How To Day Trade Options for Income (Best Way To Do It?)
So you’d like to start day-trading options for income?
That’s great, but first you need to know about the nature of options and the risks involved. Otherwise, you could end up losing a lot of money.
Beyond that, you need to develop the self-confidence necessary to become a profitable day-trader.
In this guide, I’ll cover the basics of options, the advantages and risks associated with day-trading options, and some tips on getting a winner’s mindset.
If you follow through correctly, you can generate a steady stream of income that’s immune from the broader market’s gyrations. The strategies outlined below are time-proven and should come in handy as you try to cope with the market’s extreme uncertainty in 2019.
What Are Options?
Options are financial derivatives.
Don’t let that word scare you. A derivative is just a contract between two parties about the sale of an underlying financial asset.
Specifically, an option gives you the right, but not the obligation, to buy or sell an asset at a given time for a specific price.
Why would anyone want to do that? To make a nice return, of course.
For example, suppose Bank of America (NYSE: BAC) is trading at $26 per share right now. You think it’s going to skyrocket in the near future.
Somebody who owns stock in Bank of America comes along and gives you the opportunity to buy the shares for $28 each next month. But to do that, you’ll have to pay the person $1 per share right now.
If you believe that Bank of America will hit at least $30 per share in the next month, why wouldn’t you take that deal?
You’d effectively buy the shares for $29 each ($28 for the shares plus the $1 per share charged by the seller). If the stock hits $30 (or higher) as you predicted, you could immediately turn around and sell those shares for a nice profit.
That, in a nutshell, is what stock options allow you to do. They give you the opportunity to buy or sell shares of an underlying stock at a specific price and on a specific date.
When’s a good time for ordinary investors to take the plunge and trade options? That depends on your investment profile.
Yes, in the example described above, you have the option to buy shares of Bank of America for $28 each. But someone can also sell you the option to sell shares.
The person can do that if her or she is short Bank of America stock.
You’d take that deal if you think that shares of Bank of America will plummet in the near future. Then, you can sell the shares at an above-market price for a profit.
It’s important to distinguish between options that give you the right to buy stocks versus options that give you the right to sell stocks. They go by different names.
- Call options – give you the right to buy the underlying security at a specific price on a specific date.
- Put options – give you the right to sell the underlying security at a specific price on a specific date.
You’d buy a call option if you’re bullish on the underlying stock.
You’d buy a put option if you’re bearish on the underlying stock.
Strikes: Not Just for Bowling
Remember: an option is a contract. As with any other contract, there are specifics spelled out.
One of those specifics is the price at which you will buy or sell the underlying stock. That’s called the strike price.
In the Bank of America example above, the strike price is $28. That was the price you would have paid for the shares had you taken that deal.
A call option is in the money when its strike price is lower than the current market price of the underlying stock. It’s out of the money when its strike price is higher than the current market price of the underlying stock.
A put option is in the money when its strike price is higher than the current market price of the underlying stock. It’s out of the money when its strike price is lower than the current market price of the underlying stock.
Any kind of option is at the money when its strike price is equal to the current market price of the underlying stock.
Contract Expiration: The Shelf-Life Explained
Options contracts also have an expiration date attached to them. That’s when the person who owns the option can exercise his or her right to trade the shares at the strike price.
The word “can” is important in that last sentence. In some cases, the person might not want to buy or sell the shares when the contract expires.
Why? Because if the option is out of the money, there’s a better deal on the open market.
Let’s go back to the Bank of America example above. Suppose that shares of Bank of America are trading at $26 on the open market when the contract expires. Would you really want to buy them for $28 per share as the option contract stipulates?
Of course not. You’d get a better deal on the open market. In that case, you wouldn’t exercise your right to buy the shares from the person who sold you the option.
When options expire out of the money, they’re said to expire worthless.
Worthless Options Aren’t Always Worthless
Although options that expire out of the money are called worthless, they’re sometimes quite profitable to options traders.
That’s because traders can sell options as well as buy them. When they sell options, it’s just like shorting them.
In that case, they want the options to drop in value or expire worthless. That’s how they make money.
If you’re bullish on a stock, you can sell a put option instead of buying a call option.
If you’re bearish on a stock, you can sell a call option instead of buying a put option.
There are some caveats, though.
First, keep in mind that you can take enormous losses when you sell options. In the case of selling a put option, your loss can theoretically be infinite because there’s no limit to how high the underlying stock can rise.
Also, your online brokerage will place rules on selling “naked” puts. There will be significant margin requirements in case the trade goes the wrong way.
