Day trading options

Day Trading - Swing Trading Options - Strategy and Examples.

"Day Trading, Swing Trading, And Options?… Maybe !"

Have you ever bought a stock that you “knew” was breaking out of its trading range? Have you ever had to sell that stock out at the end of the day because you were unable to hold it overnight, only to see that exact stock gap open $2.00 the next day? Has missing this type of opportunity left you frustrated?

What about bottom fishing? Have you ever bought a stock on the way down, then had to sell it out at the end of the day for even-money or maybe a small profit… only to wake the next morning to see the stock gap open dollars up? Tired of watching these available profits hit someone else’s account instead of yours?

Too often, day traders and swing traders are forced out of these opportunities. Typical day traders and swing traders who look for stocks with quick, short term movements are not in the business of holding positions overnight, let alone a week or two. Therefore, the use of options is not a component of their trading strategies.

Now, however, new opportunities for profit are becoming available as many day trading firms are allowing their traders to trade options. Unfortunately, many option strategies do not apply to the quick in and out nature of day trading or swing trading.

For instance, neither day traders or swing traders are normally in a single stock long enough for the strategy of premium collection. However, there is a strategy that will provide the protection necessary for these traders to carry positions through overnight risk, fully protected, but still allow them to take optimum advantage of the two scenarios mentioned above.

As a result, you can now put dollars in your own pocket instead of watching them go to somebody else, and do so without putting your firm’s capital at risk overnight. This particular strategy is a premium purchasing strategy. It can allow day traders and swing traders the capital security to exploit two potentially explosive profit scenarios … breakouts and bottom fishing.

Since day traders and swing traders have had no reason to deal with options until now, we’ll explain options, detail a specific option strategy, and give examples of when it can be used and the outcomes that can be expected.

Options are a wasting asset, meaning they have a limited life and lose value over time. Therefore, you want to use them quickly and then sell them out to avoid as much decay loss as possible.

There are two kinds of option philosophies: premium collecting (selling options) and premium purchasing (buying options). The latter may fit into some of the strategies used by day traders and swing traders. There are several premium purchasing strategies, and each can be used in several ways.

Some are very sophisticated and take time and effort to master. Others, like the protective put, are not as sophisticated and can be learned and implemented in a reasonably short amount of time. Strategies like the protective put require a rudimentary understanding of options, as opposed to time intensive expertise.

This is because the protective put strategy is purely defensive in nature. It functions as strict hedging, not profit capturing. Profit capturing can involve more risk than a hedging position, and requires a greater level of knowledge. In the case of the protective put, the determination of when to use it is the crucial element for its success. With our focus on breakouts and bottom fishing, the “Protective Put” is the strategy we‘ll detail.

THE PROTECTIVE PUT.

The Protective Put, also referred to as the “married put,” the “puts and stock” or “bullets,” is a strategy that is ideal for a trader who wants full hedging coverage. This strategy is very effective with stocks that normally trade under high volatility or stocks that may be involved in an event-driven, high-volatility situation.

The put option gives the owner of the option the right, but not the obligation, to sell a certain stock, at a certain price, by a specified date. For this right, the owner pays a premium. The buyer, who receives the premium, is obligated to take delivery of the stock should the owner wish to sell at the strike price by the specified date. A put, strategically used, offers protection against substantial loss since the stock will be taken by the buyer before heavy losses set in.

The Protective Put Strategy involves the purchase of put options in conjunction with the purchase of stock and, as stated above, works well in situations where a stock is prone to rapid, volatile movements.

For day traders and swing traders, this strategy can allow the capital security to exploit two potentially explosive profit scenarios…. breakouts and bottom fishing. These two opportunities can be very profitable but also very dangerous. With these two scenarios, timing is the key element. Enormous profits can be had if your timing is right.

However, if the timing is wrong, the effects can be devastating. If a trader can take advantage of the full profit potential of these two scenarios without having the full risk associated with them, logic dictates that the trader stands a much better chance of seeing a substantial profit.

BUYING THE PUT.

When traders purchase a stock that they expect will make a sudden upward move, they can buy the put (protective put) to provide a proper hedge. The construction of this position is actually quite simple. You buy the stock and you buy the put in a one-to-one ratio, meaning one put for every one hundred shares. Remember, one option contract is worth 100 shares. So, if 400 shares of IBM are purchased, then you would purchase exactly four puts.

