Would you like to know how day traders do it? How day traders decide what stock to buy? These are the questions asked of a day trader.

I will attempt to shed some light on the subject, although, it is similar to asking a heart surgeon, how he performs open heart surgery. (day traders think highly of the profession). Stocks are grouped into three categories.

1. Stocks that are outperforming the market.
2. Stocks that are trading in perfect correlation to the market
3. Stocks that are under performing the market.

Investors look at this information on a longer time frame than a day trader. A day trader will look at the stocks performance for the past hour, day or week. An investor will look at the stocks performance on the month, quarter, or year.

A large percentage of stocks trade in almost perfect correlation to the S&P 500. This means, if the S&P is up 7% on the year, most stocks will also be up 7%. Interestingly enough, this also happens on a daily basis. Unless there is new information released about an individual stock, like an earnings announcement or a new product release, the stock will usually follow the market. If the stock is outperforming or under performing the market, there should be a reason why.

Many day traders look for stocks that are up or down sharply in the pre market and trade those stocks during the day. A stock that opens for trading at 9:30 and is already up 10% will usually fluctuate a few percentage points during the course of the day.

Google is a stock that  usually trades along side the Nasdaq. When the Nasdaq goes up, so does Google, and vise versus.

Sept 1st, 2010 was a rocking day in the stock market. The S&P opened up 9 points and finished the day up 31 points!

Here is the Nasdaq 100 1 day, 5 minute chart:

Nasdaq 100 Chart Sept 1st 2010

Here is the Google 1 day, 5 minute chart:

Google Chart Sept 1st 2010

(The times on the two charts above are different because of time zones, the Nasdaq 100 is GMT -6 (Chicago) and GOOG is GMT -5 (new york))

At 10:00 am New York time, the Nasdaq jumped and so did Google (see chart below). The problem was that Google, did not move as high as the Nasdaq. With Google up 1.5% and the market up 2.5%, Google had a considerable amount of catching up to do.

 

A day trader who is familiar with a stock like Google will say, it is only a matter to time, 5 minutes, 10 minutes or maybe an hour until Google catches up to the Nasdaq. The trader will buy Google and wait for the price to go up the same percentage as the Nasdaq is up.

A pair trade would be to buy Google and short the Nasdaq and wait for the correlation to revert back to the norm and make 0.50%.

For some reason, I decided to buy Google at 10:03 for $457 and hold onto it for 42 minutes until it reached $462 . At 10:45 when I sold GOOG, I had made my 1% return and the correlation between Google and the Nasdaq was coming together. So why didn’t I wait until 11:00 or 11:45 when $GOOG and the Nasdaq where both up 2.8%? Because sometimes you take your profits early and are happy with 1% in 42 minutes.

Learn more about the: Covered Call Strategy

The covered call trade strategy (aka buy-write) involves buying the stock and selling one call option against every one hundred shares that is owned.

Learning to trade the covered call is not very difficult. Take a look at Microsoft stock ticker $MSFT as an example of buying and selling a covered call.

If we were to buy 100 shares of stock in Microsoft, Ticker MSFT for $25.80 a share and then sell the $26 call. This would be a covered call.

Let’s dig deeper and see what just happened.

In the picture below we have the option chain for Microsoft. The example shows the front month options that will expire in 26 days.

It is July 26^th and we own stock in Microsoft, which we paid $25.80 a share, what can we do to make money on it besides waiting for the stock to go up? We can sell a call.

A call option gives the buyer the right to buy the stock from us on option expiration day. The call option also gives the seller the obligation to sell the buyer the stock for the predetermined price.

If we look at the $26 call, it is trading at $0.50 – $0.53 per contract. This amounts to $50 per one hundred shares. If we sell the $26 call and on options expiration day Microsoft stock is still below $26 a share we get to keep the $50 from selling the call and the stock stays in our account. If the stock is trading above $26, say $26.10, on option expiration day, the stock will be sold from our account for $26.00 a share and we will keep the $0.50 from selling the option contract. Either way we will have made a 2% profit in one month! If we manage to do this every single month it would be 24% profit on the year.

