Stock Options trading has GROWN immensely over the last few years, the rebirth of the retail trader was sparked by the COVID19 market crash as well as the pandemic forcing people to stay home. So what better profession than trading in the markets? There were a lot of millionaires made, and a lot of people lost a lot of money. From the GME (Gamestop) and AMC frenzies of people piling into making money to the strongest bull market we’ve seen this generation.
However, that left a lot of people not necessarily knowing what they were doing, rather just getting into big swingers. That can change with education, this article is meant to break down exactly what options trading is, what you need to know to actually make money and how you can learn that.
In 2021, there were a record 39 million options contracts traded DAILY on average. This was a rise of 35% from 2020. Where 25% of trading activity in 2021 was accounted for by the retail trader.
What does it really take to be an options trader? What do you really need to know to trade options? Here is a breakdown of all the steps and theories one needs to be acquainted with.
In each of these, starting from part 5 to part 7 we are going to outline the risk management needed to day trade options.
What is Options Trading?
The options market is vast, it is the market participation of a derivative asset that is leveraged. Meaning a trader can exploit larger gains with smaller capital. Along with larger potential losses with that smaller capital.
The options market allows traders to trade almost any asset as a leveraged instrument. From stocks to ETFs, bonds and futures. An option is derived from an asset. If you take AAPL (Apple Inc.) as an example, this stock/company has stock options. Each option on a stock asset contains access to 100 shares, which are a part of the leverage in the instrument. Most assets are optionable, but not all. You can check that at FinViz.
There are options that are more liquid than others that people prefer to trade. Typically the larger the market cap the larger the liquidity. Then there are the ETFs which don’t have the largest market capitalizations but they are the most traded options for sure. We have the SPY (S&P500 ETF), QQQ (Nasdaq ETF), IWM (Russell 2000 ETF) ETF’s that expire 3 times a week and are usually amongst the most heavily traded. Then you have other really liquid options like AAPL, NVDA, AMD, MSFT. Mainly big tech options are really liquid.
Options have a few main characteristics. The expiration date, each option expires, and the strike price. The strike price is the price that you expect the underlying to be by the time the expiration date hits.
For example. AAPL 150C that expires on April 14th, 2022. This means that the person who takes on the calls (C ) expects AAPL to be at least 150 by April 14th, 2022.
Options contracts have both a buyer and a seller. One end of the party sells the option from the buyer. The buyer has the choice to exercise the options if they are favorable. (options exercise is when an options participant either takes control of the shares which are the underlying or sells them for a predetermined price at a predetermined time) The seller has the obligation to sell the shares to the options buyer should they be assigned.
To dive into this more, there are two main options counterparts:
Options call options are seen as “bullish”, they anticipate that the price of the option will increase by the time the expiration date. An options call buyer would pay a premium for the call options they would assume would increase in value by the underlying asset increases in price.
The options seller is responsible for selling options to the buyer. The call options seller would get the premium credited to their account for the options sold. The options seller would want the price of the underlying to remain UNDER the strike chosen by the expiration date to hold all of the premium collected.
Let’s take a look at an example.
AAPL 160C taken for April 14th 2022 expiry, these cost $2.50. Remember each options contract contains access to 100 shares. In which the real cost of these options would be: $2.50×100= $250.
The options call buyer pays the $250 premium to be able to hold these. Their goal is that AAPL moves either up towards the area before the expiration date or to move above into expiry. Whoever sells the options in this case would take in the $250 credit. Well not exactly. Options do have spreads (next section) where the market maker would take a piece of the action for being the middleman, finding buyers and sellers. For example, if the ASK was 2.50 the BID might be 2.45 on AAPL. The most liquid options have tighter spreads.
The goal of the options buyer is to get an increase in AAPL before the expiration and leading into it so that the call options gain value. While the seller’s goal is for AAPL to expire UNDER 160 to collect the full premium.
Here is a profit/loss diagram of a long call option and the short option.
Theoretically profit potential is unlimited as long as price keeps rising through the strike price before the expiration. (this doesn’t happen too often).
The max loss of the long call options is the premium paid for the buyer. The break even point is the strike price plus the premium paid. This is only by expiry. If the options gain value before that then you can sell them for a profit. In this case, the breakeven by the expiration would be 160+2.50 in this case $162.50.
