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How Day Traders Can Limit Speculative Risk

Short-dated long options offer an alternative to futures when speculating.
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This article first appeared earlier today on RealMoney Pro. Click here for more information on how to get timely actionable investing ideas.

Perhaps the most difficult method of aggressive speculation is day trading E-mini S&P 500 futures, yet that is the practice that tends to attract the lion's share of speculative dollars into the futures markets. Further, it is E-mini day trading that draws all of the attention and hype, and gets snake oil salesman excited. Despite the massive profit potential evident in the low margin and high volatility offered by futures day trading strategies, the reality is most attempts to profit are epic failures.

Losses are generally blamed on one simple aspect of day trading: risk management. The tool for risk management is the stop loss order. The dilemma is whether to use stop loss orders to prevent runaway losses, accepting frequent premature stop outs as an opportunity cost, or to trade without stops, eliminating the risk of being forced out of a good trade prematurely but accepting exposure to theoretically unlimited risk. This catch-22 has wreaked havoc on the accounts and minds of E-mini day traders for years. Yet, there might be a better solution: day trading with short-dated long options.

New Option Opportunities

A few years ago, the idea of day trading options in the E-mini S&P was more of a pipe-dream than a reality. Traders wishing to do so were forced to trade options with monthly expirations (the third Friday of each month) or end of month options which expire on the last trading day of the month. Aside from the week prior to expiration, option day traders would have been forced to buy calls and puts with relatively substantial time to expiration. This translated into high premiums (high option prices), less responsive option prices to the underlying futures price, and thus overall higher risks and lower rewards. However, now that the CME offers options expiring on every other day of the week (Monday, Wednesday, and Friday) option day traders can focus their speculation on hours, not days or weeks. Further, it is possible to profit from accurate intraday speculation in the ES in increments of a few points of futures market movement, not dozens of points. In short, options traders can now utilize long puts and long calls to wager on short-term day trades or swing trades.

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Figure 1: The trading session high and low price of individual options on this chain displaying options with 1 day to expiration confirms there is enough movement for day traders. (Chart by QST.)

Why E-mini S&P 500 Weekly Options?

Except for scalping, futures traders wishing to make the move to options as a means of mitigating risk and account balance volatility can do so without changing their overall game plan. In other words, the same technical indicators and time frames can be used for option day trading as are used for futures day trading. If a day trading strategy calls for a "short" position, a trader could buy a weekly put option instead. Similarly, a "buy" signal can be met with the purchase of a weekly call option. Preferably the options used for day trading should expire in roughly two to three days.

Greater Risk Control

The trader can choose the level of aggression and risk aversion by choosing an appropriate option strike price. For instance, a trader wishing to trade conservatively would purchase an out-of-the-money option for little premium, but a more aggressive trader might be willing to pay a higher price for an at-the-money option (this means the strike price is identical, or similar, to the current underlying futures price). Obviously, options with strike prices that are either at-the-money or near-the-money will be more responsive to changes in the futures price; thus, not only are these options are more expensive to purchase, they also come with more risk than an out-of-the-money strike priced option would.

Limited Risk

If you find yourself wondering why a trader would use options, which are less efficient than futures, to speculate on intraday price moves, the answer is simple; to mitigate risk while maintaining leverage. More importantly, risk of a long option is limited to a defined amount (the price paid to purchase the option) without giving up lasting power as an opportunity cost. Specifically, E-mini S&P 500 futures traders often manage their risk per trade using stop-loss orders. However, stop-loss orders are highly prone to premature execution, leaving traders to watch the market run away in the anticipated direction without them. Additionally, the use of stop-loss orders generally leads to nearly guaranteed small trading losses as opposed to protecting capital while leaving potential for gains. In short, stop orders tend to do more harm than good because they often lock in losses at the worst time. The use of long option trades, on the other hand, translates into positions that are always "in it to win it". Of course, it is possible to buy a weekly option and see the premium quickly erode to nothing; yet, even a nearly worthless option keeps the trader in the game and things can change rapidly. Losing long option positions can always get better, but a futures trade stopped out at a loss can never improve.

Mental Stability

Another primary benefit of using long weekly options as opposed to long or short futures contracts is the mental stability that comes with low and limited risk. Slower moving option positions in which the maximum loss is known are far less likely to trigger an emotional meltdown than outright futures trading might. Thus, it is a highly conceivable notion that day trading options promotes rational decision making by mitigating emotional mayhem.

