Last week, we discussed why derivatives are optimal for day trading compared to shares. We also showed why the choice between options and futures for day trading is not so clear-cut. This week, we discuss whether you should set up spread positions for day trading.
When you set up position trades in options, you must be mindful of time decay. This is the loss in option value because of passage of time. When you buy an at-the-money (ATM) or out-of-the-money (OTM) option, the premium you pay comprises only time value. This time value will become zero at option expiry.
To improve your chances of winning on the trade, it is important that you lower your losses from time decay. One way to do so is to set up spread trades. So, if you have a positive outlook on an underlying, you could set up a bull call spread. And if you have a negative outlook on an underlying, you could set up a bear put spread. Because the short option position gains from time decay, your spread’s net exposure to time decay is less than in the case of a simple long position in a call or a put. This argument does not, however, hold for day trading. Your objective in this case is to simply close the position by the end of a trading day. So, loss in time value due to time decay on the long position is not a cause for concern. Should you then set up spread trades?
The issue using spreads for day trading is that your gains are capped because the short call option (short put) position will gather losses when the underlying moves up (moves down). For instance, you set up a bull call spread by going long the next week 18000 call on the Nifty Index and short the same-expiry 18200 call for 85 points (175 less 90). If the Nifty Index moves up 55 points to 18000 during the day, your spread would have gained just 10 points! On the other hand, if you had set up just a long position on the 18000 call, your gains would be 27 points. The argument is no different if the Nifty Index moves 155 points to 18100 during the day.
Of course, the spread will lose less if the underlying moves against your position because of the gains on the short option. But if you engage in day trading, you might as well implement strict risk management rules than manage your risk through spread positions. The upshot? You should prefer long calls and long puts instead of setting up bull call spreads and bear put spreads.
The objective of a spread is to benefit from time decay and reduction in capital outlay required to set up the trade. Of course, the flip side is that you cap the gains on your position. This trade-off is meaningful if you set up positional trades — trading for more than a day. But in day trading, time decay does not benefit short options as it is the loss in time value with each passing day (not intra-day). Without gains from time decay, the negative effect of the increase in delta of the short calls (short puts) is magnified when the underlying moves up (down). That is why a call spread or a put spread is unable to generate decent gains despite a significant movement in the underlying.
Note that intra-day trades should be set up to capture price momentum, not reversals. Why? Price reversals take a while to generate gains; buying call options on price breakouts or buying put options on breakdowns could be more profitable for day trading. A caveat. Day trading is risky because intra-day charts are more noisy than daily charts. Using options adds to the risk. So, engage in day trading options only if you have the risk attitude.
(The author offers training program for individuals to manage their personal investments)