On the short side of the call options, we have the MAX profit capped at the premium received as a credit. The max loss is technically infinite. Because of the price of AAPL exceeds 160 it can go up infinitely. Anything above 160 the seller not only loses the premium but also loses the margin that is needed to get into this position. Making “naked” options selling risky.
Options call options are seen as “bearish”, they anticipate that the price of the option will decrease by the time the expiration date. An options put buyer would pay a premium for the put options they would assume would increase in value by the underlying asset decreasing in price.
The options seller is responsible for selling options to the buyer. The put options seller would get the premium credited to their account for the options sold. The options seller would want the price of the underlying to remain ABOVE the strike chosen by expiration date to hold all of the premium collected.
Let’s take a look at an example.
NVDA 190P taken for April 14th 2022 expiry, these cost $1.50. Remember each options contract contains access to 100 shares. In which the real cost of these options would be: $1.50×100= $150.
In this case, the options put buyer pays the $150 premium to be able to hold these. They would want to see NVDA continue to fall into the expiration. Whoever sells the options in this case would take in the $150 credit.
The goal of the options buyer is to get an decrease in NVDA before the expiration and leading into it so that the put options gain value. While the seller’s goal is for NVDA to expire ABOVE 190 to collect the full premium.
Below is a profit/loss diagram for puts.
In this case the put buyer, gets long puts, in which they would experience an increase in the put option value when the price of NVDA or whatever the underlying is starts to fall. The break even point is the put options strike minus the premium paid. In this case 190-1.50, break even is 188.50. The premium paid is the max loss that these traders can experience.
On the other hand, the put seller will take the MAX gain as the premium received for providing the options buyers the other side of the position. The max loss is a lot but it is limited to the price of the underlying. A stock can only go to 0, but that is probably not the case for most stocks that we trade.
We have talked about options expiration in the first part of this, however, what happens on options expiration? You can read up more on that here.
Overall, when an options expires there is two things that can happen:
- They expire worthless
- They expire and get exercised
Typically if the options fail to make it through the strike price, for calls or puts, they will expire worthless, in this case the short puts/calls will expire with the full premium intact. For example, AAPL 160C April14, if AAPL closes at 159.95 on April 14th then they will expire worthless. The call buyer loses the full premium. The call seller gains the full premium.
The same thing can be said for the put options. NVDA 190P April14, if the underlying expires 191, then the put buyer loses all of the premium put in and the seller keeps the premium.
It does get a little tricky for options that expire above the call strikes, or below the put strikes. This is what we call an In-The-Money option, or ITM for short.
The call buyer would want to see the price increase, but there are some call buyers that actually want to own the stock so they would want to let the options expire. This would mean, for AAPL. If the stock closes on Friday above 160, they will be ITM and the buyer will be exercised. In that they will buy however many shares they have. For example, if the buyer has 3 calls, then he will buy 300 shares of AAPL at 160. If the price of AAPL is at 170, then it’s favorable, he’s already made a profit. The premium paid is to be able to enjoy the fruits of this gain.
Think of the premium as a downpayment. You put 20% down on a predevelopment house. The current price of the house is $500,000. In 5 months when the house is ready if the price of the house is $620,000 you’ve made $20,000.
On the other hand, the options seller has to sell the shares to options buyer, meaning as a seller if you let them expire ITM you’re on the hook.
If you take puts into consideration. The options buyer uses this as somewhat of insurance usually, those that let the puts expire ITM own the stock, and want to make sure that they can sell it for a better price should the price fall hard. In the NVDA case if we have the 190P and the underlying closes at 180, then the put buyer will sell the NVDA shares. The NVDA put seller will have to buy the options for the buyer.
Which now leads us to options pricing, chains, and more this will explain a lot of what we talked about in greater detail.
Options Pricing, the Options Chain
Options pricing is one of the most complex parts of options trading. Understanding the theory is pivotal to begin to understand how to use options and maneuvering through their pricing.
One should be familiarized with the options chain first, before talking too much about variables and what goes into the pricing.
The options chain is something like a trading ladder where traders can see:
- Options expiration
- Options strikes
- Options prices
- Options volume
- Options Open Interest
- Options Greeks
Let’s take a look at the legend below.
