Like many options traders, I started out day trading. I liked it.
What did I like about it? Whatever happened during the day, work was finished when the markets closed. You took home your excitement about gains or disappointment about losses, but you didn't worry all night or weekend about what a gap would do to your position the next morning.
Why did I stop day trading? My life changed, and market conditions changed, too. About the time that markets sank into their low-volatility mode that persisted through some of the early 2000's, a child with complex health issues was born into our extended family. Market conditions weren't providing the needed volatility to make day trading as profitable and fun as it once had been, and I didn't have the needed focus or time for day trades. I might be called away at any time, literally having to leave everything to rush to the hospital.
Something else was happening with the markets, too. We were seeing the beginning effects of algorithmic trading, dark pools, and all those other influences that changed the character of the markets. Those of us who had rigorously studied chart formations that had allowed fairly accurate predictions of market behavior for decades and, in cases such as candlestick analysis, centuries, found that those studies suddenly didn't have the same relevance.
Still, day trading offers allure for some options traders. Here's what experienced traders would like less experienced traders to know: day trading is not as simple as it seems.
The first question that confronts those day trading is whether to use stock or options. Stocks allow the day trader to capture every cent of the movement in an expected direction (and to suffer every cent of the movement in the wrong direction) without worries about option decay or changes in implied volatilities. Still, many day traders choose options for obvious reasons. Options provide more leverage: traders can get more bang for their buck, especially if they use margin to buy calls or puts. That leverage can get traders into trouble, however. Let's walk through an example.
One-Minute Chart of GOOG, Mid-Morning, 3/10/14:
You have a clear scenario in mind for this bearish trade. If GOOG closes one-minute candles back above 1212, your supposition about the direction is wrong, and you can exit, so there's a close exit. Based on the width of the price band GOOG was churning out, you project a price movement down to about 1207 or a little below, but you'll plan to lock in profit a little ahead of that target, at 1208.00.
How are you going to profit from that move? You've heard that options sellers are smarter traders. Selling a call and having money in your hand seems smarter than buying a put and paying for it.
Note: I no longer day trade and do not follow or trade GOOG. The examples in this article are meant to illustrate several points about day trading and not to suggest a particular underlying or type of trade.
You still have a decision to make. GOOG has Weeklys as well as Minis and monthly options. You check volume and open interest on the Weeklys and monthly options and find that for nearby strikes, both volume and open interest are at least as high if not higher in the Weeklys than they are in the monthly options. Therefore, since this is meant to be a scalp or day trade, you choose the Weeklys. Based on volume and open interest and your concerns about getting in and out of the trade, you elect to sell a 14 MAR 14 1220 Weekly call for $4.10.
Expiration Graph When Selling a 14 MAR 14 1220 Weekly Call:
Theoretically, what happens if that 1208.00 price target is hit that same day?
Same Chart, at 12:40 PM:
Target achieved! GOOG actually traded at this price at this time, but the profit is theoretical since it might or might not have been possible to exit that trade at the exact mid at that moment.
Theoretical profit, then, is $78.00. Hmm. Let's investigate further.
What would have happened if GOOG had hit 1212 before it hit 1208, and an exit would have been triggered? Inputting the 1212 price, a pull-down menu tells me that the theoretical loss would be $48.00.
Is a possible $78 gain compared to a possible $48.00 loss a good ratio? On the face of it, it is, but is that all there is to the story?
Of course not. Take a look at how quickly the loss can grow if FOMC Chair Janet Yellen should announce that they're stopping the taper, and the SPX gaps above 1212 and keeps running while you're in the kitchen making a sandwich? If you're a think-or-swim client, at least, you can set a contingent order to buy-to-close that call position at a certain amount over the mid-price when the order is triggered, but that order might not fill in such a condition if GOOG quickly runs higher. You'd likely return to your trading desk with the loss growing larger every moment. Think that can't happen? Anyone who remembers what happened when the FOMC made a surprise announcement (not on a meeting day) one time maybe seven or eight years ago will know that it's more than possible. Is a $78.00 profit an appropriate profit for the risk seen on that chart if GOOG suddenly gaps and runs higher, and your stop loss trade doesn't fill or you've set an "at market" stop loss and the fill is extremely unfavorable once the stop loss is triggered? You'd have to know what kind of fill you'd be likely to get on a GOOG market order, and know it from long experience to answer that question.
We see from the dark vertical column on the chart that a one-standard deviation move higher that day would bring GOOG up to about 1224.20. On expiration day, that value would mean the trade broke even, but we're talking about a day trade, not a trade to be held until expiration. What would it mean if GOOG had gapped higher and then zoomed up to that position within a few minutes after entry while the call seller was trying to buy-to-cover that GOOG call? The pull-down menu beneath the chart tells me that the loss would be about $648. Yikes. A $78 gain balanced against a possible $648 loss doesn't sound like such a good idea.