From a premium standpoint, we must keep in mind that by purchasing an option, we are paying out money. This means that our position must “outperform” the amount of money that we paid out for the put.

If the put costs $1.00, then the stock would have to increase in price by $1.00 just to break even. The protective put strategy has time premium working against it, thus the stock needs to move up to a greater degree and more quickly to offset the cost of the put.

However, the price of the put can be adjusted depending on whether it is at-the - money or out-of-the-money. The choice of whether to purchase the at-the-money put or an out-of-the-money put simply comes down to how much protection you want to have versus the amount of money you want to spend. If you are willing to spend more money for your protective put in order for it to start providing downside protection at an earlier price, then you may want to buy the at-the - money put.

However, if you are willing to accept a little more downside risk in order to save money on your put purchase, then you may want to buy an out-of-the-money put instead. It will cost less than the at-the-money put but it will start its protection at a lower price, which means you will lose more money if the stock moves in the adverse direction.

HOW THE PUT WILL PERFORM.

Let's take a look at the risks and rewards of the protective put strategy over three different scenarios. When we buy a stock, three potential outcomes exist. The stock can go up, go down, or remain stagnant.

Let's hypothesize results across these three scenarios. Say we buy the stock for $31.00 and buy the 30 strike put for $1.00. In the up scenario, we set the stock price up at $31.50. The results are that we have a $.50 gain from capital appreciation and a $1.00 loss from the purchase of the put, which when combined, gives us a $.50 loss overall.

It is important to realize that the up scenario will only produce a positive return if the stock gain is greater than the amount paid for the put. This being the case, you calculate the breakeven point for the protective put strategy by adding the purchase price of the stock to the price of the put. In our up scenario, add the stock price of $31.00 plus the option price of $1.00, and you get a breakeven of.

$32.00. So, until the stock reaches $32.00, the position will not produce a positive return. Above $32.00, the position will gain.

In the stagnant scenario, the position will produce a loss. Since the stock hasn’t moved, there will be no capital gain or loss. Also, with the stock at $31.00 at expiration, the puts are worthless. The position lost $1.00, which is the amount you paid for the puts.

In the down scenario, the position will again produce a loss. Setting the stock at $30.00, down a dollar, we have a $1.00 capital loss. With the stock at $30.00, the 30 strike puts will be worthless, thus you incur a $1.00 loss because that is what you paid for them. Your total loss will be $2.00.

However, in any down scenario, the protective put will set a cap on your losses. Let’s see how that works. We’ll set the stock price down to $28.00. Since you purchased the stock at $31.00, there will be a capital loss of $3.00. The puts, however, are now in the money with the stock below $30.00. With the stock at $28.00, the 30 strike puts are worth $2.00. You paid $1.00 for them so you have a $1.00 profit in the puts. Combine the put profit ($1.00) with the capital loss ($3.00) and you have an overall loss of $2.00. The $2.00 loss is the maximum you can lose no matter how low the stock goes, even with the stock as low as zero. This is what is meant by maximum protection.

In every protective put position, it is possible to calculate your anticipated maximum loss. You can do so by using the following formula:

(stock price minus strike price) minus option price.

For example, suppose you paid $30.00 for your stock, and you paid $1.00 for the 27.50 strike puts. Following the formula, you take your stock price ($30.00) and subtract the put’s strike price (27.50), which leaves you with $2.50. To this $2.50 loss, you then subtract the amount you spent on the option (-$1.25), which gives you a combined, maximum loss of $3.50 for this position.

This formula will work every time. Remember, stock loss (stock price paid - strike price) plus option cost equals maximum potential position loss.

Looking at the three hypothesized scenarios, we find that only the up scenario can produce a positive return, and that’s only when the stock increases more than the amount you paid for the puts. The other scenarios produced losses. If the stock is stagnant, you lose the amount you paid for the put. If the stock goes down, you lose again - but the loss is limited. It is the limiting of loss in highly volatile situations that makes the protective put an attractive and useful strategy.

PROTECTIVE PUT'S BEST SCENARIO.