Blue: This is where you can select options expirations on Interactive brokers. In this case we have the SPY options and we have multiple weekly options broken down with a drop down “more” that allows us to find further expirations.
Red: These are the options prices. On the left side we have the calls, on the right side we have the puts. The options prices are split into bid and ask. Traders get long at the ASK and out at the BID.
Yellow: This section is split into volume and open interest. The volume of an option is not the same as the open interest. The volume of an options contract is how many times the options are traded, back and forth just like shares. The open interest is the number of OPTIONS that are currently open from the creation and not expired or exercised. Meaning if you have 1 options contract, trade it 100 times, the open interest (OI) will be 1. The volume will be 100.
Green: This is the strike price available in the chain. Strikes in options are the price points of the underlying that you expect the underlying to reach by the expiration date. There are strikes that are above the current underlying and there are strikes that are below the current underlying.
Purple: This is just one of the many greeks that can be placed on the options chain. This is the Delta of the options. You can put all of the greeks on the options chain, understanding that the options chain will get fairly cluttered. You can customize the options chain as you see fit. You can shorten the columns, and have more columns. Whatever you’d like. This is personally how I have it set up.
- In the money:These strikes are going to be the most heavily priced. The deeper you go in the money, the higher the probability the options are going to expire profitable. The ITM options have both time value and intrinsic value. For call options the ITM options are going to be below the current underlying price. For puts, the underlying will be above the strike price chosen.Imagine you buy a SPY call at 412 and it’s currently trading at 422, well you would imagine that you will automatically make money, you’re buying it $10 less than its trading. That is not the case, because you pay a premium for these options. The 412 calls are trading at 12.00 on the mid or $1,200 per contract. Meaning 412+12=424, that is the breakeven for these options if SPY is trading at 422 right now.
The deeper you go ITM, the more expensive the options are going to be, the farther you go out in expiration, the more expensive your options will be.
- Out the moneyThese options are farther out, either puts or calls. They are above the current price for calls and are more common than ITM usually. People trade the OTM because that is where they anticipate the price going, and they are cheaper. Put options OTM are below the current put price. Anticipating that they move ITM as prices drop. The point of OTM options is that they are cheaper than ITM, they only have the time value, and traders want to see price move towards the strike and though. They will gain more value in a return on investment than ITM options. The cheapest options are the farther OTM and the closest expiry. There is some negative connotation with the OTM options because of how cheap they are. People often gamble in the cheap options because they’re pennies at times, expecting a massive move and massive gain. This is how a lot of people burn money.
- At the moneyAt the money strikes (ATM) are literally the same price as the underlying. Options don’t have multiple decimals so if it’s in the vicinity then it will be an ATM. These options move a lot in price because they can easily teeter between ITM and OTM.
Using the options chain
Traders use the options chain to read how the volume, open interest, and pricing of options increases. Typically traders can trade right off the chain, by selecting the options they see just as we broke down above. If you click the “ASK” side you are going to look to purchase the options. If you click the “BID” side you are going to look to sell the options, you need margin to be able to do this. There is more that comes with understanding and reading the chain, we’ll leave that for another time.
Options Greeks are some of the most complex variables to understand and learn as a trader. They contribute to the price movement of the options, how they move, why they move. And all for different strikes and expirations. It is where a lot of people have a harder time understanding options and even options selection. Where you can learn a lot in this article.
There are 4 main options greeks every trader needs to know:
- Vega (IV-Implied Volatility)
Let’s break each of these down and understand the implications of these Greeks on the options pricing.
Delta is the rate of change of the options price based on a $1 move of the underlying. It represents the options price sensitive based on the underlying movement, up or down. Delta is measured in decimals or percentage points. Where 0.30 delta or 30% represents a $30 or 0.3x$1 movement in the options price if the underlying moves $1.
Delta is detonated in a range between -1 and 1 in options, negative deltas are for put options, positive for call options.
Call options: 0 to 1, where the closer to 1 the delta, the deeper ITM the options. The closer to 0 the farther OTM the options are. At 0.5 delta you have the ATM options.
Put options: -1 to 0, where the closer to -1 the delta, the deeper ITM the options are. The closer to 0, the farther OTM the options are. Just like calls, -0.5 delta is the ATM options reading.
