Options Theory: How to Day Trade Options

Day trading options. The phrase is filled with promise yet potential ruin. The promise is for profits if your skills prove worthy. As for the ruin, well, that comes unbidden if said skills are found wanting. Let’s see if we can’t shed some light on the topic and help you make better decisions on whether this is a trading approach that speaks to you.

First, the definition of a day trade has to do with the duration of the position. If you buy and then sell a stock within the same trading session, then it’s a day trade. And, of course, the same definition applies if you’re buying an options contract. Since options only trade between 9:30 AM and 4:00 PM EST, that means you’re in and out within 6.5 hours. Sometimes the hold time will be minutes, and sometimes it will be hours. But it won’t ever be days. Holding overnight simply isn’t something that day traders do.

If day trading is your game, then the next step is to decide what vehicle you will use to place your bets. The appeal of options, I suspect, is their cheapness and leverage. If you lack a large account or merely don’t want to tie up the capital necessary for stock, then you might prefer wielding options. Here are a few key points.

Pattern Day Trader

As far as I’m aware, options still subject you to the pattern day trader rule which states that you can’t do any more than three-day trades within five business days. If you execute four or more trades, then you fall under the rule’s requirements which state that you have to have $25k equity in your account. That essentially means that it is challenging for anyone to become a day trader with stocks and options if they are underfunded.

Alternatives do exist, however. This rule doesn’t apply to futures and Forex trading.

Volatility

Volatility is the lifeblood of day trading. More movement equates to a higher potential for profit. No movement equals no potential for profit. This is why day traders thrive on volatility and avoid trading boring stocks like utilities and staples. Furthermore, every penny matters to a day trader. Since their time frame is so much smaller, they’re playing for dimes, quarters, and maybe the occasional buck. But that doesn’t mean we’re talking small money here. Remember, you can amp up your size to make a 25 cent profit come out to hundreds of dollars.

Trading Costs

All tradable instruments involve a trading cost. And I’m not talking about commission. Instead, this consists of the bid/ask spread. This piece is the Achilles heel for using options as your vehicle. Their trading cost is more significant than stock, futures, and forex. And that makes them one of the least desirable instruments to use — at least for day trading.

Here’s an example. Right now shares of Apple Inc have a bid/ask spread of one penny ($185.20 x $185.21). In contrast, the one-month at-the-money call option has a bid/ask spread of ten cents ($4.75 x $4.85). That’s ten times as much! Now, sure you can split the spread to narrow that down. But even still, it will require a larger increase in the underlying stock to offset the spread if you’re using options instead of stock.

And since we’re only gaming for smaller moves in the stock anyways due to our short hold time, it makes options a less effective vehicle for gaming direction.

Here’s another point. You have to stick to liquid stocks. Apple is one of the most actively traded companies in the marketplace and its bid/ask spread for options was still five times larger than the shares. It’s even worse if you venture into illiquid names. So don’t!

Delta Matters

Perhaps this goes without saying, but option spreads are not designed for day trading. So you’re relegated to buying calls when bullish and puts when bearish. That’s it. Now, that should make sense when you consider that you’re using these as a substitute for long/short stock. Think of it this way. If you buy 100 shares of AAPL, your delta is +100. That means you make $100 per $1 increase. If you want to use an option as a substitute, then you have to buy a higher delta option. This is why you must purchase in-the-money calls/puts for your day trades. Otherwise, they won’t be responsive enough to the stock to generate a decent return for the small move you’re trying to exploit.

I’d caution you from going too deep in-the-money though. The bid/ask spreads widen the deeper in-the-money you go.

Let’s summarize:

First, options aren’t the most efficient vehicle for day trading.

Second, stick with buying calls and puts, not spreads.

Third, you have to use liquid stocks that have adequate volatility.

Fourth, buy in-the-money options.