If You’re a Day Trader, You Need to Consider This
Traditionally, day trading and options trading have peacefully coexisted in separate planes.
But these days, that’s changing — as more and more traders are finding ways to trade options using tried-and-true day trading methodologies.
Options trading is appealing to traders because they typically require a lower initial investment, and often the ability to cut losses more easily.
By combining the benefits of options trading with the quick pace and potential returns that day trading offers, you have many opportunities for potential profit.
In this issue, you’ll learn the art of using day trading strategies for trading options, including how to approach the market, considerations to keep in mind, and how to find strong contenders for trades.
What are Options?
Options are a type of derivative. What’s a derivative? Let’s back up for a second to make sure that you understand that before we delve into options.
A derivative is a type of security that’s valued based on an underlying asset (or a group of underlying assets). Examples of the assets in question might be commodities, bonds, currencies, stocks, or market indexes.
Derivatives can either be traded like stocks, on an exchange or OTC (“over the counter”). Like stocks, their prices will fluctuate. But in this case, the fluctuation is based on the value of the underlying asset.
OK, so back to options.
Options are a type of derivative, because their price relies on the price of the underlying asset. It’s the type of asset that will make a derivative an option. This means that while options are a derivative, not all derivatives are options. Got it?
What is an Options Contract?
Options are bought as contracts. These contracts basically give you as the buyer the opportunity to call dibs on an asset.
They’re an agreement where you have the opportunity to buy or sell an asset at an agreed upon price, either on or before a specific and predetermined date. While you have permission to buy or sell within a finite period, you aren’t obligated to pull the trigger.
The fact that the execution isn’t mandatory differentiates options from another financial security which you may know: futures.
In the case of futures, you once again have dibs on the asset, but you’re obligated to buy or sell if certain criteria are met within the agreed upon timeframe.
Options are pretty much what they sound like in that you have the option to buy or sell, but you also have the ability to decline.
Are Day Trading Strategies Suitable for Options?
Traders with small accounts looking for alternate methods of getting in on the action of day trading while also mitigating risk sometimes trade options using day trading strategies.
Applying day trading technique techniques to options trading actually makes a lot of sense. In particular, it provides opportunities if you have a small account. Day trading options allows you to get in on the action of day trading while also mitigating risk and protecting your capital.
Here are some of the reasons why trading options is well suited to day traders:
- Low cost: It’s typically a low-cost investment strategy. Options usually cost less than an outright purchase of underlying asset by itself. Instead of buying or selling the shares of a stock, for instance, you can buy the option and maintain control over a comparable amount of shares.
- Ease of entry/exit: With options, you often have the ability to get in and out of positions quickly and easily than with stocks, bonds, and mutual funds.
- Less risk: Because options contracts give you the ability to opt to buy in/out or not, they can be less risky than other types of day trading investments.
Types of Options
Before we delve into applying day trading strategies to trading options, it’s important to gain a better understanding of how options work.
To educate you on the basics, let’s discuss the two key types of options: call options and put options. Here’s what they are:
The call option is kind of the prospector’s choice. It’s a potential investment for the future.
Here’s an example.
Say you want to purchase an asset for $50,000 at some point in the future … but only if it meets certain criteria.
If you believe it could happen, you can purchase a call option for this asset. This means that you can lock in a price now, and if it meets your criteria within a predetermined period of time, you have the ability to buy.
Sounds awesome, right? But wait: it’s not totally without risk or consideration. The owner/seller of the asset in question doesn’t just want to give you the option to buy without a little collateral in return.
Typically, the option buyer is asked to put down a deposit or a premium. This is a portion of the total buy.
As the buyer, you stand to benefit because if the asset goes up in value (which is your hope), you can buy at the agreed upon price, which might become extremely advantageous within the window of time you’ve agreed upon.
However, if the expiration date of the option comes up and you decide that you don’t want to move forward, you won’t receive a refund on that initial payment.
If the call option is for prospectors, the put option is for those who want to hedge their bets.
A put option is a contract where you have the right to sell the asset in question at some point in the future within a predetermined period of time, if certain conditions are met.
With a put option, you set what is called a strike price. Say that you set the strike price at $10 per share. With your put option, you can call in your option to sell at that price at any point up until the expiration date of the option.
The benefit here is that even if the value of the stock goes down, you can still fetch the agreed-upon price within the predetermined time period. If the stock price goes below the strike price, you can profit from this style of trading. When the expiration date hits, you can either sell the option or cash in.
Of course, like a call option, it isn’t all benefit with zero risk. As a put seller, you receive a premium or down payment.
A single put option represents a certain amount of the asset in question. Often, it’s one per 100 shares of the asset, so the down payment would be 1/100th of the total purchase.
Tomorrow let’s have a look at how to actually find good options.
There are a few techniques you should be using to guide your decision. What do you look at?
Do you know what is the most important criteria to look at?
Find out tomorrow.