Delta is typically known as the probability that the options selected will expire ITM. So a 30% delta has a 30% chance of expiring ITM into expiry. They can be loosely used as the amount of shares that an options contract acts like. For example 30 delta means that the options will act as if they were 30 shares of the underlying.
Delta is one of the readings that traders mainly look at as day traders, to gauge which options are worth selecting. It plays a role in other options strategies as well.
If Delta is thought to be the velocity of the options contracts, then gamma is the acceleration. In other words, the measure of change of Delta. Gamma is a derivative of Delta in itself. Delta changes as the options prices move around, the closer we go ITM or deeper the Delta will increase, increasing the gain you experience. The farther OTM you get, the more Delta drops. Gamma is the rate of change of Delta as the price moves. You can learn more about Gamma trading here.
Long options have a positive gamma, short options have negative delta. The highest gamma reading is ATM on options and drops off when we go ITM and OTM. This is because ATM is most susceptible to a move in Delta. Teetering from ITM to OTM.
Through 2021, there was a phenomenon called the Gamma Squeeze “meme names” like GME and AMC. You can read more about it and Gamma here.
Theta is the peskiest Greek for day traders and shorter term traders. The Theta is the time value portion of the options pricing variable. It measures the options price sensitivity to the options time maturity. Each day that goes by, the options will lose a certain amount of premium based on Theta. It is TIME DECAY.
Usually, Theta is negative for options, the shortest expiries have the biggest effect from Theta. In the final 30 days, the time decay decays the options exponentially. Making the short-term options lose value a lot faster.
Theta really comes into play when the options move against you but also when they don’t move at all. You need movement for options pricing to move.
d. Vega (IV-Implied volatility)
Vega is the option’s price sensitivity to a change in volatility in the underlying. Each option has an implied volatility based on the expiry. Instead of focusing too much on Vega, IV is what traders should understand a little better. If the volatility increases by 1%, the Vega will affect the price accordingly based on the Vega amount.
Vega is expressed in monetary value rather than percentage. Long options (calls and puts) benefit from an increase in IV, short options (calls and puts) decrease in price when IV increases. Overall if you have long options you want to see IV low and have the potential to increase. When IV is high, you want to be selling premium.
In periods of high IV, traders will be paying more for flat out calls or puts and have to be careful with the IV crush, because even if the position is going in your direction; there is the potential the drop in IV kills the profit that has been accumulated on the position.
You can learn more about IV here.
Technical Analysis and options trading
Technical Analysis, just like all of the above is a big part in an options traders mission to make money from the markets. There is a lot to cover in this regard, which we won’t break down here, but rather in another blog.
As an options day trader, you need to understand that trading based on the chart comes with risk that the options price won’t move the same way as the underlying. There is a way to adjust for that, select deeper ITM options, and farther strikes. However that may not be favorable for day traders. Options price movement/gains and loss, are dependent on the speed of the market too which could be something to consider when looking at technical analysis.
The main pieces of technical analysis options traders need to know are as follows:
- Multiple time frame charts
- Market Structure/Price action
- Volume Profile
- Moving Averages
Overall the list is short and it would seem simple, but there is a lot that goes into these. We will explain these briefly in this breakdown.
1. Multiple time frame charts:
In options trading there are three main “styles”, day trading, swing trading and LEAP trading.(Greater detail in the sections below) Day traders get in and out of positions before the day ends. Swing traders can hold positions for days, weeks, even months, LEAP traders hold positions for months to years.
Meaning that there are going to be different time frame charts used for each.
The general time frames used, all of them are; the weekly, daily, hourly, 10-min, 5-min. There is no real need to go under the 5-min if you are not scalping taking small positions.
Below you can find:
- Weekly: top left
- Daily: top right
- Hourly: bottom left
- 5-min: bottom right
2. Market Structure
The best way to define market structure can be laid out in the following blog. This covers everything from basics to advanced market structure understanding. No matter what trade style you use you need to be aware of how the market moves.
“Market structure is simple and a basic form of understanding how markets move. It’s made easier with just 3 different types of market structure. While Price Action is how the market moves based just on price. Without the consideration of trends and how they may continue.
