Day Trading using Options

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Day trading options

The term “day trading” assumes that a trader opens and closes positions within a single trading session and doesn’t take positions overnight.

Also, when talking about day trading, people generally think of instruments such as – equities, ETFs and futures. Not options.

However, let’s analyze whether we can use options for day trading and, if so, we should consider how to adjust trading styles and which nuances to focus on while trading options within such a short time frame.

Day trading requirements

First, let’s consider which conditions an instrument must satisfy to be traded within a day without taking positions overnight. The most important are:

  • Relatively high volatility
  • Enough liquidity
  • Acceptable commissions

Volatility is required to allow a trader to catch a relatively large price move. Certainly, we could say that volatility may be “scaled” if an instrument can be traded with leverage, but in this article, we consider non-leveraged trading.

Liquidity is required to allow a trader close his position at any moment with a tight bid/ask spread. When analyzing liquidity level, we must take into account the size which we trade. If we trade only one contract, then liquidity is not an issue in most of the instruments you might want to trade. Besides the quantity of contracts which you can buy/sell in any given moment, an important metric is the size of the spread between best market orders. You pay half of the spread to the market each time when buying/selling at market price.

Commissions is not only an instrument property as it mostly depends on your broker/FCM. The only requirement is that commissions must not kill a significant part of your profit.

Now let’s take a look at whether options satisfy these requirements.

Options price volatilities

The heading above is a bit misleading for anyone who knows something about the implied volatility concept. This paragraph is not about IV/HV of an option’s underlying instrument; it is about the volatility of the option’s price itself. Here we are considering options not as a derivative, but as an independent security.

To start, let’s take three options on the S&P 500 futures index, which are being traded at the moment of writing this article. We consider three options, one is at-the-money, and two (call and put) are out of the money. For each of the options, we build a candlestick chart for daily prices from the beginning of the instrument’s lifecycle to the current day. We can see on the chart that price movements are significant, sometimes moving more than 100% in one day.

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ES mini 2200 put and call daily prices, 4 months

Now let’s build the chart for intraday data, 10 minute periods:

ES mini 2200 put and call prices within one day

The day was selected randomly, 2020-11-22. It’s easy to see that the price range of the put option for this day was between 22 and 27.5 points or more than 20%.

In other words, the option’s price changed significantly more than the underlying’s. Therefore, options price volatility is more than enough to allow traders to use them as a speculative security for day trading.

The charts above were built for option strikes which now are at the money. If an option is far in or out of the money, then it’s price will not be so volatile.

Options liquidity

Liquidity of a single option is always lower than the liquidity of its underlying. There are several reasons for this.

  1. The number of options is bigger than the number of underlyings by thousands of times. For example, right now (when this article was written) there are 6 options series for the ES mini December futures. Each series contains about 400 options. Even if we assume that the number of people who trade options is equal to the number of people trading futures (the underlying), their interest is dispersed on all the different options.
  2. In reality, the number of people who trade options is much fewer than number of traders for linear instruments

Near the money liquidity concentration

The further the strike is from the money, the less liquidity exists at that strike. If we open a big position in an ATM option, we must remember that it might become harder to close that position if the underlying price changes significantly causing the option to be far in or out of the money.

To demonstrate this let’s visualize some data from the CME Group website. This is a time and sales report, a simple table containing the following columns:

  • Trade time
  • Trade instrument (call/put and strike)
  • Trade price
  • Number of contracts in trade

We want to understand at which strikes the most trades are concentrated. The best way to visualize such kind of information is a histogram. We’ve built two: the first shows a distribution of the number of trades, while the second illustrates a distribution of the number of traded contracts.

Number of trades per strike in one day

As expected, most trades occurred near the ATM strike. The black dashed line on both charts denotes current underlying price.

But since we are talking about intraday trading, it’s not likely that the liquidity of a particular contract will change significantly in one day.

Spreads

What really can affect the performance of intraday options trading is the bid/ask spread. Let’s compare the spread of the underlying (ESZ16 futures) with that of the corresponding ATM call option.

Right now the spread in ESZ16 futures orders book is 0.25 or 12.5 $ and this is equal to the minimum price step, denoted in contract specification. Contract nominal value at current price is 2200/0.25*12.5 = $110,000. The spread in futures then is equal to 12.5/110000 = 0.011%.

