Options day trading is one of the most exhilarating parts of trading, have you ever seen a return on investment that is hundreds of percent? Imagine you tell your family that you just returned 100% of your portfolio in a week when the average return of the S&P500 is 9% annually.
This is exactly what gets people interested in day trading options, the potential of massive returns and that’s what keeps traders coming back.
However there are too many nuances in options day trading, the main one: how to choose the right strike for options day trading?
A common misconception with options day traders is that you can easily select the cheapest option available and hope for the best. $10 can turn into $1,000 quickly right? Not the case. As a day trader, you need to select options very carefully and understand the risk and the variables that go into the selection.
What Are the Variables in Options Day Trading Strike Selection?
As an options day trader you will have to understand that you are trading short term options, weeklies, which are affected by the following:
- Time/Theta
- Delta
- Pricing
- Implied volatility
Each of these variables affects the overall price and movement of the options price.
The shorter the time to expiry the more the options move for you or against you.
Let’s break down these variables in depth.
How to Identify the Right Expiration Date?
The expiration date for short-term options is pivotal, typically day traders will trade short-term options because they want to take advantage of the faster movement in pricing of the options.
Think of it this way. If you are looking for a day trade and you have the opportunity to select one of the following options:
1. An option that expires in a month
2. An option that expires in a week
The options that expire in a month are going to be less subject to the movement which can be more risk-averse, meaning you may be riskless but you may also get rewarded less.
Let’s take a look at an example of NVDA (Nvidia options):
1.1 Option 1: 230C that expires April 01, 2022 (23 days to expiry) cost 12.50 at the point of entry.
1.2 Option 2: 230C that expires March 11, 2022 (2 days to expiry) cost 3.50 at the point of entry.
The longer options have a drawdown, they reach 11.45 to the lowest point (9% drawdown or $1.05) and reach 14.75 at the peak (18% or $2.25 gain).
While the shorter options have a drawdown as well, they reach 2.70 at the lowest point (23% drawdown $0.80) and reach 5.95 at the peak (70% gain or $ 2.45).
The shorter-term does experience a larger percentage drawdown but a smaller dollar drawdown. While they experience a much higher percentage gain as well as dollar gain.
Meaning the shorter-term options, although more volatile, are cheaper and have the potential to return more on the investment, based on the risk to reward.
Risk to reward:
- Option 1: 2.14: 1
- Option 2: 3.06:1
The point is there is a better potential to day trade with shorter-term expiration that is within the week. I would rather trade the weeklies unless it’s a 0dte, other than SPY and QQQ, they have multiple expirations. (3 times a week, avoid trading 0dte).
There is another variable in this, theta. A Greek that is a “time burn” variable. The shorter-term options have a higher time burn because the changes that out-of-the-money options expire in the money are lower the closer you get to the expiration and the farther away the options are.
So that means if you trade short-term expirations, you want to trade close to the money, rather than super far out of the money, no matter how “attractive” the cheap options appear. Which segways perfectly into the next topic.
How to Identify the Right Delta?
Options delta has a huge impact on day trading options and selecting the right strike. The delta is the rate of change of the options price based on the change in the underlying price movement. The delta is a percentage of the underlying $1 move.
For example, if AAPL moves $1, depending on the options delta you will experience a different gain or loss. If AAPL is trading at 160, and you can either choose the 160 calls or the 180 calls, the 160 calls may have a delta of 50% or 0.5 (they’re ATM, at the money). The 180 calls might have a delta of 15% or 0.15. This is also known as the probability that the options expire in the money on expiry.
If a low delta option moves against you, it’s going to be extremely hard to recoup the losses in a short-term expiry, that is why the cheaper options aren’t going to be the most attractive.
Let’s take NVDA (Nvidia) as an example. Using the same example as above. Let’s take the 230C for Mar11 and the 250C for Mar11. Comparing the two.
- Option 1 230C Mar11 0.40 Delta
- Options 2 250C Mar11 0.10 Delta
We know that the 230C Mar11 experienced a 23% drawdown before a 70% return. What about the 250C?
The 250C was 0.20 or $20 a contract at the same time.
The max drawdown was: $0.08 per contract or 60% while the max gain was 0.25 (25%) so you are taking a lower than 1:1 risk to reward in this case. Meaning we would have to choose our delta carefully.
Here is a little cheat sheet to selecting delta:
Assuming that you trade weeklies. (same week expiry)
- Monday-Wednesday: Select between 0.22 and 0.40 delta.
- Thursday-Friday: Select between 0.35-0.6 delta.
On Fridays you can consider the options pure lottery trades, meaning you’re risking the full premium. Or you can trade the following week’s options.
It is different for ETF options. SPY and QQQ trade: Monday, Wednesday, Friday. Meaning you can avoid 0dte all the time.
Another note:
Typically delta ranges between 1-0 for calls. Then -1-0 for puts.
ITM (in the money options are greater than 0.5 delta and get closer to 1 the deeper ITM you get)
OTM (out the money options range from 0.45 to 0 typically the cheaper you get the further OTM you get)
ATM (at the money is right at the money, 0.5 whatever the underlying is)
When day trading options I do like to gravitate towards OTM options, they’re cheaper and with the movement, they can really gain value fast. If you want the options to act closer to the underlying, which can present solid gains dollar-wise you would move towards ATM or ITM options.
How to Identify the Perfect Strike?
The final piece to the puzzle, how can you perfectly select the right options? Rather, how can you mitigate your risk by proper options selection?
The main that we’ve identified so far are:
- Timing
- Delta
Assuming that we are trading weeklies, and understand theta will burn us, along with selecting a closer to 0.5 delta. What else can we do?
We have to measure the liquidity of the options. How easily can you get in and out with the smaller loss. Each option has a spread, where the market maker will take a piece of the action. Spreads between the bid and ask can spread from $0.01 to multiple dollars.
What do we look for? Let’s take the NVDA options chain below as an example.
We have identified that we would probably look for a strike between 230 and 240 based on delta.
The next steps:
- What are the spreads?
- What is the open interest?
- What is the volume?
Spreads with anything other than SPY and QQQ (ETFs, in general, are going to be wider). If we look at these, the tightest spread is 240, it’s pretty far OTM, the cost of options is low, meaning it’s riskier. The 235C has a 0.15 spread, which isn’t ideal, I would rather $0.10 and lower, but this is the best one out of the lot.
Then with open interest and volume, you look for high volume, ideally higher than open interest (OI). Ideally, OI is high as well. Typically non-demical strikes have better liquidity. You can see the heaviest traded is 230 and 235 on the call side. There is 72.6K volume on the 235C and 32.9K on the 235C with higher OI on the 230C.
Based on these the liquidity is higher for 230C however the liquidity for 235C is still really higher. It’s above 10K volume and over 1K OI. Meaning we would go with 235C in this case.
This seems like a long process but once you get the hang of it you will see this and scan this easily.
Select your options carefully, manage your risk, and happy trading!
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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.