The market trend in 3 different directions at any given time and understanding when a shift occurs based on the timeframe YOU watch is pivotal to successful trading. The 3 types of market structure are:
- Bull trend
- Bear trend
- Sideways trend
Markets trend in one of the three directions above and understanding how to read the continuation of the trend of the failure of the trend all comes from being able to read market structure. The majority of the time, the market trends in a sideways motion. Or a range, then you have quick bursts in either direction.
The bull trend is depicted by higher highs and higher lows. The trend will continue in that direction until a lower low is printed by the asset price. The trend begins to show signs of weakness when it fails to print and is higher high.
The bear trend is the price action of lower lows and lower highs. The bear trend will continue to fall as long as lower highs continue to print, once a higher high comes into the price, the trend will end. The sign that the trend may be reversing is price beginning to print higher lows or equal lows.
The sideways trend is a trend that has equal highs and equal lows. Price trends in a range during this point of the market and is in consolidation. Markets can move in a period of consolidation for a long time. This trend is broken if the price breaks out from the top or bottom of the range. This could be the beginning of one of the first two trends.
Along with market structure, you can draw your support/resistance levels based on highs, lows and areas of consolidation on the market.
You can use these rules for day trading, swing trading and LEAP trading.
Starting at the highest time frame that you plan on starting from. (more above on multiple time frame analysis). Let’s use the daily to start and go from there.
Find the “ledges” or “shelves” on the volume profile and prior peaks on the daily chart. Let’s use the SPY for example.
This is what we come up with on the daily:
Then we can drop down to the hourly, refine and add, and so on down to the 5-min. Notice how we identify the VP ledges and combine them with the peaks of support and resistance.
3. Volume Profile
The volume profile (VP) is a game-changer for all traders, this is our favorite tool hands down, and cannot stress enough how important it is for both finding direction and finding levels to trade off. Here you can find a breakdown blog of the volume profile in its entirety.
“The volume profile is a volume indicator that is shown as a histogram on the y-axis of the chart. It shows the volume that has been traded at a level of an asset. The volume profile is based on a specified time frame. Based on the example below, the volume profile is a blue and yellow histogram. Shown on Apple stock below. The volume profile timeframe is based on the current year to date.
The volume profile has a different length and different shares of coloring as you’ll notice in the image below. The first thing that you need to know there is an area of major volume (darker coloring) and an area of low volume (either edge of the whole volume profile). The volume profile naturally has areas that stick out farther than others. This is going to be important as we go through the rest of the article.”
There are 6 parts to the Volume profile:
- Value area (VA)
- Value area high (VAH)
- Value area low (VAL)
- Point of Control (POC)
- High volume nodes (HVN)
- Low volume nodes (LVN)
All of these areas are important to understand in the volume profile and can make up a core strategy in itself. Let’s take a look:
- The value area (VA) is 70% of the volume traded within that area, you can usually see it based on the intraday or based on the overall volume profile (to the right). This is what we call balance and price wants to stay in this area. When price escapes the balance we have the next leg that is going to go into “imbalance” and look for balance elsewhere.
- The value area high (VAH) is the top band of the value area that stands the value area sandwich. This is the level at which the market participants want to react to keep price in balance, back into the value area. Should this level be broken, then the mission to a new balance begins. This is an area of support/resistance.
- The value area low (VAL) is the bottom band of the value area and where price wants to sustain support so it remains balanced. Overall this should hold and push price back to the value area high. If it breaks then the price is imbalanced and looking for a new balance. Overall can be used as support structure as well.
- The point of control (POC) is the area at which we have the most volume traded on any given session. It is an area of attraction because volume attracts to high volume. Usually, when price is around the POC “chop” and sideways movement is created, price likes this area as a home.
- High volume node (HVN) these areas where there is a lot of volume traded. Now they don’t really have to be within the value area, they can be anywhere. They stick out a lot and they create areas of attraction. They can create a whole area of attraction or balance which we call a “distribution”. The POC will always be in an HVN area.
Low volume node (LVN) is an area where the volume drops off and there is little price movement through that area. Price passes through these areas easily and they usually surround the high volume nodes that create “ledges” or “shelves”.
