Option Day Trading Rules Explained
Day trading with options can be a lucrative and rewarding experience if done correctly. Knowing option day trading rules is key to success in this field, as it helps traders understand what strategies they should use and how to avoid common mistakes. Options allow investors to take advantage of rising and falling markets without risking their entire capital on one trade; however, certain risks are involved when investing in options that must be considered before entering any trades.
- Pattern Day Trader Rule
- Pattern Day Trader Rule Workaround
- Day Trading Rules
- Wash Sale Rule
- Can You Day Trade In a Roth IRA
What is Option Day Trading?
Day trading options is a type of stock market investing and trading that involves buying and selling options contracts within the same day. Options are derivatives, meaning they derive their value from an underlying asset such as a stock or index. Option day traders use options trading strategies to take advantage of short-term price movements in the markets.
Rules for Option Day Trading
Before engaging in option day trading, there are several rules you should follow for optimal success.
Does the Day Trading Rule Apply to Options?
Yes, the pattern day trading rule also applies for options trading in the United States and for all rules relevant to options trading, this is the most frequently asked one. The pattern day trader rule defines how many trades one can make as a day trader.
Once options traders open a margin account, they automatically fall under the PDT rule. And the PDT requires a minimum balance of $25,000 once a new trade is opened, independent of how many options contracts are traded.
Those who make more than 3 options day trades within 5 business days in a margin account with less than $25k get flagged as a pattern day trader and are blocked from opening new options positions. The trading restrictions keep active for 90 days with some brokers, and then another maximum of 3 day trades within 5 business days are possible.
So, if you are located in the United States and open a brokerage account with a U.S.-broker and want to trade U.S. options, then there is no workaround for you. Traders residing in Europe or other regions have depending on the local law, the opportunity to trade with less than 25k.
U.S. residents can trade futures and forex as an alternative to options if they want to avoid the PDT rule since those two assets don’t have any FINRA minimum account value requirements.
Understanding the Basics of Options
Besides the FINRA and SEC pattern day trading rules and margin rules, there are other important rules to consider before starting to trade options.
A key rule for successful option day traders is understanding how options work and what types of strategies you can use when entering into trades. An option contract gives its owner the right (but not obligation) to buy or sell a particular asset at a predetermined price within a specific time frame. There are two main types of options – calls and puts – which give traders different ways to speculate on market movements without owning any underlying assets directly.
Setting Up a Risk Management Plan
Another important rule for a successful option day trader is setting up an appropriate risk management plan before entering into any trades. This includes deciding how much capital you’re willing to risk per trade and setting stop-loss orders so that your losses don’t exceed your predetermined limits if the market moves against you unexpectedly. Additionally, it’s important to understand margin requirements so that you don’t get caught off guard by unexpected costs associated with leveraged positions such as spreads or straddles and strangles.
Investors should always keep their fingers away from naked call and naked put options, regardless of what returns some self-claimed gurus promise. Trading calls and puts naked is equal to unlimited risk. In addition, it should be avoided to use too much buying power to trade equity options, index options etc.
So, developing an effective strategy for entering into profitable trades is another essential rule when engaging in option day trading successfully. This means researching different stocks, indices or other assets prior to making any decisions about whether they may be good candidates for short-term speculation through options contracts.
Types of Options Strategies for Day Trading
Options trading is a popular way for traders and investors to potentially make money in the stock market. Various types of options strategies can be used when day trading, each with its advantages and disadvantages.
Conservative Long Call and Long Put Strategies
A long call or put strategy involves buying an option with the expectation that it will increase in value before expiration.
Bullish Sentiment: For example, if you believe a stock’s price will go up, you could buy a call option on that stock. If the stock does indeed rise above the strike price of your option before expiration, then you would profit from this trade.
Bearish Sentiment: On the other hand, if you think a stock’s price will go down, then you could buy a put option on that same stock instead.
In the money vs at the money vs out of the money options
By buying out-of-the-money (OTM) call or put options at higher than intrinsic value prices, the chances of ending the trade with a profit decline. However, OTM options are often priced at low fractions of a dollar, like $0.05, so if they run into the target, the return can be exponentially higher. However, the chances of success are the lowest. For example, the price of AAPL is at $150, and the strike price of the option is $200, then this options contract is OTM.
At the money options (ATM) are relatively close to their fair value, and most options traders use a strike price close to the current price, which is then ATM. So, if Apple Inc. is at $150 right now, and the chosen options strike price is $150, then it’s perfectly at the money.
ITM (in the money options) are those where the strike price is below the current price of the stock. The chance that the stock ends in the money is relatively high compared to OTM options, but the paid premium when going long a call options contract is high. So, if the trade works, the return is a small % of the total money of risk, but if the trade fails, the traders lose a relatively high amount of pre-paid options premium.
Day trading options can be a profitable and exciting way to invest, but it is important to understand the different types of strategies available and how they work before getting started. In addition, choosing the right options brokerage platform is an essential part of successful options day trading.
There are not that many options day trading rules that limit trades to get started. However, the pattern day trading rule is a high hurdle an options trader has to take. From there on, is essential to learn how to trade options first, and then in a second step, proceed by placing options contract buy and sell orders within a paper trading platform. Finally, only proceed with real-money trading if consistent profits are made with the simulated trading.
In addition, keep in mind that the wash sale rule also applies to options trading. That means it is not allowed to realize losses for tax season optimization. Please consult your tax office or financial advisor to evaluate the best tax-relevant strategies in case needed.
A trading course focusing on options trading helps to build in-depth knowledge about options trading. Combined with a good options broker with integrated paper trading capabilities, the chances of success increase.
Do day trading rules apply to options?
Yes, day trading rules do apply to options. Day traders must adhere to the same pattern day trader rule that applies to stocks, which requires a minimum of $25,000 in equity in their account and limits them to no more than four round-trip trades within five rolling business days. One round trip equals a completed buy and sell transaction.
How many options day trades can you make?
Three options day trades within 5 business days in a margin account with less than $25,000, unlimited options day trades with more than $25,000 in a margin account, and as many as you want in a cash account. Still, the funds are settled in the cash account with 1 to 2 business days delay.