Why is it hard to day trade options ?

Most experienced traders play options for expiry, they buy options on events when high volatility is expected. Both are positional style trades, for our day trading we can either buy or sell options, as said earlier it is not recommended to buy options on a daily basis unless high volatility is expected. Therefore we are left with options selling, let us instigate further in this.

Note hedging stocks using options is not the scope of this writing.

options day trading

First thing will come in mind is, best way to day trade will be, price-action trading, here use of “Options Strategies” is out of question as that again is for positional trading, by price action I mean, using technical things like support & resistance, candlestick patterns, trend analysis, risk-reward knowledge etc to carry out trades.

So basically we are asking, is it possible to trade options like stocks? and not use traditional “options strategies” and too much rely on news analysis etc which are main tools for any positional option trader. How we use price-actions?  obviously they will be used on underlying instrument and using that we put options trade.

Now let’s discuss what are the major issues with approach, first options prices tend to drop little earlier than underlying so you will always get the late entry making risk reward worse for you, when second selling options will have very awful risk-to-reward ratio, what this means is, if you get 2 point drop for some fall of underlying will get 3 point rise when underlying recovers, so selling options will force you to wait longer as you get stuck in a losing position, and perhaps convert your your trade to positional.

Third issue is options price will rarely be match their fair value. Fair value of options are calculated using Black scholes model. What this effectively may do to your trade entry is, you get under priced options sold or over priced bought.

Together all these factors makes up the returns limited even if you correctly predicted underlying movements, and unfortunately that’s a proven way to become loser in long term!

Why is options selling difficult ?

Options have evolved in ways that they works in favor of sellers, but wait its not for every seller, you have to have mastery in smelling market sentiments and then only you can use options to make trading robust. We will discuss more on options behavior without which one cannot become an option champion.

Options are hedging instrument, but in standalone trading, why are sometimes options preferred over stocks ? this is because options give you more time, as opposed to stocks where a losing position, necessarily create a emergency situation where one has to decide and act hast-fully, which means run stop loss before it becomes too large.

This emergency situation is eliminated from options trading which is a huge advantage, temporarily your position may come under loss but you are not really a loser unless the underlying price crosses the option strike on expiry day.

options selling
Options are used by variety of traders for different reasons

Day trading is chewing iron bullets – the style which option value change with underlying price, creates a very poor risk-to-reward ratio for sellers, this is due to the fact that when underlying price drops, corresponding option drops by logarithmic function and during rise its exponential rise, this makes them difficult to use for day trading, as when you lose its manifold than what you get in winning trades. Look at the diagram below which shows how option price adjust.

options price with underlying

Historically Oom ( out of the money) options selling wins 90% of the times, so its only 10% trades are loser, now the tricky thing to understand in losses in an option trade are never small, it cannot be small, why?

This is because when selling you earn only small option premium, but when lose you always shell out the difference between underlying price and strike price which is completely in a different scale. Therefore those 10% trades have enough capacity to eat up all profits generated from 90% winners, sounds ironical…isn’t it !!

Another thing is options price do not drop during days when an important news is about to be released, so even if you get the direction right don’t expect options to generate profit for you.

A frustrating thing about options are, they do not carry one-to-one correlation with underlying value, and anyone who trades options by watching spot price will have disappointments, this is because underlying and options are abide by only strike and expiry date. in between options can behave like an independent instrument.

Myth of options time decay

One of the much touted jargon of trading industry is, that option value decays over the time,  hence with selling options – easy and consistent premium can be earned on a regular basis, everyone wants to believe that, specially new option sellers fall into prey for that, In this post we will discuss risks involved in options selling.

First of all let say that, I am not debunking option selling or instead suggesting to buy options, For nimble traders in fact it does work with right risk management in place. But just ask yourself, if selling were so easy everyone would have done the same? and no one has to lose money in stock market!

options price change

Big money fund managers sell options but they do it for hedging purposes this is, so called option experts won’t tell you. And to profit in selling a naked option you must have a robust prediction mechanism in place, there is no excuse for that along with that you need a stop loss too.

We hear all the time, that options decays its value over the time, and there are popular pricing models (Black scholes) for that like, can it be simple as plain vanilla ? Well not denying that there is drops at discrete times, but its not like they lose value every hours or so, certainly in a longer expiry like months or more you will see options price losing its value on some days.

Wait, but peoples want to apply that on day trading or where holding period is few days. Let me tell you as long as there is a hope in traders who bought those options, it will not drop 1 penny, real options work like that, get this clear.

First thing to keep in mind is in options risk-reward don’t work in favor of a seller , an option seller may get 10-10 points in 3 trades and can lose 50 in 2 trades later. that’s how options price moves, to put it in simple words option price don’t change similar on either sides of falling and rising market.Without bringing in complexity of option pricing models, let us see little bit of math of this then it will be clear.

We can roughly say, at any point of time option moves by certain percentage of its own price, this is in either direction, in technical terms we call this delta, so a 100 rs option may be changing +/- 5% every 5min (5 rs either side), when the options are rising the further change also becomes large, for example that 100 rs option becomes 150, next change will be 7.5rs and thus options rise at exponential rate, on the opposite side if market is falling further drop is curtailed on every next drop. hope this is clear.

Reality of option selling trading do not rely on prediction or trend following rather a guess of market limits, so you may be having an opinion that market will remain range bound around +200 and -200 during this expiry so you can take a position