The Price Isn’t Right
When you look at options chains for specific stocks, you’ll see that they’re usually traded at a much lower price than the stock itself.
Go back to the Bank of America example above. The $28 call option was trading for just $1.
That doesn’t mean it costs only a dollar to buy the option.
Options contracts are bundles of 100 shares. So you have to multiply the price of the option by 100.
If you were to buy the Bank of America $28 call option for $1, you’d really pay $100 ($1 x 100 shares = $100).
That’s something you need to keep in mind as you trade options.
Also, as is the case with stocks, you buy options contracts at the Ask price and sell them at the Bid price.
Day-Trading Options: The Advantages
Now that we’ve covered the basics, let’s look at the advantages of day-trading options.
- Ease of trading – First and foremost, options trade just like stocks. If you buy an option this morning and its price goes up in the afternoon, you can sell it for a profit. So if you already like day-trading stocks, you’ll be happy to know that you can trade options in much the same way.
- Leverage – With stock options, you can earn a very nice return with just a little bit of money. In the case of the Bank of America call option above, if the price of the underlying stock rose from $28 to $29, then the price of the option would rise from $1 to about $2. In that case, the price of the stock increased by a small percentage, but the price of the option almost doubled.
- Low cash requirement – It’s safe to say that if you want to generate a decent income as a day-trader, you need to start with tens of thousands of dollars (or get very lucky). However, you can start with much less money if you trade options instead of stocks. That’s because of leverage (see above).
- Diversity – Because options are so much cheaper than stocks, you can more easily create a diverse portfolio so that you’re protected if one sector goes south in any given day.
- Ability to hedge – Because you can buy and sell both put and call options, you have the opportunity to work both sides of the market. You can protect much of your capital in the event that something goes horribly wrong on the long or short side.
- Reduced risk of loss due to time-decay – Options have a contract expiration date so they’re subject to time-decay. That means the option price will drop every day as it gets closer to expiration, all other things being equal. Traders who are long on options for weeks (or even months) will often see their positions drop gradually to $0 even though the underlying stock doesn’t move. People who day-trade options, however, won’t need to worry as much about time-decay.
Day-Trading Options: The Risks
There are plenty of advantages to day-trading options, but there are risks as well:
- Risk of significant loss – Although leverage can give you significant gains, it’s also a two-edged sword. You can take enormous losses because of leverage. Going back to the Bank of America call option above, if the stock dropped from $28 per share to $27, the option price would drop from $1 to just a few pennies. That’s a loss of almost 100%!
- Wide spreads – Options aren’t always as liquid as their underlying stocks. As a result, the bid-ask spreads can get fairly wide. That means even if you’re right about the movement of the stock, its option might not make you a whole lot of money after you close out the position.
- Less chance to profit from time-decay – Although you don’t have to worry about time-decay on your long positions when you’re day-trading options, you also can’t benefit much from time-decay when you’re short. You aren’t holding the position long enough to see any significant gains.
- Margin requirements – If you plan on selling options, your online brokerage will have margin requirements. Those requirements vary from broker to broker, but they could be quite steep.
Do You Have a Guerrilla Mindset?
It takes more to be a successful options day-trader than a simple understanding of the pros and cons. You also have to develop the right mindset.
You need to approach options like a guerilla fighter.
That’s not easy.
If you’re already successfully day-trading stocks, you may be part of the way there. But you’re not all the way there.
Why? Because trading options is like trading stocks on steroids.
Remember: options use leverage. That means small swings in stock prices can send your position tumbling 100% very easily. You’re not accustomed to seeing that kind of loss very often with stock trades.
In other words, you really need to know how to ride out swings in prices. When your hard-earned money is on the line, that can be a challenge.
If you’ve never day-traded stocks before, your current assignment can be explained in one word: practice.
Find an online brokerage that allows you to practice trade with an account that doesn’t use any real money. Usually, you can set up a fake portfolio with $10,000 or so and start trading.
Then, put your strategy for picking winning options trades to the test. See if it passes.
When you take losses (and you will), learn from your mistakes.
When you make nice profits (and you will), find out what you did right.
Then, practice some more. Get to the point where you’re confident enough in your abilities as a trader that you’re willing to risk some real money.
At that point, start small. Don’t trade a significant percentage of your cash at first.
You’ll find that your mind thinks about a trade with real money quite a bit differently than it did about a trade with fake money. You’ll need to discipline yourself to stay focused.
And, once again, learn from your successes and failures.
Once you develop even more confidence, start trading with more of your money. All along the way, train yourself to stay focused, disciplined, and fearless.
That’s how you’ll be successful.