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Thursday, March 3, 2011

Perils associated with day trading stock options

Day trading has between a 5-30% statistical chance of success according to market observers and financial analysts. The North American Securities Administrators Association (NASAA) has reported 70% of stock day traders lose all their capital through day trading. (1)

Risk alone is a major peril of day trading stock options. The reasons why day trading stock options is risky, especially to those unfamiliar with the practice, is lack of know how, the debt leveraging involved in day trading stock options, and the unpredictability of the market in general.

Stock options risk
Stock options are risky derivative financial instruments

Complexity of options rules


The actual process of day trading stock options is a peril because of the complexity and attention to detail that rapidly changes with fluctuations in market conditions. Moreover, risk management methods vary with the financial instrument, industrial sector, investment type etc., and a new technique may be needed for each trade depending on what is most financially suitable for the market. Properly learning how to day trade stock options can have positive results on the probability of success, but this isn't necessarily easy. However, those who are able to learn how to day trade mostly do not lose money as confirmed in a U.S. Securities and Exchange Commission (SEC) report that quotes the Electronic Traders Association (ETA).(2)

High capital investment


According to the Financial Industry Regulatory Authority (FINRA), day traders who do so more than 4 times in one week with more than 6% of their trading capacity are subject to a minimum stock reserve of $25,000.(3) This is a large amount of liquid capital that can incur opportunity cost and risk of its own.  For example, if the $25,000 consists of the majority of the day traders net capital worth, and the aforementioned day trading risks apply, then that day trader is putting a large amount of their financial security at risk.

Margin calls, commissions and fees


Another peril of day trading stock options are the costs of day trading. Since day trading involves frequent buying and selling, transaction commissions and fees can add up fast. If those transactions do not yield a profit in excess of the commissions and fees, not only has the option day trader lost money, but time as well.

Options contracts are usually based on cost per 100 shares not including broker commissions and generally cost more per contract when the perceived chance of success is higher. For example, an option to buy 10 option contracts to sell British Petroleum before January 2012 might cost  $38.80 per contract at a share price below $70.00 but only $3.50 at a share price below $17.50.(4)

Increased stress


A fourth peril of day trading stock options is the stress. The U.S. Bureau of Labor Statistics (BLS) sites professions in Securities, Commodities and Financial Services Sales to be among the more stressful.(5) In the case of retail stock option day traders, this follows by extension as the amount of money that can be gained or lost in a matter of moments is large making the threat of bankruptcy, massive debt and great loss of financial stability real.

In summary, the perils of day trading stock options are considerable and worth paying attention to if sound financial planning, and a relatively stable life are of interest. The potential loss, stress, costs, time and risks involved in day trading stock options are significant perils that make it less of an easy money scenario, and more of a high stakes, time consuming and complex series of tasks that repeat themselves several times per week.

Sources:

1. http://bit.ly/cjZBLs (NASAA)
2. http://bit.ly/bHsmy5 (Securities and Exchange Commission)
3. http://bit.ly/9PzpRD (FINRA)
4. http://yhoo.it/cTv1Gp (Yahoo Finance)
5. http://bit.ly/9sFnOT (Bureau of Labor Statistics)

Image license: Damian Gadal, CC BY 2.0