On the other hand, the current price of an ATM call for this futures contract with expiration in two weeks is about 16 points. Price step of this contract is also 0.25 = 12.5$. Spread can’t be less than the price step. Thus minimum bid/ask spread is 0.25/16 = 1.56%, which is huge in comparison to the spread for its underlying futures contract.

Commission

Commissions are mostly a property of the brokerage firm, not the contract. In our understanding, commissions must be at least smaller than half of the contract’s price step.

Day trading options, conclusion

Near the money options can be used as a speculative instrument for intraday trading. When selecting the appropriate contract, it’s worth it to pay attention to the following things:

  • average size of the bid/ask spread
  • how far an option’s strike is from underlying’s price; always try to select ATM option for best liquidity
  • how many contracts traded per day on average

Day Trading Options

Kevin Ott

Day trading options is a very risky game. Not only are options risky assets to begin with, but day trading is a particularly risky form of investing. Trying to predict price movements on an intraday basis is not an easy task, and when you throw decaying assets into the mix, it’s a borderline recipe for disaster.

Here are some of the top reasons why you should and should not day trade options:

Reasons to Day Trade Options

  • Collect option premium by selling options (can’t do this with stocks)
  • Keep your max-loss risk very small (only when buying options)
  • Trading 1 options contract is cheaper than trading 100 shares

Reason NOT to Day Trade Options

  • If it is more expensive to trade options than stocks
  • Options decay and can expire totally worthless
  • Increased leverage could result in total loss of capital

A Little Information about Options

Options provide additional leverage. This is a very important fact that wee need to keep in mind when discussing options. Professional investors, like hedge funds, pension funds, and endowments, seldom use options, because they have ample funds and buying power. They don’t need any additional leverage.

If hedge funds decide to use options, it’s usually to take advantage of an inherent characteristic of an options contract, like premium decay.

Overtime, the value of any options contract that is out of the money will asymptotically approach zero until it reaches expiration, where it will ultimately expire worthless if it is not in the money.

Therefore, some investors look to sell options to take advantage of this premium decay. This is a solid strategy that works well, right up until the moment that it doesn’t.

Selling options is what Nassim Taleb refers to as the “Bob Rubin” trade. Where someone can make over $100,000,000 over the course of ten years, and then lose billions in a few days when the same strategy that has worked for a decade suddenly implodes due to a market crash. If you sell an options contract, your hope is that the value declines and ultimately the options contract expires worthless. If it doesn’t expire worthless, however, you will be obligated to buy back the option or the corresponding amount of stock at a loss. This is where the danger of options comes in, because, remember, options are leveraged instruments. If short options position moves against you, the losses could be very significant.

Why Bother Day Trading Options?

The only real reason to day trade options, as opposed to day trading the underlying stock, is because you want to sell options on an intraday basis.

For example, say stock XYZ is trading at $75 per share in the morning, and you are bearish and want to short the stock. You could sell out of the money call options in the morning and buy those same call options back at the end of the day, hopefully for a profit if stock XYZ declines. Additionally, some time value, known as theta decay, will come out of the value of the option. This would be an options “day trade.” Hopefully, you will benefit from a decline in the stock price as well as theta decay.

Keep in mind, the PDT (pattern day trader) rules still apply for options. If your total brokerage account value is less than $25,000, you can only make three day trades per rolling 5 trading days. If you make four or more day trades in one week, you will receive a PDT violation from your broker, informing you that you cannot make any more day trades or risk not being able to trade for 90 days.

You won’t owe any additional money if this happens, but a PDT violation can be a headache. Assuming your account equity is less than $25,000 the only way around the PDT rule for options or stocks is to have multiple brokerage accounts, and therefore increase the number of day trades you can make in a week.

Consider Day Trading Stocks Instead

With all of this said, there is one reason to buy options in a day trade situation. If it costs $5.00 to buy stock, you could buy up to 4 options contracts for less than the price of buying 400 shares, assuming you’re paying $1.00 per options contract.

By buying call or put options at $1.00 per contract, you will almost always save on commissions by day trading options vs day trading stocks.

TradeStation is a great broker that has per contract options pricing of $1.00.

