Options Scalping Part 3

Options Scalping

Options Scalping Part 3

In part three of our options scalping series, we will discuss more granular details regarding how to profitably scalp option contracts as well as provide a method to enter, maintain, and exit a scalp trade. We’ll also cover more nuanced topics as we discuss various aspects of options scalping, including an easy-to-understand strategy that can be employed by any trader with a grasp of the basics.

 

COMMONLY USED INDICATORS, TIME FRAMES, AND CANDLESTICKS
Before getting into more granular details of scalping, it is useful to cover a final bit of general advice. Scalping is much different from long term investing and even short-term swing trading the BlackBox options flow plays. As a result, elements such as fundamental analysis are not needed. The name of the game is to quickly enter and exit a position, taking advantage of price action. As is the case with all types of options trading, there are many indicator choices. Helpful scalping indicators include RSI, MACD, and other stochastics indicators. When used properly, these can help judge the power of a particular move and a possible reversal. Additionally, moving averages are also used as confirmation Finally, many scalpers use Bollinger Bands to help specifically with exits. Your mileage may vary, but these are some of the big ones.

Many scalpers use the five or three minute charts for scalping. However, the one minute chart is very commonly used. Remember that scalp trades are meant to be opened and closed quickly. Strong entries, management, and exits can definitely occur with the one-minute chart if good support and resistance are mapped out.

Finally, some scalpers prefer to use Heiken Ashi style candle sticks. Take the time to learn how these work and give them a try. Many traders believe they can keep you in a winning trade longer. And, after all, “leaving money on the table” is a common regret of day traders. So investigate Heiken Ashi candles, and see if they can work for you.

 

HAVE A WRITTEN TRADE PLAN
It is common to keep a journal of all trades. This is recognized as a powerful reflective tool paramount to trading development. Typically journaling occurs post-trade as a reflective process. Additionally, it can be a powerful practice to have a written trade plan. It doesn’t have to be elaborate, but the goal is to develop a rules-based trading system that is much more mechanical than you may currently be utilizing. “When the chart does this, I will do that,” is a rough paraphrase of the theory. It should be support and resistance telling you when to enter and exit a trade…or when to stay in a trade. “Intuitive” trading is a disaster waiting to happen. Physically writing out your reason for looking at a particular stock on a particular day, your entry and exit protocol, and what you plan to do if you get a really strong trending winner (or loser) can help you be more mindful and mechanical in your trades. It can also pair up with post-trade journaling to create a total record of your thought process regarding the specific trade.

 

DELTA SELECTION
So now we arrive at some more technical aspects of scalping. Volume one of this options scalping series discusses expiration choices as well as how implied volatility might affect your contract choice to enter an options scalp. A third useful consideration is delta selection. Depending on your risk tolerance and timeframe, delta selection might be among the most important element of trade selection. Other than theta, delta is the most crucial greek for the options scalper to understand. It is paramount in understanding risk and trade planning.

Recall that delta is a concept that describes how much an option contract will move if the underlying security moves one dollar. A delta value of .05 denotes that for every dollar the underlying increases, the options contract will increase 50 cents (remember that one contract controls one hundred shares, so always move the decimal two points to the right). If you buy a SPY call for $300 when SPY is $375, if SPY moves to $376, your call will increase to $350. That is the power of the leverage inherent in options. Of course, like all leverage, it cuts both ways. If SPY drops one dollar, your contract will lose fifty dollars.

Knowing this will help you choose the correct contract to scalp. An at the money, approximately .5 delta contract will fluctuate in price much more than a .2 delta contract. A .8 delta contract will move even quicker. Depending on your risk tolerance and your appetite for adrenaline, your delta preference will differ. And understanding and utilizing the relatively simple math behind delta, you can estimate how much a certain contract will lose or gain as it reaches a certain support or resistance level in the charts. This is how you evaluate your risk/reward as well as potential PnL of any given contract.

 

A SCALPING METHOD: STATIC AND DYNAMIC SUPPORT AND RESISTANCE
So, now that you have selected which contract strike price and how many contracts you want to trade, it is time to place a scalp trade. This section presents a very simple and effective way to enter, manage, and exit a scalp trade that is mechanically oriented. It uses dynamic support or resistance so first we need to understand what that means.

 

STATIC SUPPORT AND RESISTANCE
The typical notion of mapping out support and resistance based on previous lows and highs with horizontal lines is known as “static” support and resistance. If price rejected off $290 three times today and you are waiting for price to rise above it, you are stalking $290. That price doesn’t change. It is static, and it is represented with a horizontal line.

