A foolproof strategy to make money day trading (no, really).
Day trading. We’ve all been warned against it. We’ve been told “95% of day traders lose money”. Couple that with an over-abundance of micro-influencers who publish click-bait content claiming to make 100% returns or 10k per week, only to find that they want to sell you some over-priced course that reveals all of their “secrets”.
My goal is to reveal some of those secrets here, and help you understand how you can actually beat the odds, to consistently make money. Sounds too good to be true, I know. And maybe it is. But maybe it isn’t… it’s your choice to continue reading.
Why you should believe me
When it comes down to it, day trading is just like any other skill. It takes time, money, and persistence in order to be good at it. You will not always succeed, but you will learn from your mistakes and get better over time. The people who are looking to get rich quick and don’t want to put the work in to learn the market are the ones who lose money. That is a lot more people than you think.
The reality is that you don’t need to trust me, or anybody really. There is an easy way to prove or disprove my strategy (and any strategy) without risking any of your own dollars.
The way that you can do that is by using the ThinkOrSwim platform by TD Ameritrade. On this platform, they have a feature called PaperMoney which allows you to simulate trades in real-time with fake money. This is better than back-testing because back-testing can be subject to hindsight bias, where you only test your theory on situations that you believe will prove the strategy. There is a condition on unlocking this feature that you need at least $500 in your brokerage in order to access real-time data.
Before you go and implement any strategy, you should use PaperMoney to test your strategy over and over again. Do not risk your real money until you have proven that you can make fake money. It’s that simple. I’d give it at least 2 months of practice, but that is up to you.
A quick disclaimer
I am not a financial professional and you should consult one before making any decision that involves financial risk. When day trading, you should only bet what you are willing to lose completely. Don’t bet the farm.
If you choose to day trade, you will need at least $25,000 in your brokerage order to avoid any penalties associated with being a Pattern Day Trader. Realistically this means you’ll need between $35,000 to $40,000 as you will need money to trade, and you may lose some. That or choose another asset such as Forex. I won’t be discussing that here, but make sure you do your research.
Ok, on to the strategy. I’ll be using the ThinkOrSwim platform for all trades.
The Strategy
This strategy is nothing new and is widely documented already. It uses a combination of options contracts and technical analysis. Day trading is actually a diverse field. What we will be doing is technically labeled scalping. Scalping is a form of day trading in which you profit off of very small movements of a stock over the course of a couple seconds, minutes, or hours (usually not hours). In the following sections, I will first go over all of the components, then I will discuss putting it all together.
Time of day
Most any time of day will work, but I believe that the first 1 hour after market open is the best time of day for a couple reasons.
The early bird gets the worm. I like day trading because I can spend one hour a day and make enough money to sustain myself, my hobbies and my interests. By choosing the morning, I have the whole day to do something else. This is especially useful if you are working a 9–5 like me.
Volatility. The first hour of the day is the most volatile time of the day in the market. This scares a lot of people away, as it can be unpredictable. But since we are usually in and out of a position in a matter of minutes, our risk is minimized and the volatility can actually work in our favor.
Volume. Volatility usually brings volume. And volume reduces the bid-ask spread of the option. I won’t go into too much detail here, but the bid-ask spread is essentially the difference in price between what people are selling an option at and what they want to buy it at. I’ll expand on this concept in detail when describing how to pick a stock.
Picking the right option
I use options for one reason, leverage. Options allow us to control a much larger amount of stocks without paying for them. I won’t go into how options work here, but you should have a solid foundation of how options work before proceeding. The flip side of this is that you can lose money a lot quicker. So, read my disclaimer again if you need to.
Now let’s get into how to choose an option. When selecting options, there is no one right choice, but there is a wrong choice. You’ll see what I mean in a minute.
The most important principle of the option that we choose is that we can get in and out of a trade quickly, and that it will actually make us money. Here are the following factors that go into a good pick.
Delta. Delta is a measure of how much an option moves compared to the underlying stock price, usually expressed as a percentage. For example, a delta of 50% means that the option will move 50% of whatever the underlying stock moved. While delta is a somewhat complicated concept, what is important to us is that it’s high, at least 30% but preferably much higher. This is usually found with in-the-money options. As a general rule of thumb, I would go with an option that is at-the-money or one in-the-money.
Volume and open interest. The volume (number of options traded) and open interest (the number of held contracts) should be very high, in at least the thousands. This means that there are a lot of people who are participating in the trading of these options, meaning we increase our likelihood of our order being filled quickly.
Bid-Ask Spread. The bid ask spread is the difference in price between what people are trying to buy options at and what people want to sell them at. For example, if our option has a bid price of $2.50 and an ask price of $2.65, then the spread is $0.15. Since we would like to get in and out of trades quickly, the easiest way to ensure this is to buy at the ask (the higher number) and sell at the bid (the lower number). If the spread is large and we buy and sell an option immediately, we would incur a net loss that is equal to the spread. This means that the larger the spread, the bigger the movement in the option needs to happen in order for us to profit. Minimizing this spread is key to maximize profits and minimize risk.
Trend of underlying stock. This one is easy, if the stock is going up, we want to buy a CALL, if it’s going down, we want to buy a PUT.
