Day Trading Options – The Ultimate Guide for Beginners

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The excitement, the exhilaration – profitable trading sessions never get boring. If you know what you’re doing, options can provide the same benefit as day trading stocks. Predicting the direction of the underlying isn’t the only variable.

Day Trading Options: The Basics

Options. Options. Everyone likes options. From what to wear to what to eat – the choice is the spice of life. In a financial context, it’s no different. Options give you the right but not the obligation to engage in a transaction. Ultimately, the choice is yours.

The great thing about financial markets is that there are plenty of profitable opportunities just looking to be exploited. And with the right option income strategies, you can do just that.

Covered Call

A covered call is a beginner option strategy where you earn income on a stock you already own. Owing to the asset acts as a hedge, but you’re still exposed to downside risk.

How do you write a covered call?

It works like this:

Say you own 100 shares of Microsoft (MSFT), and the current share price is $105. To execute a covered call, you simply sell a weekly or monthly call option contract on the position. For example, a weekly at-the-money contract – with a $105 strike price — is currently priced at $1.55 per share. Since contracts sell in lots of 100, the transaction results in a cash inflow of $155.

The strategy is popular because there is a minimal risk outside of the underlying going to zero. Even if you suspect the stock is in trouble – since you own it – you can sell your shares and exit the position.

  • Covered Call Max Profit: $155
  • Covered Call Max Loss: [(105 – 1.55) * 100] = $10,345

Covered Put

A covered put is similar to a covered call. The strategy involves shorting the underlying stock and selling put options. Remember, when you short a stock, you profit from any downside movement. Since puts increase in value when the underlying declines as well — having a short position ensures you’re hedged.

Unlike a covered call, though, losses are unbounded. When a stock price falls, it can only go to zero. However, a stock can increase by 200%, 300% or even more. While it’s unlikely to happen – especially for a mature company like Microsoft (MSFT) – the possibility still exists.

Weekly at-the-money put options for Microsoft (MSFT) sell for $1.56 per share. Executing the strategy results in a $156 cash inflow per contract sold.

  • Covered Put Max Profit: $156
  • Covered Put Max Loss: unbounded

Bear Call Spread

Now you get to mix things up. A bear call spread is used if you think the underlying will decline. The strategy involves selling a call option with a lower strike price and buying a call option with a higher strike price.

The lower strike call is always more expensive, so the transaction results in a cash inflow. Using the Microsoft (MSFT) example, the strategy works like this:

A weekly-at-the-money call option – -with a strike price of $105 – is priced at $1.55 per share. An identical call option with a strike price of $108 is priced at 45 cents per share.

The net result is a cash inflow of $1.10 per share or $110 per contract. The main advantage is less downside risk. If the underlying increases, you’ll have to sell the stock at the lower strike price. However, since you also bought calls with a $108 strike – any gains above are entirely hedged.

  • Bear Call Spread Max Profit: [(1.55 – 0.45) * 100] = $110
  • Bear Call Spread Max Loss: [(108 – 105) – (1.55 – 0.45) * 100] = $190

As you see, the risk-reward trade-off is much greater.

Bull Put Spread

Similar to a bear call spread, you can use a bull put spread to generate income as well. The strategy involves selling puts with a higher strike price and buying puts with a lower strike price. But, again, the higher strike put is more expensive and results in a cash inflow.

Current Microsoft (MSFT) weekly at-the-money put options are selling for $1.56 per share. Put options with a $103 strike are selling for 77 cents per share. The net result is a cash inflow of 79 cents per share or $79 per contract.

Again, risk-reduction is the most significant benefit. By owning the lower-strike put, you’re hedged for any decreases in Microsoft’s share price below $103.

  • Bull Put Spread Max Profit: [(1.56 – 0.77) * 100] = 79$
  • Bull Put Spread Max Loss: (105 – 103) – (1.56 – 0.77) * 100] = $121

Collar Strategy

A collar is a clever way to hedge an existing position and generate options income simultaneously. The strategy involves owning the underlying, buying a put option and selling a call option. A collar acts as a hedge against large increases and decreases in the stock price.

Take Microsoft (MSFT) again:

The current share price is $105. A weekly at-the-money call option sells for $1.55 per share, while a similar put option sells for $1.56. Remember, both have a strike price of $105. By selling the call and buying the put, you’re completely hedged. The transaction also results in a cash inflow of 1 cent per share or $1 per contract.

  • Collar Max Profit: [(1.56 – 1.55) * 100] = $1
  • Collar Max Loss: 0

As you can see, a collar protects you in either direction. The downside, though, is profits are minimal. The strategy is meant to mirror a risk-free investment, similar to owning a 10-year US Treasury. Many collar-enthusiast decrease the put strike price to increase their cash flow to get around this. Remember, a $103 strike put is priced at 77 cents.

