I received an email from a student about the subject of day trading options. He writes:
“I am very interested in a way to do intra-day trading of high-priced stocks, without putting a lot of money at risk. I know that options allow you to control a large amount of stock value with a small investment. Could I use options as a way to day-trade stocks like Priceline, Google, Amazon and Chipotle?”
In a word, No.
Put and call options are some of the greatest trading vehicles ever created. And there are plenty of option strategies that can be used to make money on $500-plus stocks, like the ones listed above, with only a few dollars per share at risk. But day-trading the options is not one of those strategies. Options are simply the wrong tool for that particular job, like trying to cut a board with a tape measure, drive a car to an island or cook a steak in a microwave. Here’s why.
The first issue is that of trading liquidity and bid-ask spreads. For almost all options, the bid-ask spreads, as a percentage of their value, are much too wide for day trading purposes, although not a problem for longer duration trades.
When day trading a stock or a futures or Forex contract, we look to capture price movements that take place within a day’s activity. We enter and exit trades with precision timing as the price of the asset touches small-scale demand and supply zones. This can be very effective and lucrative, but it requires quick trade entries and exits.
When we buy an option, if we want to get it done that quickly we will have to pay the asking price for it. Later, when we sell it, we will have to accept the bid price. The difference between the bid and ask prices for even the most liquid options can easily be 2% to 10% of the value of the option. When we have the time to wait, we can avoid paying the full spread by using limit orders. In day trading there is no time for that. That alone pretty much rules out options as a day trading vehicle.
Also, the thing that makes options unique is that there are three separate sets of forces acting upon their prices at all times. This gives us opportunities that nothing else provides, but only one of these forces is the supply/demand for the shares of the underlying stock and the resulting actual stock movement.
Another of the forces acting on options is market expectations of future stock price movement. These expectations can and do change from moment to moment. This causes option prices to inflate or deflate, completely separately from the effect of stock price changes. Sometimes the effects of current stock movement on the one hand, and of the expectations of future stock movement on the other hand, both act to push option prices in the same direction. But sometimes they act in opposition.
Finally, there is the issue of time decay. This puts steady pressure on option prices (both puts and calls), while not affecting the underlying stock at all.
So, even the best analysis of probable stock price movement alone does not give us enough information to trade options effectively, most especially over very short time frames. We also need to assess market expectations. Are those expectations too high, making options overpriced and therefore a good bet to sell short? Or too low, making the options an especially good buy?
Answering these questions is not especially difficult, and we have great tools to do just that. However, the effects take longer to play out than a few minutes or hours.
So let’s use options where they are the most effective tools, by taking advantage of their special features. We can make the three option forces into three separate profit centers when we use them correctly, as taught in our Professional Option Trader class. Use the right tools for day trading, and use the finely-tuned instrument of options in the environment where they can really sing.