How to day trade

The world of day trading can be exciting. Day traders are unlike many other investors because they only hold their securities—as you would expect from the name—for a day.

Day trading overview

FINRA rules describe a day trade as the opening and closing of the same security (any security, including options) on the same day in a brokerage account.

Determining a day trade

Example 1

Trade 1—Jan 7—Buy to open (BTO) 10 QQQ Jan 70 calls

Trade 2—Jan 7—Sell to close (STC) 10 QQQ Jan 70 calls

Making these trades on the same day would constitute a day trade.

Example 2

Trade 1—Jan 7—BTO 50 XYZ

Jan 8—Customer starts the day with a long position of 50 shares of XYZ

Trade 2—Jan 8—STC 50 XYZ

Trade 3—Jan 8—BTO 50 XYZ

This would not be a day trade. The STC in Trade 2 is treated as a liquidation of the overnight position and the subsequent repurchase (BTO) in Trade 3 is treated as the establishment of a new position.

Example 3

Trade 1—Jan 7—BTO 50 XYZ

Jan 8—Customer starts the day with a long position of 50 shares of XYZ

Trade 2—Jan 8—BTO 25 more XYZ, making the customer long 75 shares

Trade 3—Jan 8—STC 25 XYZ

The day trade here is the BTO of 25 in Trade 2 and the STC of 25 shares in Trade 3. First-in-first-out (FIFO) is not used in day trading calculations. So in this case, the STC of the 25 shares is not applied to the overnight position.

Hypothetical example, for illustrative purposes only.

Pattern day trader accounts

Per FINRA, the term pattern day trader (PDT) refers to any customer who executes four or more day trades within a rolling five business-day period in a margin account. Keep in mind a broker-dealer may also designate a customer as a pattern day trader if it knows or has a reasonable basis to believe the customer will engage in pattern day trading. Once an account is designated a PDT account, it remains a PDT account until it is reset by the broker-dealer.

In regards to margin requirements, the minimum equity required for the accounts of customers deemed to be pattern day traders is $25,000. This minimum equity must be deposited in the margin account before the customer may open trades and must be maintained in the customer’s account at all times.

If a PDT account’s value closes below the $25,000 requirement, the customer will be issued a day trading minimum equity margin call the next business day, and the account will be moved to restricted status until the account value is brought above $25,000.

How are day trades counted?

Day trades are measured by the customer’s intent when placing trades. For example, a purchase of 10 contracts placed in a single order and subsequently closed in several sequential transactions, will constitute one day trade.

The same holds true for spreads, which are executed all at once. A credit spread entered and executed as a spread and closed exactly as it was opened will count as one day trade. This is true for all recognized spreads, such as butterflies, condors, etc.

However, a spread entered and executed as a spread, where the legs are closed separately, will count as multiple day trades.

Trade 1 (10 a.m.)—BTO 10 XYZ Oct 50 puts/STO 10 XYZ Oct 55 puts (credit put spread)

Trade 2 (12 p.m.)—BTC 10 XYZ Oct 55 puts

Trade 3 (1 p.m.)—STC 10 XYZ Oct 50 puts

This would be two separate day trades.

Note that modified orders (e.g., price, quantity) are considered a new and separate trade for day trade counting purposes.

Making several opening transactions and then closing them with one transaction does not constitute one day trade. Remember, it has to do with the customer’s intent. In the following example, the customer clearly intends to execute multiple trades, so they are counted as multiple day trades. Each buy is a separately placed order and therefore, the STC is not considered one single trade but rather qualifies as three distinct closing trades.

Trade 1 (9:30 a.m.)—BTO 5 XYZ Jan 60 calls

Trade 2 (10 a.m.)—BTO 3 XYZ Jan 60 calls

Trade 3 (10:30 a.m.)—BTO 2 XYZ Jan 60 calls

Trade 4 (11:15 a.m.)—STC 10 XYZ Jan 60 calls

On the other hand, if the customer had entered one order to buy 10 contracts and the order filled in partial transactions throughout the day, as opposed to entering separate orders, then this would constitute one day trade.

Are you ready to start day trading or want to do more trading? Let E*TRADE help. Open a margin enabled account, or visit the knowledge library to learn more.

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