 

DYNAMIC SUPPORT AND RESISTANCE
If support and resistance are fluid and changeable, it is “dynamic.” A very common dynamic indicator are moving averages. For this example, consider the 8 period exponential moving average. Perhaps you notice that on a bullish trend day, the price action of a ticker keeps staying above the 8 EMA and every time it comes down to the 8, it bounces. If you entered long, your thesis might be to stay in the trade until the 8 is breached to the downside or you are nearing a major area of static resistance. The 8 ema cannot be represented by a horizontal line on a chart because the price level is constantly changing…it is dynamic. EMAs and SMAs are often used as sources of dynamic support and resistance. They are mechanical, and if a trader has discipline it can keep you in the trade longer than might be the case otherwise.

 

TRADING “THE 34”
And that is, as it turns out, the example of a scalp we are examining today. Among EMAs, the 34 period EMA has gained almost mythical status among a lot of day traders. Simply put, it is pretty common that the 34 works as effective dynamic support or resistance. Therefore, consider the following thesis and written plan on a hypothetical day that you notice price action is approaching the 34 EMA on the five-minute chart of XYZ. Your written trade plan might proceed thusly:

If the five-minute price action rises above the 34, retests and hold, I will enter long a starter position of one ATM .5 delta contract. My stop will be once a candle closes below the 34. If the price continues upward, and there is no discernable static resistance above, I may add to the position up to a maximum of five contracts. I will manage the trade according to the 34. As long as no significant static resistance is in the chart, I will close the trade when price breaks back below the 34.

That is an actionable, reasonable, and mechanical trade plan. If it goes against you in the beginning, you are stopped out of your one contract for a small loss. You chalk it up to the cost of doing business and start the hunt anew. If the trade continues upward, it might continue to work out for two candles or twenty candles. This mechanical trade plan does not use a predetermined dollar amount or percent gain. The market doesn’t care about our subjective gains or losses. Don’t stop out or take profit based on a percentage or a number. Let the chart tell you when to do these things. If you reach a target goal of fifty dollars per contract, let’s say, and you take profit when that is reached, you feel victorious unless the price keeps running all day. If the price stays above the 34, you could have stayed in the trade much longer with much more massive profits than your predetermined amount you would be happy with. If fact, having a predetermined subjective stop loss or take profit based on a number or percentage is one of the main mistakes new traders consistently make. Support, resistance, price action, and volume work together to tell you when it is most logical to enter, stay in, or exit a trade. Option scalpers need a functional mechanical rules-based trading strategy, and the above is an example of a simple one. Depending on how developed your trade psychology is, it is relatively easy to follow as well.

Paper trade this 34 strategy. See how it works and plays out in real time. Don’t risk real money until you are comfortable with it. Follow the rules, and be mechanical.

 

TWO LAST THINGS
Finally, be aware of the wash sale rule and consider looking into scalping the index futures micros to work on your scalping. The Wash Sale rule is a much maligned and often misunderstood reality the scalper must contend with, especially if she is scalping common shares.

This is a rule that states if you sell an investment for a loss and rebuy it with the same or a “substantially identical” investment 30 days before or after the sale, you will not be allowed to write off the loss on your taxes. If this happens enough, you can find your taxes for next year could be higher than you expected.

Many scalpers focus on a small basket of tickers, sometimes making many hundreds of buys and sells over a month. If these are sold for a loss, and if you re-buy the same ticker within thirty days, the wash sale rule will apply. For common shares, this can add up quickly.

It is a bit better for options scalping however. The rules are fuzzy, and you should always consult a tax professional, but the wash sale only applies to options if they are “substantially identical,” and for options, this involves the same contract, not necessarily the same ticker. Again, do your due diligence and consult a tax professional about your particular situation.

Finally, along with options scalping, many traders within BlackBoxStocks have been scalping the index futures market with micro contracts. Just keep in mind that you may want to explore this too, and we will write about this in coming entries. The futures market is a completely different situation with unique aspects throughout the different products available to trade. As is the case with all trading, be sure you thoroughly understand any instrument before you buy. Do your own very due diligence.

 

FINALLY
We hope this three-part options scalping series is helpful to your trading endeavors. Remember that with proper entries, exits, position sizing, management, and discipline, significant gains can be made from scalping the options market. Proceed with care, caution, and a mind geared to learning and, as always, don’t trade alone!