A stock that has the potential to rise quickly also has the potential to fall just as quickly. A stock that has substantial potential gain has an equal potential loss. A trader choosing to buy a stock like this should have more protection to the downside, and at the same time, ample allowance for a large upside potential move. This is a perfect time to use the protective put strategy. The purchase of an out-of-the-money put will be a relatively inexpensive investment, but will provide the kind of results that will best fit a bullish lean. You will have unlimited downside protection with all the room you need for your potential run up. Of course, this comes at a price. You must pay for the protection and freedom this position can provide.

The protective put strategy, when used correctly, will allow investors to take advantage of some opportunities that could provide large potential gains without being exposed to the severe risks the position would have posed without the use of protective puts.

BOTTOM FISHING.

Use the Protective Put in the case of a stock in the process of a steep decline. Quite often, stocks experience bad news or break down through a technical support level, and trade down to seek a new, lower trading range. Everyone wants to find the bottom in order to buy and catch the technical rebound.

Although this scenario sounds good, these types of trades are risky. The risk is in identifying the true bottom. A stock that is in a free-fall or rapid decline might give a false indication of a bottom, which could lead to substantial losses. The protective put will provide protection against this kind of substantial loss.

A stock that goes through a free-fall finally “exhausts” or works through the sellers. The stock proceeds down to lower levels where sellers are no longer interested in selling the stock.

At this level, the stock consolidates and buyers move in. Because the sellers are now done (exhausted), the pressure is lifted from the stock and it proceeds up as buyers out-number sellers.

There are models that are used to calculate where this bottom may lie, commonly referred to as “exhaustion models.” The problem is that the stock, on the way down, may stop and give the appearance of exhaustion but then continue further down. If you had bought at the false appearance of exhaustion, you could be looking at a big loss.

There is a potential for a very big reward if you pick the “right” bottom. However, with the big potential gain comes the big potential loss that is common in these types of risk/reward scenarios. Here is a perfect opportunity to employ the protective put strategy!

Remember, the protective put allows for a large potential upside with a limited, fixed downside risk. If you feel that the stock has bottomed-out and is starting to consolidate, you purchase the stock and purchase the put.

If you are right, and the stock runs back up, the stock profit will well exceed the price paid for the put. Once the stock trades back up, consolidates, and develops its new trading range, the need for the protective put is over.

Use the formula for maximum loss discussed earlier. Calculate the loss in the stock and the amount you paid for the put, and add them together for your maximum loss in this position. The protective put has limited your loss.

Maximum Loss = (Stock Price – Strike Price) – Option Price.

BREAK OUTS.

As seen with the exhaustion example, the protective put strategy is best used in situations where the stock has potential for an aggressive upside move and the chance of a big downside move.

Another potential opportunity for using the protective put is in combination with Technical Analysis. Technical Analysis is the study of charts, indicators oscillators, etc. Charting has proven to be more than reasonably accurate in forecasting future stock movements.

Stocks travel in cycles that can and do form repetitious patterns. These patterns are predictable and detectable by the use of any number of charts, indicators and oscillators.

Although there are many, many forms and styles of technical analysis, they all have several similarities. The one we want to focus on is the technical “break - out”. A break-out is described as a movement of the stock where its price trades quickly through and beyond an obvious “technical resistance” or resistance point.

For a bullish break-out, this level is at the very top of its present trading range. Once through that level, the stock is considered to have “broken out” of its trading range and will now often trade higher, and establish a new higher trading range.

The “break-out” is normally a rapid, large upward movement that usually offers an outstanding potential return if identified properly and acted upon in a timely fashion. However, if the break-out fails, the stock could trade back down to the bottom of the previous trading range.

If this were to happen, you would have incurred a large loss because you would have bought at the upper end of the previous trading range. As you can see, the “break-out” scenario is an opportunity that has large potential rewards, but can, on occasion, have a large downside risk.

However, if you were to apply a protective put strategy with the stock purchase, you can drastically limit your downside exposure. For instance, say you were to buy the 65 strike put for $2.00. If the stock trades up to $75.00, you would make $9.00 if done naked, but only $7.00 if done with the protective put.

This difference is the cost of the put. This $2.00 investment is more than worth it should the stock go down. If the break-out turns out to be a “false” break-out and the stock reverses and trades down, your 65 put will allow you to sell your stock out at $65.00 minus the $2.00 you paid for the put. This limits your loss to $3.00 instead of a potential $8.00 loss. This is a much better risk/reward scenario.

