Investors can apply classic day trading techniques to buying and selling options to successfully generate a profit.
Options offer investors a low-cost way of getting into and out of positions more quickly and with less risk than securities like stocks or bonds. In this article, readers will gain a basic understanding of how options can be used to generate positive returns when day trading.
By using an option, investors can control the same number of shares as owning a stock without owning the shares of stock outright. Therefore, the cost of owning an option is much cheaper than the cost of owning the shares outright.
Options are a legal contract that gives the buyer the right, but not the obligation, to buy or sell an underlying security at a strike price by an expiration date. The seller holds an obligation to fulfill the transaction, which is to buy or sell, if the buyer chooses to exercise his right on the option before its expiration. There are two types of options: calls and puts.
When day trading options, investors can experience two possible drawbacks.
Firstly, option price movements can decrease due to the time value element of the option premium, such as with “at-the-money” options. The more time an option has until expiration, the more value it has. Options that are day traded do not have a lot of time until expiration. Therefore, the internal value of the option may go up with a change in the underlying stock’s price, but the gain will be undermined by the loss in time value.
Secondly, the bid-ask spreads are usually wider for options than for stocks. This is because of the reduced liquidity of the options market.
These drawbacks can be worth it to investors if they seek new ways of diversifying their portfolio and hedging their portfolio against losses. Day trading options can be an effective tool for investors as long as they understand the risks involved in options trading.