Positioning this collar results in a net inflow of 79 cents per share or $79 per contract. However, there are two sides. By lowering the strike price, you increase your downside risk. Any losses from $105 to $103 will not be hedged.

Short Straddle

A short straddle is the highest income generating option strategy available. Unfortunately, it’s also the riskiest. You play it by selling both a call and a put – of the same strike price — without having a hedge in place. Going back to the Microsoft (MSFT) example, weekly calls and puts are priced at $1.55 and $156 per share. If you sell both, you receive a total inflow of $3.11 per share or $311 per contract.

The income factor looks excellent, but the downside is significant. Naked calls are unbounded on the upside, so your losses can theoretically extend to infinity. On the other hand, the put is bounded by zero, so your maximum loss is Microsoft going bankrupt.

  • Short Straddle Max Profit: [(1.55 + 1.56) * 100] = $311
  • Short Straddle Call Max Loss: unbounded
  • Short Straddle Put Max Loss: [105 – (1.55 + 1.56) * 100] = $10,189

Keep in mind a short straddle is a highly speculative strategy. It should only be used if you have significant option experience or have other hedges in place.

Short Strangle

A strangle is similar to a straddle, but you’re mixing up the strike prices here. The main benefit is more control over upside and downside risk. For example, if you think Microsoft is more likely to rise than fall — you can sell an at-the-money put for maximum income as well as increase the call strike price to $108 from $105.

Conversely, if you think Microsoft is more likely to fall than rising, you can sell an at-the-money call and decrease the put strike price to $103 from $105. But, again, both variations are highly speculative, so proceed with caution.

Options Trading Risks

Basically, you should stay away from options trading. The risk of losing all your money is significant. Trading stocks might allow you to make a mistake without ruining yourself. However, one wrong decision trading options can cost you all your money, and you can also end up losing more money than you have.

If you have experiences trading options and you are aware of the risk, then the bear call spread, bull put spread, or the collar strategy might fit with lower risks. When breaking down the math, it’s easy to see all three generate solid income while at the same time protecting from catastrophic losses.

As well, the strategies allow you to tweak your strike prices so you can tailor your position to your own perceptions about the stock. Of course, if you want to increase risk, plenty of options are available, but you should definitely stay away from such high risk options income strategies.

Options Greeks

Before you begin day trading options, make sure you understand the so-called Greeks. As financial variables, Greeks are option factors that affect the options price within and outside of changes in the underlying.

Delta

Delta is a first order effect and measures the linear change in the option price given small changes in the price of the underlying. Call deltas range from 0 to +1 and put deltas range from 0 to -1. For example, if a call option has a delta of 0.70, it means a 1% change in the value of the underlying will result in a 0.70% change in the value of the option.

Gamma

Gamma is a second order affect that attempts to quantify delta error. Since delta measures the linear change in the price of the option, gamma accounts for non-linear changes or large increases and decreases in the underlying. Gamma is always positive, and the larger the number, the less you can rely on delta. When you see a large gamma, be careful.

Vega

Vega is extremely important. It quantifies volatility priced into an option. Volatility is the most important variable in option pricing, and the higher the volatility, the more expensive the option is. Look at the implied volatility statistic on an options chain: the higher it is, the more you need the underlying to increase for your position to turn a profit.

Theta

Theta represents an options time value. So until an option expires, there is always some dollar value left in it – even if it’s completely out-of-the-money.

Rho

Rho is an options sensitivity to interest rates. This is important because rising rates increase the value of call options and decrease the value of put options. Call options are considered ‘waiting to make a purchase.’ When money is still in your account – and not currently invested in the underlying – you can earn interest on that capital until you decide to exercise the option. Because of this, interest rates are always added over the holding period.

Options Day Trading Strategy Examples

There are two perspective approaches when day trading options: fundamental and technical.

Fundamental Options Trading Strategies

Trading Information

When trading information, you’re buying and selling options based on news of the day. Economic data, interest rate rhetoric from the Federal Reserve, or just a Tweet. If you follow the markets, you know a single piece of information can send equities spiraling in various directions.

It wasn’t that long ago the Dow erased an 800 point loss because Jerome Powell – Chairmen of the US Federal Reserve – issued a dovish statement regarding the direction of future interest rates.

When material information like this hits, volatility spikes as the market assesses the news. And for the third time, volatility is the most important variable affecting option prices. If you can position yourself on the right side of the wire, you won’t have any problem ending up on the right side of the trade.

Arbitrage Trading Strategies

Trading Put-Call Parity

Trading put-call parity is a strategy built around exploiting arbitrage. Arbitrage profits occur when you earn a riskless profit without having to use any of your own capital.