4. Moving Averages
Moving averages have a place in options trading technical analysis. It does depend on which time frame you use and according to that, some moving averages are better than others.
Let’s break it down by day trading, swing trading, LEAP trading.
a. Day trading options:
Each time frame is associated with a different moving average that holds value.
In day trading these are the following timeframes used:
- Daily (overall larger levels, Volume profile): 20EMA as a gauge.
- Hourly (large levels can be identified): 34/50 EMA cloud as a gauge.
- 10-min (direction on the day): 34/50 EMA cloud as a gauge.
- 5-min (day trading main chart): 20EMA as trend finder, 5/13 EMA cloud as a trailer.
Below is a 10-min chart.
b. Swing trading options:
- Weekly (overall larger levels, Volume profile): 200MA, 20EMA as a gauge.
- Daily (overall large levels and profile): 20EMA, 34/50EMA cloud.
- Hourly (large levels can be identified): 34/50 EMA cloud as a gauge.
Below is an hourly chart of IWM.
c. LEAP trading options:
- Weekly (overall larger levels, Volume profile): 200MA, 20EMA as a gauge.
- Daily (overall large levels and profile): 20EMA, 34/50EMA cloud.
Below is a weekly chart of AMZN.
The final piece of the technical analysis puzzle is volume, using volume confirms trends and levels alike.
Volume can be found at the bottom of the charts, you can also look at the time and sales of an individual asset to identify the buyers vs sellers strength. It is a more advanced tool.
Volume doesn’t end there, we can also look at volume on the options chain for the options we select. Based on the strikes and expiration some options have heavier volume than others. More liquid options have higher volume and typically closer expires get a lot more volume as they’re more actively traded.
a. Volume on a chart.
Whether you’re day trading or swing trading, volume needs to be looked at. The volume at the bottom of a chart is not “buy volume” or “sell volume” rather it is the volume traded in that specific candle. It will highlight red or green based on the candle itself. Meaning you can change the volume to whatever color you want.
The rules of thumb for volume use:
- Wait for the price to get into your zone, watch if the volume is weak into the move into the zone (pullbacks) then starts to increase as you leave the zone.
- Trends should have heavier volume accompanying them for strength.
- A move on weak volume won’t last too long.
Here is an example of AAPL on the 5-min chart. If you are day trading, know that we typically have the largest volume on the first candle of the day so don’t get tripped up by that. Then at the end of the day there is heavy volume as well.
Notice in the example below we do have heavy volume as price moves back to the downside into our zone. This is then met with some strong buy volume, not amazing strength but still holding above the volume average. When we move in the second time, we get the volume pop that confirms the trend.
b. Options volume
Options volume is seen on the options chain, this is where we have a lot of our data. The options volume on the chain isn’t like the volume above, its not simply “volume increases on the way up”. We watch it as a whole number and if traders are piling into calls or puts there is a chance that those gain value. Mainly used for calls and puts that are ITM, ATM and slightly OTM rather than far OTM.
You can also take it a step further and use your options price chart, with volume below, the contract will have a volume histogram just like the underlying shown above.
This is an example of weekly SPY puts.
As the price of the puts starts to increase, you can see the volume spikes on the put side. Especially around 12:30 even as price is rotating the put options are pricing up on chart. Suggesting there is money flowing into these for a move to the downside. These options then go from 0.90 or $90 a contract up to 2.10 or $210 a contract. 133% gain.
Day Trading Options
Day trading options is one of the three pillars we’ve discussed and there is A LOT that goes into this.
The distinctions that traders have to grasp are:
- Day Trading technical analysis
- Day Trading Options Selection
- Day Trading Risk Management
If you want to learn more about day trading and technical analysis, you will need to be familiar with; smaller time frames, market structure, volume profile, moving averages, and volume.
As a day trader, the better your levels are the higher chance you will have of success at those levels.
You can draw levels on the daily, hourly, and 5-min. Take a look at the example above (technical analysis section).
So let’s use the SPY example to draw out the 1-hour, 10-min, and 5-min levels below.
Now, what about the 10-min? Where we can actually identify some trades we can take, or at least areas of interest.
Notice in the image below we have the 10-min on the SPY with the prior tops getting retested intraday that is the potential for the long trade there to grab a piece to the upside.
