Options Scalping

June 28, 2022

Options Scalping

OPTIONS SCALPING - Part 1
There are many ways to trade the markets, and one of the most preferred-for many traders-is options scalping. There are several types of trades that can be considered scalping in trading, and they all revolve around holding a position for a short amount of time and always intraday. The most technical sense of the term refers to the trading done by the algorithmic high-frequency trading firms that specialize in opening and closing many thousands of trades a day. This is not, of course, relevant to the individual retail trader. As discussed here, scalping will refer to opening and closing a trade position in a relatively small amount of time, always intraday. Generally a scalp position will be relatively large and the trader will seek to make a small profit on a large number of contracts. Thirty dollars may not seem like a big profit; however, if one has twenty five contracts, the small gains add up explosively. Scalping can be learned by beginning traders, and it can reach advanced levels suitable for highly developed traders also. So how can a trader learn to scalp options?

The leverage inherent in options, and their defined risk, make options a powerful scalping instrument. As is the case with a lot of different types of trading, options scalping requires solid trade planning. It depends on choosing the correct contract to buy, developing charting skills, patience, and extremely strong exit discipline if the trade goes against you. Exit discipline is perhaps one of the most important skills because scalping positions typically consist of larger than average number of contracts held for a small amount of time with the goal of securing a small gain per contract. Scalps can sometimes last less than a minute, and if the trade suddenly goes against you, a large scalping position can incur heavy losses quickly.

Of course large position sizes are not, by any means, required. This is, however, a very common way of going about this high-speed type of trading. Any way you set up your approach to scalping, you have to be ready to get out of the trade on a moment's notice if things go wrong. Additionally, traders should know when they will exit a trade if it goes their way or if it is a losing trade before entering the scalp trade. Let's examine a hypothetical setup. Keep in mind that this is only one of many ways to scalp options contacts.

First, why not just scalp commons and avoid theta burn and other options specific dangers? In a word: leverage. The leverage inherent in options trading make it possible to make gains that are simply unavailable to scalpers of common shares. Additionally, the defined risk of options is a positive. Furthermore, it's possible to make really good returns with around three thousand dollars in a cash account if you are trading options. Always be sure you are on a cash account. There is no pattern day trading (PDT) rule with cash accounts, and options funds settle the very next day. That means you can open and close trades today, and tomorrow morning that buying power will be available to you.

PLAN THE TRADE; TRADE THE PLAN
Imagine ticker XYZ has a lot of relative volume in the premarket, some news, and is abuzz on social media. This could be a good reason to examine its chart premarket to see if scalping might be of interest.

Once support and resistance is charted out on the hourly, the fifteen, and the five minute charts the trader goes to the one-minute chart to watch for an entry. The exit must be planned as well. It is a good idea to actually write out your trade thesis. First, this makes you slow down and think more deeply about the trade and second, when you see your rules writ large, it is often easier to follow them. A thesis might be similar to this:

Once price action breaks a resistance level with volume, I will enter a starter call position. If a one-minute candle closes below my broken resistance entry level, I will close the contract out for a loss. If the trade continues upward I will take profit right below the next resistance level on the chart. If volume stays heavy, I may add to the position up to ten contracts maximum.

Things to note about this thesis. First, the intention is to enter with a starter position (in this case, a single contact). This minimizes losses if the trades goes against you. Too often, traders begin a trade with a full size trade. This is a mistake for several reasons, and not the least of which is that if the trade reverses on you the 5 percent loss (or whatever pre-planned stop loss percentage) is amplified by ten contracts instead of only one.

Secondly, notice that the thesis has a pre-arranged profit target. Of course, if you approach your profit target and price action is still rampaging upward and beyond it, it might behoove you to stay a bit longer, finger on the sell button. However, the thesis has an area of resistance predestined for profit taking. There is no discrete absolute limit of profit; therefore, it can be psychologically difficult to keep profit in perspective. Well, if it has risen this much…one might think in the heat of the moment…what's to say it won't continue? This type of thinking is counter to success, and planning out entrance, stop-loss exit and take-profit exit will save you a good deal of on-the-spot, real-time illogical thinking that will…most likely…eat away at your profits in the end. The stop-loss exit and the take profit was preordained before this trade was opened.

Finally, the thesis allows adding-to the position to a maximum of ten contracts. This is an important concept in options scalping. New traders too often add to losing positions while selling winning single-contract positions too soon. First, "averaging down" is never considered a good practice in losing trades with very few exceptions. And it can seem counterintuitive to add to a winning position. The psychological block there is that one may think they are raising their cost basis by adding to a position at a higher price point. This discounts the fact that the gain is amplified by each contract added. In the end, adding to a winning position and then scaling out of the position as it approaches the exit can be a very profitable methodology.