Date of expiration. The longer the date of expiration, the more expensive the option. Choose one that is expiring within a week (but not the same day). Since we’re going in and out on the same day, we don’t need to buy longer out options as that will only cost us more.
Time Interval
I have found that a 2-minute chart works best for this strategy as it provides a good balance of high-fidelity, short-term information while smoothing out the variance of micro-fluctuations in the stock that are not indicative of a larger trend.
Technical Indicators
The last component that we must outline before we are ready to put it all together are the technical indicators. Once again, I will not go into detail about what they are conceptually, but you should have a good understanding of what they are generally and how they can be used before proceeding.
The overarching theme that we are aiming to uncover by using these indicators is momentum. If we can identify when a stock is gaining momentum in a certain direction, then it will be an indicator for us to ride that wave.
As it turns out, it may be hard to predict where a stock will go in a few hours, days, or years, but it is pretty easy to predict where a stock will go in a few minutes. Observe the following daily TSLA chart
From this chart, it may be very difficult to predict whether this chart will end in a net gain over the course of the day or a couple days. However, we can observe a noticeable pattern in the swings of the stock. Our goal is to take advantages of the swings that happen throughout the course of the day.
5–8–13 Simple Moving Average (SMA). Do those numbers look familiar? They are fibonacci numbers. The idea is that you superimpose the 5, 8, and 13-bar SMA lines on top of the stock you are trading. When all three of these lines are in agreement, it indicates that the stock has momentum in that direction. Conversely, a disagreement indicates that the momentum is not strong or is shifting.
The following example illustrates how the 5–8–13 SMA can be used to identify trends.
Let’s break down each section in this image
- We notice the 5-day SMA intersect the 8 and 10 day SMAs. Then, the 8-day SMA intersects the 13-day SMA. Finally, the 13-day SMA begins to trend upwards. This indicates that a trend is emerging and we can interpret this as a buy signal for a CALL option.
- The 5-day SMA intersects the 8-day SMA in the opposite direction, indicating a shift in momentum. The 8-day intersects the 13-day shortly after. We can interpret this as a sell signal for a CALL option
- Similar to example (1), we now see the same trend occurring in the reverse direction. We can interpret this as a buy signal for a PUT option.
- This example demonstrates where we must be cognizant of the overarching trend of the stock. The 13-day SMA does not gain enough upwards momentum to give us confidence to buy. This is reinforced by the downward trend in the underlying stock.
MACD. The Moving Average Convergence Divergence (MACD) works similar to the SMA. It uses moving averages from different lengths to identify changes in momentum. For more context, see the explanation from Investopedia.
Let’s look at the MACD chart that corresponds to the AAPL chart above
- We notice an intersection between the MACD line and the signal line followed by a couple strong bars of positive divergence between the two lines. We can interpret this as a buy signal for a CALL option
- The lines converge (the histogram bars become very short). This tells us that the upward momentum of the chart is weakening. We can interpret this as a sell signal for a CALL option.
- The lines begin to diverge in the opposite direction, indicating a buy signal for a PUT option.
- We notice a slight intersection, but not enough momentum building. We would reject this indicator and refrain from executing a buy order for a CALL.
As you can see, having the MACD helps reduce the uncertainty when trying to determine momentum of a stock.
In summary, you use the indicators to influence your decision, but the decision is ultimately a judgement call based on all the available information.
Using multiple indicators are a way to provide you with more confidence in your judgements. Your goal is to have multiple indicators that account for various factors to increase the likelihood that we will make a winning bet. Put another way, the more indicators we use effectively, the less likely we are to be wrong.
Advice for Buying and Selling Options
Choosing the right price is important. As a scalper, you want to be able to get in and out of trades as quickly as possible. In order to do that, your best bet is to buy at the ask price and sell at the bid price. The caveat is that you will lose money if you try to buy and sell an option without a positive change in the price of the premium, so keep that in mind.
Depending on your time horizon, you can also set limit orders on your buys and stop loss orders on your sells. In doing so, you have a lower likelihood of getting fills but a lower margin of loss on your option.
Set, and adjust, your STOP orders. Setting STOP loss orders are extremely important for maximizing your upside potential while minimizing your downside risk. Stop losses allow you to automatically execute an order when the price falls to a certain value. You should always have a STOP loss in place in the case of sudden volatile movements. As the price goes up, adjust your STOP loss up so that you may retain profits by selling if the price starts to drop.
If you want to make more money, adjust the quantity of options you are purchasing and NOT the risk you are taking. This speaks for itself. Stick to the strategy as it is designed to minimize your losses. As the great Warren Buffet advises, the most important rule of investing is to not lose money. If you want to make more money, do so by increasing the number of contracts you buy, not by increasing your exposure to risk. That is a costly mistake.
Use your judgement. The strategy is designed to help inform your judgement, not to be applied blindly. Watch the stock, watch how it moves. Use your judgement if there is a disagreement between the technicals and the movement of the stock.
Keep in mind the trading fees. On ThinkOrSwim, this is $0.65 per option you buy or sell. If you buy 30 options, that $19.50 to buy, and another $19.50 to sell. This means you must clear $40 in your trade just to break even. You pay this whether you win or lose the trade.
Keep a running tab of your taxes owed. If you’re like me and you want to use this money for fun, make sure you’re keeping track of how much you’ll owe Uncle Sam at the end of the year for your capital gains.