Use the Protective Put when you expect an aggressive, volatile, upward swing in the price of a stock.

Purchase one put for every one hundred shares owned.

Time and price the put for the maximum protection according to your risk parameters.

Choose a put that presents the best cost for the needed coverage that fits your risk tolerance.

Get out of the put quickly to diminish the effects of time decay.

Most professional traders, including day traders and swing traders can reap huge rewards from the protective put strategy. The reason is inherent in how most traders attain profits and experience losses.

Normally, successful traders make a little money on a consistent basis. They make a little bit day-in and day-out. But when it comes to losses, they lose in large chunks. They spend a month building up profits, only to lose that money in one day (and typically with only one stock). If a trader could figure out how to avoid even a handful of those large losses, then his or her profitability would soar.

To address this issue, I strongly recommend that you leverage the protective put when buying on breakouts and when bottom fishing.

How Options are Traded.

Many day traders who trade futures, also trade options, either on the same markets or on different markets. Options are similar to futures, in that they are often based upon the same underlying instruments, and have similar contract specifications, but options are traded quite differently. Options are available on futures markets, on stock indexes, and on individual stocks, and can be traded on their own using various strategies, or they can be combined with futures contracts or stocks and used as a form of trade insurance.

Options Contracts.

Options markets trade options contracts, with the smallest trading unit being one contract. Options contracts specify the trading parameters of the market, such as the type of option, the expiration or exercise date, the tick size, and the tick value. For example, the contract specifications for the ZG (Gold 100 Troy Ounce) options market are as follows:

Symbol (IB / Sierra Chart format): ZG (OZG / OZP) Expiration date (as of February 2007): March 27 2007 (April 2007 contract) Exchange: ECBOT Currency: USD Multiplier / Contract value: $100 Tick size / Minimum price change: 0.1 Tick value / Minimum price value: $10 Strike or exercise price intervals: $5, $10, and $25 Exercise style: US Delivery: Futures contract.

The contract specifications are specified for one contract, so the tick value shown above is the tick value per contract. If a trade is made with more than one contract, then the tick value is increased accordingly.

For example, a trade made on the ZG options market with three contracts would have an equivalent tick value of 3 X $10 = $30, which would mean that for every 0.1 change in price, the trade's profit or loss would change by $30.

Call and Put.

Options are available as either a Call or a Put, depending on whether they give the right to buy, or the right to sell.

Call options give the holder the right to buy the underlying commodity, and Put options give the right to sell the underlying commodity. The buying or selling right only takes effect when the option is exercised, which can happen on the expiration date (European options), or at any time up until the expiration date (US options).

Like futures markets, options markets can be traded in both directions (up or down). If a trader thinks that the market will go up, they will buy a Call option, and if they think that the market will go down, they will buy a Put option. There are also options strategies that involve buying both a Call and a Put, and in this case, the trader does not care which direction the market moves.

Long and Short.

With options markets, as with futures markets, long and short refer to the buying and selling of one or more contracts, but unlike futures markets, they do not refer to the direction of the trade. For example, if a futures trade is entered by buying a contract, the trade is a long trade, and the trader wants the price to go up, but with options, a trade can be entered by buying a Put contract, and is still a long trade, even though the trader wants the price to go down.

The following chart may help explain this further:

Limited Risk or Limitless Risk.

Basic options trades can be either long or short and can have two different risk to reward ratios. The risk to reward ratios for long and short options trades are as follows:

As shown above, a long options trade has unlimited profit potential, and limited risk, but a short options trade has limited profit potential and unlimited risk.

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However, this is not a complete risk analysis, and in reality, short options trades have no more risk than individual stock trades (and actually have less risk than buy and hold stock trades).

Options Premium.

When a trader buys an options contract (either a Call or a Put), they have the rights given by the contract, and for these rights, they pay an up front fee to the trader selling the options contract. This fee is called the options premium, which varies from one options market to another, and also within the same options market depending upon when the premium is calculated. The options premium is calculated using three main criteria, which are as follows:

In, At, or Out of the Money - If an option is in the money, its premium will have additional value because the option is already in profit, and the profit will be immediately available to the buyer of the option. If an option is at the money, or out of the money, its premium will not have any additional value because the options is not yet in profit. Therefore, options that are at the money, or out of the money, always have lower premiums (i. e. cost less) than options that are already in the money. Time Value - All options contracts have an expiration date, after which they become worthless. The more time that an option has before its expiration date, the more time there is available for the option to come into profit, so its premium will have additional time value. The less time that an option has until its expiration date, the less time there is available for the option to come into profit, so its premium will have either lower additional time value or no additional time value.