And remember the goal is small profits repeated multiple times over a trading session. If one is scalping SPY, the goal is not to make ten dollars per contract. The goal is more like making 11$ per contract, and having a large scalping position size to amplify the gains. Then you are out of the trade, and you look for the next. Many option scalpers make many trades per day during trending markets.

CHOOSING WHICH CONTRACTS TO SCALP
Above is a discussion of a hypothetical scalp trading thesis. But which contracts should you buy of ticker XYZ? There are many options up and down the chain. A lot of the contract selection will depend on your personal risk tolerance, account size, and expected time frame of the scalp. Regardless of these factors, you should be aware of Implied Volatility and Expiration Date.

Note that since many scalps are only held for a few minutes, there is little attention paid to things like fundamental analysis or even Theta. In fact, that is one of the biggest benefits to scalping. And, of course, there is the added luxury of being all cash at the end of each trading session. That helps many traders sleep well at night.

IMPLIED VOLATILITY
One could argue that implied volatility also doesn't factor much into a trade that is opened and sold on a very short intraday time frame. Typically, times of high implied volatility favors options sellers, and many are advised to not buy options when IV is elevated. Not only is the contract price jacked up from heightened IV, but the premium is going to be elevated as well. It can be argued that most scalps are so short term this doesn't matter. For example, if you buy a contract at ten am with 300% IV for a scalp, odds are that you are going to close it out within a short timeframe and IV likely won't have time to change much. Therefore the elevated premium you paid will be similar to the elevated premium you are paid when you sell it to the next person.

However, it is good to be aware of implied volatility while scalping due to what IV is. Remember that IV is increased if there is a larger expectation of the price action moving violently one way or the other…the literal volatility that is implied by this reading is high. Therefore, be conscious if you are scalping a position during times of high IV…you may need to be quicker than average on the sell button if things go awry.

OPTIONS EXPIRATION DATE
How far out should scalping contracts be bought is another pertinent choice the trader has to make. Some advocate for buying a week or two away so you "have time" if the trade goes the wrong way. I don't advocate this at all. If you enter a position with a scalp time frame mindset, you should exit it with the same mindset as well. Having a scalp go wrong, and then holding on to a losing trade until next week just because "you have time" on the trade is akin to hopium. If an intended scalp turns into a swing trade, you have not followed your trade plan. Have a pre-ordained stop-loss exit on the chart, and if the price action breaches that exit…kill the trade, take the small loss, and move on. For this exact reason, Zero days-to-expiration are the preferred contracts of the true options scalper. If your pre-planned stop-loss exit is three or four bars of price action below your entry, you will know quickly if you are wrong and will be able to kill the trade with a minimal loss. No extra time…or blind hopium…needed.

Be aware, that as logical as this is, this discipline takes time to develop. For some traders, it takes years to develop. Until you know you possess that discipline, tread cautiously with weekly contracts. As many have learned, they can go to nothing relatively quickly. It can give a trader a sense of confidence knowing the contracts they are trading do not expire at the end of the current trading session. Nonetheless, once one acquires requisite stop loss discipline, there is no need to pay for extra time for a contract you will be selling within the hour, most likely.

OTHER CONSIDERATIONS
In part two of this series, other considerations will be explored including Knowing your broker, Delta selection, active and dynamic support and resistance, commonly used indicators, keeping PnL out of it, keeping exits mechanical and more. There are more elements to learn once you get deeper into short term intraday trading options; however, the next installment will include a discussion of these items.

However, bear this in mind. If you are new to this type of trading it can seem jarring to buy a contract only to sell it minutes later. The traditional idea of risk/reward can be skewed to a degree, and that is hard for some traders to get accustomed to. For example, if you buy a SPY at the money contract for $400 and sell it in six minutes for $445, some people may have the following question. How does it make sense to risk four hundred dollars just to make forty five dollars? In the world of option scalping, this logic is flawed. First, you are not risking the entire premium paid. Successful option scalpers do not risk losing the entire premium. You are only risking your pre-determined stop-loss amount. Perhaps you may risk ten percent of that total premium. If it falls below that level, you sell it and take the loss. The trade is over; the rest of your premium is not at risk.

And beyond that, a more logical way to think about buying at 400 and selling at 445 is the notion that you just made over ten percent return on a cash investment in less than ten minutes. There is no other possible market that exists where that is possible. The leverage of options make them a powerful scalping vehicle. That makes it highly desirable, but it does take skill and experience. There is a lot more ground to cover, and if you have a trade plan, broad knowledge of trading, good charting skills, and advanced exit discipline, scalping may be a great fit for you. See you in part two!

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