5-min chart, we can have a lot more levels on the chart the deeper we go, remember we don’t want to get caught out with these levels and trade every single one that we see. Realistically even on this 5-min there may only be two trades.
After you have those levels, you want to identify how to play them, here is a simple list of rules you can implement in a strategy:
- Find the area where the longs win and shorts win (pivot).
- Find the extremes where there is massive support/resistance (1-hour is helpful for this)
- Can either play the pullback from the move through the pivot either way or the fade of the extremes of support/resistance.
- Need to have volume
- Need to have confirmation of candlesticks
Let’s use the example above considering that we already did the heavy lifting.
We can see our long trade setting up, comes into key support and we have a nice engulfing green candle just after the large red candle at the lows. From here we identify that the volume is starting to perk up on the long side.
The entry is defined with stops under with the target the highs of the day.
What about options selection?
In this case, we have already given a link to the options selection for day trades blog, but let’s dive into this a little more.
- Select weekly options, the spy has 3 expiries a week. Since this was a Thursday you can select Friday or Monday options. (Monday will be more expensive)
- If selecting Friday, then make sure you have a higher delta, around 35% should be good.
- If the price is at 434.50 around entry, then 437-438 OTM calls are solid selections.
- Remember, the pricing of the options shouldn’t be the main concern, cheaper is not always better. You want to make sure the delta makes sense for the position.
Risk management as a day trader?
As a day trader, trading options, you need to first understand the variables that go into options price movement and that weekly options are more erratic. Typically a good starting point of risk (stop loss) is 20% of the premium position. With a take profit around 30% to begin, ensuring 1.5:1 RR.
If you have a 20% premium risk, that means on a $1,000 position your risk is $200. You can reverse engineer the position sizing from this.
Typically when trailing you would want to take profit on 40-50% of your position at 30% gain and try to let the rest run, trailing your stop loss accordingly. Traders do not want to trail too tight because you may get kicked out of a position and then see it go in your direction.
Make sure you only take the trades that are to plan, meaning there may not be 10-15 trades a day, rather 1-4 and you need to be able to patiently wait for those and manage the risk accordingly.
There is also another aspect of this, where day traders can look at order flow to get a better grasp on what the current situation is in the market. Options order flow allows you to read where the big money is pouring money into the market and to what degree. You can read more about options order flow here.
Swing Trading Options
Swing trading options is the second pillars we’ve discussed and there is A LOT that goes into this.
The distinctions that traders have to grasp are:
- Swing Trading technical analysis
- Swing Trading Options Selection
- Swing Trading Risk Management
If you want to learn more about swing trading and technical analysis, you will need to be familiar with; larger time frames, market structure, volume profile, moving averages and volume.
As a swing trader, you need to understand both the technical analysis aspect along with the order flow analysis of the market. (More on order flow in the link above).
Technical analysis with swing trading was covered in this article, however we can break it down a little more.
Here is what we need to know for our pillars of swing trading options:
- Multiple time frame analysis (starting on the weekly)
- Order Flow
- Options Selection
Starting with multiple time frame analysis, we tend to look for the bullish trades in swing trades more so. Meaning we’re looking at continuations to the upside, reversals and strong breakouts.
The break of a massive resistance or a new high is usually a higher probability trade.
Start on the weekly, then daily, and confirm on the hourly.
Let’s use ABBV in this example.
Here is the weekly:
Here is the daily:
Notice on the daily, we have circled two potential areas for the breakout and continuation after a consolidation period. Here we have the 138 area and then most recently 151. Where we would look for the confirmation, break, and continuation higher. This is why we like breakouts on swing trades.
Here is the confirmation on the hourly:
Notice we have the areas circled and the confirmation, what we would want to see ideally is a 1-hour close above the key level we have and then strong volume on that push higher. Ideally would want to enter as close to the level as possible but if you close above strong you may have to get eager on the next candle.
We can use order flow to find these trades and these breakdowns, where is there flow coming into the stock? Is it net bullish or net bearish? Are there call buyers coming into the market with a longer expiry (which denotes the swing).
Options selection for swing trading, we are going farther out, this is a trade that you want to hold for multiple days if not weeks so you have to select options that allow for that.