Here's where the trader's experience must guide the trader, too. Does GOOG move fast enough to produce that kind of action? Seems so. Does it tend to gap intraday, trapping bearish traders? That, I don't know since I don't follow its intraday movements. However, it's my belief, based on lots of years of experience, that whatever "shouldn't happen" occasionally does happen. The unlimited risk in that chart would scare me, especially when balancing against a small gain. This kind of possible loss is the reason that most brokerages will make the would-be naked call seller jump through hoops and deposit a whole lot of money before allowing permission to sell naked calls.
Let's look at buying a 14 Mar 14 1220 Put to Capture that Same Move in GOOG.
Buying a 14 MAR 14 1220 Put:
In this case, the most that can possibly be lost is what's paid for the put. Theoretically, that would have been $1442.50, including commissions both ways. I chose the 1220 because when I was buying calls or puts when day trading, I preferred to day trade options with deltas of about +/- 70. When you're day trading, you want your option's value to move in step with the movements of the underlying as much as possible, to mimic what would happen if you had bought or sold the stock. However, the deeper in the money those options are, the more you pay for them, so the less leverage you get from them. Back in the old days when we rode around in carriages, I thought a delta of about +/- 70 was a good balance between providing some leverage but also gaining in value when the underlying moved the direction I had hoped it would.
Did this option gain in value when GOOG retreated to 1208 That Morning?
Later That Morning:
The trade theoretically gained $58.00 or 4 percent of the cost of the trade. A four-percent gain in a little more than two hours might or might not thrill you. What would have happened if GOOG had instead moved up to 1212, and you'd exited for a loss? How much would that loss have been? If I position the cursor at the right edge of the dark blue column marking a one-standard deviation move for the day, a pull-down menu tells me that the loss would have been $226.00 or 16 percent of the cost of the trade. Is a 4-percent gain opposed to a 16-percent loss an acceptable ratio?
I don't think so. You'd have to have a spectacular win/loss ratio to make that work over the long term!
What about an ATM option, a 14 MAR 14 1210 Put?
The cost of this trade is $792.50, including commissions both ways. That's the most that can be lost in this trade.
Forwarding the time to 12:40 pm when GOOG hit 1207.95:
The greater leverage with the lower-cost option has actually benefitted the trade when GOOG moved through the strike and it became an ITM option. The trade has theoretically gained $133.00 or 17 percent. What if GOOG had moved up to 1212 instead and the trade was stopped for a loss? Inputting that price returns a loss of $69.00 or 9.00 percent.
What if the option chosen at 10:20 am that morning was an out-of-the-money 1200 put? The cost of the trade would have been only $410.00, including commissions both directions. At 12:40 pm, when GOOG was 1207.95, the trade's profit was only $52.50, but that was 11.11 percent of the cost of the trade. We have a lesser price gain but a greater percentage gain. What would have happened if the 1212 price had been hit first and the trade had been exited for a loss? The loss would have been $77.00 or 16 percent of the trade's cost. Once again, the win/loss ratio would have to be a good one to make that work over the long term, but it's still better than the outcome with my preferred +/- 70 delta option.
What have we learned? When considering which option to use, volume and open interest must be checked. Day traders must have enough liquidity that they can easily enter and exit.
Consider not only the loss at your intended stop but also the loss that might occur if the unexpected or impossible occurs. It doesn't matter if your trading plan says that you'll exit at 1212 if GOOG tends to gap intraday and run up quickly or if you forgot to check news before entering the trade only to find out later that some special company announcement was expected. You may not be able to contain your loss to the expected loss, so you should know what the possible loss could be if all goes wrong.
Options provide leverage and the lower the absolute value of the delta and the cost, the more leverage you have, but the less your option's value may move in concert with the price movement of the underlying. Your gains may be smaller but bigger in percentage of the total cost, for example. If the underlying doesn't move big enough, soon enough, however, decay will swamp the smaller price gains due to the movement in those OTM options.
And, lastly, is a GOOG day trade with a two-point price range either side of the current GOOG price for the profit taking and stop-loss level an appropriate setup for an underlying with a one-day standard deviation of just under ten points? Was that setup too tight, so that too many trades might be stopped out during regular noise for the period you intend to be in the trade?
I'm not the expert here any longer. I'm not in the trenches. The last time I regularly day traded, Enron was my vehicle of choice, if that gives you any insight into how long it's been. I can't provide you with the answers to these questions. What I can give you, however, and have tried to give you, are some points to consider before you decide that day trading would be easier than trading complex options positions.
Just as with any other type of new trade, day trading should be approached with as scientific a testing method as you can devise. Backtest if possible. Practice with simulated trades. That's important, but it's not going to tell you that much about the ease with which you can get fills in fast-moving conditions. Also, emotions--and the adrenalin rush that goes with them--tend to be higher with day trades and that's hard to simulate. When you switch to live trading, start small. Do not be too quick to size up, either, as a week of successful day trades while prices are climbing tell you nothing about what happens when a rally starts breaking down and prices chop back and forth unexpectedly and then take off again.