The formula looks like this: Put price + the underlying price = call price + present value of the call options strike price. When this equality formula doesn’t hold, you have an arbitrage opportunity. Say, for example, we take Apple’s (AAPL) stock.

If the current share price is $154, an at-the-money put option costs $5, an at-the-money call option costs $4 and the current yield a 10-year US Treasury is 3%, the math works out like this:

  • 5 + 154 = 4 + [154/ (1.03) ^ (1/52)]
  • 159 = 157.91

As you can see, equality doesn’t hold. As an astute options trader, you can earn an arbitrage profit by shorting the stock at $154, buying an at-the-money call option for $4 and selling an at-the-money put option for $5.

With the transaction, you earn $1 per share. As well, interest isn’t a factor because you can invest the short proceeds during your holding period. Most importantly, you’re completely hedged. If the stock price increases, you can exercise the call and cover any losses from your short position.

If the price of the stock decreases, that’s fine as well because — while the at-the-money put you sold will be exercised – you shorted the stock, so you profit from all price decreases. For equality to hold and eliminate the arbitrage opportunity, the call price would need to be $5.09.

Arbitrage opportunities like this don’t last long. When they spot it, traders execute the same riskless transaction over and over until supply and demand reset the price of the options. As a daily strategy, though, the opportunity can be quite profitable. Similar to scalping with equity day traders, arbitrage profits are minimal but can add up to meaningful gains over time.

Day trading weekly SPY options

The SPDR S&P 500 ETF (SPY) is one of the most highly traded and liquid ETFs out there. Many professional option traders use the index to make speculative bets or hedge risky positions in their portfolios. Because of its high liquidity, it makes a great underlying asset for day trading options.

Buy or sell weekly SPY call options

A simple strategy is to buy or sell weekly SPY call options. Beforehand, most options traders feel out the mood of the market and decide which direction offers the greatest risk-reward trade-off. If you believe the market is primed for a rally, owning call options is a great way to participate with very low risk.

On the other hand, selling weekly call options can earn you quick income over a short holding period if you’re pricing in bearish sentiment. The greatest upside of selling weekly call options – rather than longer-dated options – is the benefit of time value decay.

Above, I wrote about the importance of theta. For short-term options, theta is much higher, which means you earn a greater time value premium with short-term options compared to long-term options. A second benefit is risk management. For example, when selling weekly call options you can narrow your prediction down to a short interval.

Instead of being liable for weeks or months, the short-term contract expiration allows you to take profits without the long term risk.

Buy or sell weekly SPY put options

Put options are always popular. They act as insurance for long portfolios, and selling them can be a great way to add income to your account. The best part is puts are usually priced much higher than calls. Because of the insurance characteristic, investors are willing to pay a premium for peace of mind. If you have a strong sense the market will rise over the week or even remain flat, selling weekly put options is a great way to turn a profit.

Trade SPY Volatility

Remember above; I wrote Vega (volatility) is the most important variable affecting option prices. Well, if you believe the market is primed for turbulence, owning puts will pay off in two ways: the decrease in SPY’s price and the increase in volatility.

Rising volatility results in the implied volatility statistic increasing on the options chain. This will make future put option contracts more expensive and increase the value of your position along with it.

FAQ

Is The SEC Pattern day trading rule Relevant If You Day Trade Options?

The pattern day trader rule is a regulatory requirement passed down by the US Financial Industry Regulatory Authority (FINRA). It stipulates that any investor who “executes four or more day trades within five business days” given the trades represent “more than six percent” of total trades within the same time period must do so in a margin account of at least $25,000.

The rule applies to both stocks and options. The US Federal Reserve employs a freeriding prohibition mandating you can’t use ‘unsettled funds’ to engage in another transaction.

Trades officially settle within two business days. When you day trade, whether in equities or options, you buy and sell so quickly that previous transactions don’t have time to officially clear.

According to FINRA, this makes the strategy against the rule, and you are, per definition, a pattern day trader. So if you place one day trade a week, everything is okay. If you complete 3 day trades within 5 business days, that’s still okay, but if you make more than 3 day trades per 5 business days, then you need the $25,000 minimum balance in your account.

Other financial instruments like currencies for forex trading are not defined in the same way, that’s why some day traders prefer to day trade currencies, but forex trading has its own specifics.

What is options income?

Option income is the premium you earn from selling options contracts. Like bond interest or an equity dividend, option income is compensation for taking on risk. For example, when you sell a call, you give the buyer the opportunity to participate in a rally, so the premium is your return for the service. When you sell a put, you’re protecting the buyer from downside risk. Thus, the cash inflow is similar to insurance premiums.

Do you pay taxes on options?

Yes. Option profits are considered short-term capital gains. Therefore, they are taxed as ordinary income at your marginal rate, similar to bond interest. Any investment held for less than one year receives the same tax treatment.