The financial markets have always been driven by innovation. While market developments fall into various categories, derivatives are the most influential, and the most interesting of derivatives are options. You’ve likely heard about stock options in the financial news already. However, in this article, we aim to provide a comprehensive guide for traders who are willing to capitalize on short-term price movements by day trading options.
As financial markets continue to evolve and become more accessible, understanding how options trading works is gaining more importance. Options not only offer flexibility in creating personalized trading strategies but also provide unique opportunities for day traders to profit from volatility.
This guide will assist traders, from novice to seasoned, in understanding options. We will describe the different kinds they include and some popular methods and strategies for trading them. Moreover, we will introduce binary options and explain how they work. Finally, we compare them with the traditional type when it comes to day trading options.
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Fundamentals of Day Trading Options
In order to learn how to profitably day trade options, you should first understand what day trading is. Sufficient knowledge about options and how they work is also necessary.
What Is Day Trading?
Day trading is a short-term trading strategy where individuals called “day traders” buy and sell financial instruments within the same trading day. Contrary to investing, day traders do not hold positions for months, weeks, or even overnight. Day trading focuses on profiting from the intraday volatility of the financial instruments.
The broad accessibility of computers and the Internet has made day trading one of the most attractive careers for those interested in the financial markets. Some people also day trade as a side hustle, looking to make some extra money besides their regular job. With only a mobile phone or a laptop, an internet connection, and, of course, sufficient knowledge, you can begin your day trading journey.
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What Are Options?
Options are financial derivatives that provide traders and investors with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and within a specified time frame. While the previous sentence has presented a complete definition of an option, its parts will be broken down in the next section for better understanding.
As already mentioned, options are derivatives; they derive their value from the performance of an underlying asset. These assets can include stocks, commodities, indices, or even cryptocurrencies. Options are valued based on the probability of profit realization by the investor holding them. The more profit the holder can realize by exercising the option, the more valuable the option is. Moreover, exercising an option is not obligatory for the holder, hence the name “option.”
There are two primary types of options: “call” options and “put” options. A call option provides you with the right to buy the underlying asset, while the put offers you the option to sell the asset. Depending on how you expect the market to behave, you should select the suitable one to trade.
How Options Work: Components of an Option
Similar to other financial derivatives, options are comprised of multiple components that determine their value. The most prominent components and terms of an option are:
- Underlying Asset: The security or financial instrument on which the option’s value is based. This can be stocks, indices, commodities, currencies, or crypto.
- Type of Option: There are two main types of options: call options and put options. A call option gives the holder the right to buy the underlying asset, while a put option gives the holder the right to sell the asset.
- Strike Price (Exercise Price): The predetermined price at which the option holder can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
- Expiration Date: The date at which the option contract expires. After this date, the option is no longer valid, and the holder loses the right to exercise it.
- Option Premium: The price the option buyer pays to the option seller for the option rights. The premium is determined by various factors, including the current market price of the underlying asset, volatility, time to expiration, and interest rates.
- Option Holder (Buyer): The individual or entity that purchases the option and, therefore, gains the right to exercise it if they choose.
- Option Writer (Seller): The individual or entity that sells the option, committing to selling (in the case of a call option) or buying (in the case of a put option) the underlying asset if the option holder decides to exercise.
Most Prominent Option Pricing Factors
The option price is influenced by a combination of intrinsic value, extrinsic value, volatility, and time decay. Intrinsic value represents the tangible worth of an option, determined by the difference between the current market price of the underlying asset and the option’s strike price.
Extrinsic value, also known as time value, contains factors beyond intrinsic value, such as volatility and time to expiration. Volatility plays a crucial role in option pricing, reflecting the magnitude of price fluctuations in the underlying asset. Higher volatility generally leads to increased option premiums.
Time decay, or the erosion of an option’s value as it approaches its expiration date, is also a critical consideration. Options with more time until expiration tend to have higher extrinsic value, but this value diminishes as the expiration date approaches.
A Comprehensive Example of Day Trading Options
In order for you to fully grasp the idea of day trading options, we present a detailed example of doing so.
Example of an Options Day Trade
Let’s consider a call option on Bitcoin (BTC). You decide to buy a BTC call option at midnight with $43,600 as the strike price. The option, priced at $300, expires at 12 pm the same day, and you will have the right to buy BTC at the strike price before expiration. In case you exercise the option when the price is below $43,600 (or don’t do it at all), you will lose your whole investment of $300.
On the other hand, if you exercise the call when BTC is trading above the strike price of $43,600, you will earn the difference between the exercise price and the strike price minus the initial investment as net profit.
In this example, you decide to exercise the option when Bitcoin is trading at $44,600. As a result, you will gain a profit of $700 ($44,600 – $43,600 – $300 = $700).
