall in the short term. They sell a call for which they gain a premium. They buy a call at a higher strike price to cap any losses if the market surprises them. They start the trade with a credit which they retain if the stock, currency, or commodity future falls in price or remains flat. The day trader will then exit the contract and retain their profit when the value of the contract goes up in this case. If they are doing this on the day that the options contract expires they can just wait for the end of the trading session to gain their profit.
Common Pitfalls to Avoid When Day Trading Options
No matter what you are trading or how you are trading it, fear and greed are the usual enemies. Day traders who use options need to routinely exercise discipline in how they enter, manage, and exit their trades. It may be tempting to always sell calls and puts that are about to expire and routinely collect premiums. This is a dumb approach because eventually you will be clipped for all of your profits for the last six months or a year when the market surprises you. Smart options traders, day traders or not, always hedge their risk with offsetting trades or simply purchase calls and puts where the risk is limited to the premium paid.