This sounds very exciting and enticing, but there are downsides to selling covered calls.

One downside to the covered call trade can happen when the stock losses too much of its value and then the profit from selling the call doesn’t cover the losses from the stock itself.

Example: We sold the $26 call for $0.50. We bought the stock for $25.80. On expiration day the stock is now at $25.05. We will have made 2% on the calls but lost 3% on the stock.

OK, so we are only down 1% overall on expiration day, let’s do it again and sell the $26 call for the next month.

Another negative to the covered call trade is when a call is sold and then the stock far surpasses the strike price and now the profit was limited.

Example: We sold the $26 call for $0.50. We bought the stock for $25.80. On expiration day the stock is now at $27.00. We will have made $0.20 on the stock, $0.50 on the options we sold and the other $0.50 that we could have made, is now the profit of the person who bought the option.

So is a covered call a worthwhile trade?

If you are like me and every time you buy stock it goes down. Then the covered call is a very good trade. Buy the stock, immediately sell a call against it. The stock goes down, and along with it the call option starts declining in value. Now at least there is some profit to go along with the loss.

If we go with the false assumption that the stock market will return on average 8% a year, doing a covered call that returns 1% a month will beat the market and do 12% a year.

Buying & Selling the option

When you are creating a covered call trade, it can be done at one time by placing a combination trade. A combination trade is when the stock it bought and the call is sold simultaneously.  Or, if you already own the stock you can sell a call, either the weekly option or the option that expires in six months from now. Selling a call against stock you own is called sell to open (just like short selling). Some brokers have two different order types for selling options and you will need to select “sell to open”. To buy it back you will “buy to close”.

Do I need to wait for the option to expire?

No. You can go back and buy the option you sold, either for a profit or loss. Sometimes people will sell the call that expires in this month and then the stock has an earnings announcement and the volatility of the option drops giving them a profit on the far out of the money call that they sold. They can lock in profits by placing a “buy to cover” order on the call and sell another call that expires next week or next month.

As we come closer to May and earning season starts making the markets gyrate we are going to hear the calls to “Sell in May & Go Away” get louder and louder.

Be what if we need or want to stay fully invested in the markets, what do we do?

The simple answer is to buy the S&P 500 index (Ticker: SPY) and sell a call against the position.

For a more detailed explanation of the covered call strategy see our article Covered Call Option Strategy explained.

The S&P 500 currently stands at 1563, the SPY ETF is at $156. The S&P 500 is up over 10% year to date and up over 13% in the past 12 month.

There are two approach’s we can take to this:

1. Buy the SPY and sell out of the money calls against it every month. Meaning sell May expiration calls now and when they expire sell the June calls and so on until Labor day.
2. Buy the SPY and sell the September calls against in now and wait the four and a half months until expiration.

Taking the second approach of selling September $157 Calls at $5.00 would yield us a 3% return if the SPY stays where it is and the calls expire worthless. This also gives us 3% padding if the S&P drops 3% during this time.

Another option would be to sell the September $160 calls at $3.60 which would increase the potential return to 4% at option expiration the SPY is over $160, but it does not give us the same downside protection that the $157 calls give with the $5.00 premium they have.

Remember, you do not need to wait until the option expires to lock in profits. If the S&P falls and the option you sold is now worthless, you can try picking market tops and bottoms by buying back the call you sold and wait for the market to swing higher before you sell the same call again.

Just some thoughts and a different twist to those who decide buy puts for protection or those who liquidate everything going into May and the summer months.

When Weekly Options started trading a few years ago, everyone though wow, those expire quickly. Now there is a new phenomenon called binary options that expire after 60 seconds or one day!

Here is a typical binary options trade. Not much different from a regular weekly or monthly option, just the time to expiration.  The Binary Option show options traders how to trade binary options.