- Options that are at least a few weeks out
- Options that are liquid for tight spreads (high OI and higher volume preferred)
- Options that have a higher delta between 0.25-0.35 are a good start.
Now which options to select and how far out? That does depend on the expected move, so if there is an expected move to get to 160, the 160 calls look good.
You can identify this better with order flow seeing which calls are getting bought the most and then you can take those expirations as well as those strikes.
You can also look at the options chain, to see which calls are getting the most volume and how it increases, then OI. Careful when you go too far out in these you will see higher volume but those can be market participants that sell these options to collect premium.
LEAP Trading Options
Our final pillar of options trading: LEAP trading (Long term equity anticipation securities). This is the long term approach to options trading where a trader can treat the options as shares, in that they can hold them through at least a year of time. These options are best in trending stocks, high market cap stocks and ETFs.
The goal of a LEAP is to catch a trend that is anticipated to last at least several months. The LEAP positions should expire in a year’s time.
LEAPs are trickier for individual stocks because you don’t really have a high probability of knowing when a stock is going to trend to the upside for months. You can cut that guesswork out by identifying:
- Large market cap stocks
- ETFs (SPY, QQQ)
- Stocks that are surrounded by massive news (MRNA during the pandemic)
Let’s focus on the first 2 aspects, they are a little easier to identify and to understand.
We will be using weekly and daily charts for these examples.
Take AAPL, MSFT, GOOGL, BRK.B into consideration over the last few years.
There is a defined uptrend in all of them, with some periods of consolidation but these are massive companies that are widely successful and tied to the US economy in general. So we would have to find either areas that the price pulls back or areas where we break out for these longer trend moves and use LEAPS. The LEAP beats the shares because of leverage so you can squeeze more money out of them.
Traders can take the moving average approach, waiting for the 200day on a daily or the 50EMA on a daily to get the move back to the upside. If the stock trends well. Alternatively the breakout approach from a long period of consolidation.
This does work well on ETFs for the longer period holdings. ETFs like SPY and QQQ have the tendency to move up over an extended period of time. Pinpointing that timing is a little more difficult, however. The best way is to analyze the trend.
Is the market above the 20EMA? Then it is most likely in a bullish trend, has it closed 2 days above the 20EMA, then that trend can continue. Let’s take SPY for example on a daily chart.
Using this example, we have
Then we have to select the options appropriate for this, keep in mind we want 10-15 months out, meaning there will be expensive. At the same time, you can afford to go farther out because the delta will be extended for these. You can find 30-40 delta really far OTM if you buy enough time.
With the SPY example above, we found an area where we have the trend holding, back above the 20EMA, and the final threshold the 34/50 EMA which holds. At this point we get 2 green closes above the area, that is the point where we can look for our LEAPS. This was in April 2021.
Fast forward to mid-September when we have the first close under the 50 EMA which caps out our position.
Followed by a green circle of potential entry again, the same criteria closed out at one of the two red circles after.
Trade 1: SPY 395 to 445 (12.65% underlying) In 6 months’ time, meaning you can and should cut your LEAPS before expiration. In this case, you can look at a 450 call that expires in March 2022.
If you had a 1 year LEAP during this time, the gain would be somewhere between 150% and 200% based on the options profit/loss calculator you can see below.
When choosing options for LEAPS you can go farther out because they’re going to be expensive, with the anticipated move of the underlying during the holding period is going to be 15-20% from the area that you picked up, that is how you can start your options selection process.
We’ve talked mainly about calls and puts, straight calls and puts. Meaning that they are either bought or sold, however, there are a lot of different options trading strategies out there that can mix up the calls and puts, longs vs shorts, etc.
There are spreads that you can take, all kinds, debit, credit, iron condors, butterflies. All used for different reasons. You can have a long spread, short spread, etc.
Take a look at this cheat sheet for strategies for optionstradingiq. (all credit goes to optionstradingiq for the image used below)
This was an intensive long article all about understanding options from a beginner’s standpoint. There is so much other information that you can learn and should know to trade options and really get the hang of it all. You can check us out at tradeproacademy.com for a full options course on technicals, theory, and order flow.
We also have a live options trading room that consists of hundreds of like-minded traders you can join on our website.
If you want to join with us in our live trading room, Check This Out.
The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.