Volatility - If an options market is highly volatile (i. e. if its daily price range is large), the premium will be higher, because the option has the potential to make more profit for the buyer. Conversely, if an options market is not volatile (i. e. if its daily price range is small), the premium will be lower. An options market's volatility is calculated using its long term price range, its recent price range, and its expected price range before its expiration date, using various volatility pricing models.

Entering and Exiting a Trade.

A long options trade is entered by buying an options contract and paying the premium to the options seller. If the market then moves in the desired direction, the options contract will come into profit (in the money). There are two different ways that an in the money option can be turned into realized profit. The first is to sell the contract (as with futures contracts) and keep the difference between the buying and selling prices as the profit. Selling an options contract to exit a long trade is safe because the sale is of an already owned contract. The second way to exit a trade is to exercise the option, and take delivery of the underlying futures contract, which can then be sold to realize the profit. The preferred way to exit a trade is to sell the contract, as this is the easier than exercising, and in theory is more profitable, because the option may still have some remaining time value.

Day Trading using Options.

With options offering leverage and loss-limiting capabilities, it would seems like day trading options would be a great idea. In reality, however, the day trading option strategy faces a couple of problems.

Firstly, the time value component of the option premium tends to dampen any price movement. For near-the-money options, while the intrinsic value may go up along with the underlying stock price, this gain is offset to a certain degree by the loss of time value.

Secondly, due to the reduced liquidity of the options market, the bid-ask spreads are usually wider than for stocks, sometimes up to half a point, again cutting into the limited profit of the typical daytrade.

So if you are planning to day trade options, you must overcome this two problems.

Your DayTrading Options: Near-month and In-The-Money.

For daytrading purposes, we want to use options with as little time value as possible and with delta as close to 1.0 as we can get. So if you are going to daytrade options, then you should daytrade the near month in-the-money options of highly liquid stocks.

We daytrade with near-month in-the-money options because in-the-money options have the least amount of time value and have the greatest delta, compared to at-the-money or out-of-the-money options.

Furthermore, as we get closer to expiration, the option premium is increasingly based on the intrinsic value, and so the underlying price changes will have a greater impact, bringing you closer to realising point-for-point movements of the underlying stock. Near month options are also more heavily traded than longer term options, hence they are also more liquid.

The more popular and more liquid the underlying stock, the smaller the bid-ask spread for the corresponding options market.

When properly executed, daytrading using options allow you to invest with less capital than if you actually bought the stock, and in the event of a catastrophic collapse of the underlying stock price, your loss is limited to only the premium paid.

Another Day Trading Option: The Protective Put.

If you are planning to daytrade a particular stock for short upside moves for the next few months, you can purchase protective put options to insure against a devastating stock crash.

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Writing Puts to Purchase Stocks.

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Effect of Dividends on Option Pricing.

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Bull Call Spread: An Alternative to the Covered Call.

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Dividend Capture using Covered Calls.

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Leverage using Calls, Not Margin Calls.

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Day Trading using Options.

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Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity.

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks.

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks". [Read on. ]

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Real World Options Trading Strategies That Earn.

Welcome to Day Trader Options, we are your premier destination for guidance finding the right options trading strategies. Let’s take a journey into the lucrative world of options trading. Regarded as one of the most difficult markets to trade, options trading can produce huge profits if your trading system is designed correctly. Would you like to learn more about trading options and gain insight from an options trading system developer with over two decades experience?

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The goal of this site is to take two decades of stock market experience and present the options basics in an easy to follow manner so that you can become a better trader. Throughout this site we will discuss the fundamentals of options trading and move up to more sophisticated options trading systems and strategies. From time to time we will present topics on mutual funds, stocks, bonds, and other securities and investments.

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Do you know which stock option to buy and what price to pay for each call or put option? If you forget to check the crucial factors discussed within it could make the difference between success and failure. If your success is minimal and you would like to increase your winning percentage then please continue reading.