Free From the Shackles

Some other benefits of this style of day trading are a lack of margin concern. Many day traders are utilizing excessive leverage. They are often basing their position sizing on discounted intraday margin rates, and simply don't have the money to hold positions beyond the close of trade (which triggers a much higher margin requirement). As a result, overleveraged day traders are typically scrambling to cover positions in the last hour of trade. An options trader could avoid getting caught in the herd and allow trading signals to play out beyond the close of the day session. Remember, the market doesn't care if you must be flat by 4:00 pm Central. Trading signals are produced and carried out on the market's time, not the trader's time.

Putting it in Practice

Now that we have discussed the advantages of trading weekly options on the E-mini S&P 500, we'll discuss the practicality of it. For instance, we will discuss the cost and risk of this type of trading, choosing a strike price, and walk through an example of how reactive the option prices are to underlying moves in the futures market.

Determining Desired Risk

Longer-dated out-of-the-money options tend to be less sensitive to intraday price moves, but options that expire a day or two in the future can be positioned relatively close to the current market price allowing them to be explosive at times. For instance, traders with good timing might find it possible to purchase an ES put or call for 2.00 to 4.00 points (or $100 to $200) and later sell the same option for double, triple, or quadruple the premium. Of course, there is no guarantee this will be the case and it is easier said than done. Nonetheless, the point is these types of intraday swings in weekly options are frequent; a trader can enter a position with a risk of $200 or less in hopes of a profit potential of $200 to $600. Furthermore, the said trader doesn't have to worry about being knocked out of the position with a small loss. Regardless of how poor the timing of entry was, until the option is sold or it expires worthless, there is always a chance at recovery.

A futures trader, on the other hand, might enjoy higher and faster profit potential but he also must choose to either face much higher risk (using no stop-loss order) or running the risk of being stopped out with a $200 loss before the market moves in the desired direction. In other words, futures day traders have little room for error and arguably more risk. To reiterate, an intraday option trader has the comfort of low and limited risk with lasting power to ride the ebb and flow of the market.

Also, unlike trading futures outright, weekly options traders can determine how aggressive they would like to be. For instance, an E-mini S&P 500 futures traders who goes long a futures contract will make or lose $50 per point regardless of whether they are comfortable with that risk. Aside from hedging the position with options, there is no way of getting around the contract size and position delta. On the contrary, an options trader could purchase an at-the-money call option with a delta of 50% (meaning the position makes or loses about half of what an S&P future would), or the trader can opt for an out-of-the-money call option with a delta of 25%. This person won't make money as quickly if he is accurate in the direction, but he stands to make roughly a quarter of a point for every point the futures market moves in his favor. In short, the options trader has the "option" to slow the trade down to mitigate account balance volatility and stress.

Choosing an Expiration Day

Again, the option day trader chooses a strike price and expiration as a means of controlling the risk of the trade. That said, it makes sense to pick options that have a chance to gain in value. I believe it is optimal to choose an option that expires in 2 to 3 days. Those options that expire on the day of the trade, or even the next day, are highly susceptible to blowing up (losing all their value in a very short period). This is because, with such a short lifespan, any adverse turn in the futures market renders the options nearly worthless immediately.

Choosing a Strike Price

I also like the idea of choosing strike prices that represent a price target, or a price that might be surpassed by a price target. In other words, the strike price of the long weekly option should not be beyond the price level believed to be seen. That said, the futures market doesn't necessarily need to reach the strike price of the option for the trader to turn a profit. Nevertheless, traders choosing strikes that are not likely to be seen are prone to being in a scenario in which the market moves in the intended direction, but the option fails to increase in value. This is obviously a frustrating endeavor, but we must always remember there is a big difference between being correct in market speculation and making money from it.

Practice, Practice, Practice

The only way to truly learn how this process might work is to test it out. In theory, aside from scalping, buying calls and puts using weekly options could be substituted for buying or selling futures contracts in any day trading strategy. I recommend starting with a paper trading or demo account to get comfortable with option symbols, contract specs, day-to-day volatility. However, paper trading doesn't account for the emotional toll trading takes on market participants, so it is only beneficial for a short time (30 days or so). Beyond that, it makes sense to simply open a trading account and dip a toe in starting with one option at a time.

(This article originally appeared on Real Money Pro. Click here to learn about this dynamic market information service for active traders and to receive columns from Ed Ponsi, Paul Price, Bret Jensen and others.)

At the time of publication, Garner had no positions in any securities discussed.

There is a substantial risk of loss in trading commodity futures, options, ETFs. Seasonal tendencies are already priced into market values.