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Advantages and Disadvantages of Day Trading Options
Similar to any kind of trading, day trading options also have its fair share of advantages and disadvantages. In this section, we analyze the most prominent benefits and drawbacks for option day traders.
Benefits of Day Trading Options
There are various benefits to day trading options, depending on the type of trader you are. However, we present a list of the most common ones below:
- Leverage: Options allow traders to control a larger position with a smaller amount of capital. This leverage can potentially magnify your returns.
- Diversification: Day trading options provide an innovative way to diversify trading strategies. This allows you to benefit from various market conditions, including bullish, bearish, or neutral scenarios.
- Flexibility: Options trading offers a wide range of strategies, allowing you to adapt to different market conditions. Whether through directional bets, hedging, or income generation, options provide versatility compared to other trading instruments.
- Risk Management: Options can be used for effective risk management. Defined risk goes a long way, especially in volatile market conditions when your simple stop-loss order might not get filled at a desirable price.
- Profit Potential in Volatile Markets: Options can be particularly profitable in volatile markets. The ability to capitalize on short-term price fluctuations can lead to quick gains for options day traders.
Drawbacks Associated with Day Trading Options
While day trading options offer several benefits, it also includes certain drawbacks you should consider before diving in. Here are the primary disadvantages:
- Complexity: Options trading involves a learning curve and understanding the intricacies of different strategies. If you are a novice trader, you might find it challenging to make options day trading work.
- Time Sensitivity: Successful day trading requires constant monitoring of the markets, which can be time-consuming. While this is not specific to options, as a day trader, you should keep this issue in mind and adapt accordingly.
- High Risk Due to Leverage: While leverage can amplify gains, it also magnifies losses. Options trading carries inherent risks, and traders can lose their entire investment. Therefore, remember to employ effective risk management strategies.
- Transaction Costs: The frequent buying and selling of options in day trading can result in high transaction costs. Commissions and fees can eat into profits, particularly for those with smaller trading accounts.
- Long Expirations: One drawback specific to day trading options is that traditional options typically have long expiration dates. Therefore, you might not get your results quickly and be forced to hold positions overnight.
If you are curious about other types of financial derivatives, like futures, visit our futures vs. options article to make wise choices.
What are Binary Options?
Binary options are a more straightforward type of derivative compared to traditional options. Day trading binary options offer you two possible outcomes: a fixed monetary gain if their prediction about the direction of the underlying asset’s price is correct or a total loss of investment if you are wrong. This simplicity distinguishes binary options from traditional options, as novice traders can also day trade these instruments.
Example of Day Trading Binary Options
Let’s consider an example of a binary options trade. Imagine you want to day trade a BTC binary option. Similar to the previous example for traditional options, you are buying a high/low call binary option at $43,600 at $100 per contract. The option expires at 12 pm. Two scenarios can now occur:
- If Bitcoin’s price is below the strike price at expiration, you will lose your entire investment of $100 (the option expired out of the money).
- In case BTC is trading above the strike price upon expiration, no matter how much, you will gain a fixed percentage of your investment as profit (say 80%). Note that you will also get your investment back (the option expires in the money).
In this example, the option expires in the money (above the strike price). As a result, you will realize $180 ($80 profit + $100 investment). Note that your net profit is $80.
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Day Trading Options vs Binary Options
Day trading options and binary options are distinct trading strategies with unique characteristics and considerations. Here are the primary differences between the two, which are somehow the benefits of day trading binary options compared to the traditional ones:
- Complexity vs Flexibility: Day trading options involve actively buying and selling options within a single trading day. Options are already complex enough, and this could make it even more challenging. However, binary options remove these difficulties due to their simplicity.
- Fixed Payouts and Short Timeframes: Binary options provide fixed payouts, typically a percentage of the initial investment, regardless of how much the underlying asset’s price moves. Additionally, binary options have short expiration times, often ranging from minutes to hours, making them more suitable for day traders looking for quick results.
For a more comprehensive guide to binary options trading, visit this CrypOption binary options beginners guide article.
Conclusion
In this article, we explained how day trading options work, fully defining option contracts, their types, and their primary components. We also presented an example for better understanding. Moreover, we evaluated the benefits and drawbacks of day trading options, providing insight for you to decide whether it is ideal for you or not. For most traders, especially novice ones, day trading options might not be a good idea.
However, there is a special type of option that is ideal for day trading: binary options. Due to the short expiration date and simplicity of binary options, they are recommended for new traders or even professional traders looking for options day trading. Nevertheless, remember to manage your risk effectively. Whether trading traditional or binary options, the financial markets can be a very cruel place without risk proper risk management.
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