The trader thinks that the EUR/USD strike price will close at or above 1.3000 at 3:00 p.m. can buy a call option on that outcome.

The trader who thinks that the EUR/USD strike price will close at or below 1.3000 at 3:00 p.m. can buy a put option.

At 2:00 p.m. the EUR/USD spot price is 1.2999. the trader believes this will increase, so he buys 10 call options for EUR/USD at or above 1.3000 at 3:00 p.m. at a cost of say $40 each.

The risk involved in this trade is known. The trader’s gross profit/loss follows the ‘all or nothing’ principle. He can lose all the money he invested, which in this case is $40 x 10 = $400, or make a gross profit of $100 x 10 = $1000. If the EUR/USD strike price will close at or above 1.3000 at 3:00 p.m. the trader’s net profit will be the payoff at expiry minus the cost of the option: $1000 – $400 = $600.

The trader can also choose to liquidate (buy or sell to close) his position prior to expiration, at which point the option value is not guaranteed to be $100. The larger the gap between the spot price and the strike price, the value of the option decreases, as the option is less likely to expire in the money.

In this example, at 3:00 p.m. the spot has risen to 1.3005. The option has expired in the money and the gross payoff is $1000. The trader’s net profit is $600.

Visit the Binary Option Exchange to learn more about Binary option trading.

How do I buy options to make a huge windfall profit when a company gets taken over? This question is typically asked by someone who heard from a friend who heard from another friend that a publicly traded company is a merger / acquisition target.

The people asking usually do not let onto the fact that they think they have insider information. Let me just say this; If after you read this article you buy options and then make a million dollars, you can be sure the F.B.I. and S.E.C. will come knocking on your door pretty soon!

The details of the trade:

The public company is currently trading at $20 a share. The rumor is that they will be bought or merged at a price of $30 a share. So the simple thought is to buy the $25 call for a nickel, and them boom make 100 times your money.

Here are the problems with trading takeover announcement:

When is the deal going to be announced? If the deal is announced in 3 months time the speculator needs to buy options that expire in more than 3 months. Which strike price do you buy? The $22.50, $25.00 or the $30. Buying the $30 call is useless and I will explain why.

A deal can be either all cash, cash & stock or all stock. If the deal is all cash, which are the best deals, it may be subject to financing or regulatory approval. If the all cash deal is announced on June 1st for $30 a share and they say the deal will close on Dec 31st, the stock price will rise to $29, not $30 because there is a merger arbitrage discount that factor in the risk of the deal falling apart.

If the deal is cash & stock, the stock rise but the portion that is in stock will cause the stock price of the acquirer to fall and again, the stock will not rise to the full $30 unless but the cash component and the stock component add up to $30. Theoretically, if the acquirers stock rises, the deal can be worth more than $30 a share.

When you are dealing with options, you must remember the “time value”. Options are constantly losing value because they are closer to expiration. So as we mentioned earlier, you must buy a call option that expires after the deal announcement.
Sometimes the rumor says the announcement will come in June but only comes in August and your July options are now worthless. Thinking about using weekly options? You better be best friends with the investment banker and know 100% that this insider information is worth it!

Option markets very far out of the money are not liquid. Meaning, say you wanted to buy that $25 call, on a stock that has had no indications that it is a takeover target, there will be no big and the ask price will be $0.15. And there will probably only be 45 calls for sale at that price. If you try to buy $5000 worth of call options (333 calls) the order will not get filled and will also raise a red flag on why the hell would someone BUY a 333 call that far out unless they think there is a reason for the stock to bounce 20% in such a short span.

Have a look at the chart for Best Buy which is open knowledge to everyone that there is an effort by the former CEO and minority shareholder to take the company public. See that pop and drop in mid December? It is called, deal on deal off in a matter of 24 hours.

Read more about covered calls, or as we like to call it, go for singles not home runs!

Also, have a look at the beginners guide to trading options. You may learn a thing or two!