Problems with Swing Trading Using Options

Published: 15th September 2010
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Swing trading is one of the most common ways of trading in the stock market. Whether you know it or not, you probably have been swing trading all these while. Swing trading is buying now and then selling a few days or weeks later when prices are higher, or lower (in the case of a short). Such a price increase or decrease is known as a "Price Swing", hence the term "Swing Trading".

Most beginners to options trading take up options as a form of leverage for their swing trading. They want to buy call options when prices are low and then quickly sell them a few days or weeks later for a leveraged gain. Vice versa true for put options. However, many such beginners quickly found out the hard way that in options swing trading, they could still make a substantial loss even if the stock eventually did move in the direction that they predicted.

How is that so? What are some problems associated with swing trading using options that they failed to take note of?

Indeed, even though options can be used quite simply as leveraged substitution for trading the underlying stock, there are a few things about options that most beginners fail to take note of.

1) Strike Price

It doesn’t take long for anyone to realize that there are many options available across many strike prices for all optionable stocks. The obvious choice that beginners commonly make is to buy the "cheap" out of the money options for higher leverage. Out of the money options are options that have no built in value in them. These are call options with strike prices higher than the prevailing stock price or put options with strike prices lower than the prevailing stock price.

The problem with buying out of the money options in swing trading is that even if the underlying stock move in the direction of your prediction (upwards for buying call options and downwards for buying put options), you could still lose ALL your money if the stock did not exceed the strike price of the options you bought! That’s right, this is known as to "Expire Out Of The Money" which makes all the options you bought worthless. This is also how most beginners lose all their money in options trading.

In general, the more out of the money the options are, the higher the leverage and the higher the risk that those options will expire worthless, losing you all the money put into them. The more in the money the options are, the lower more expensive they are due to the value built into them, the lower the leverage becomes but the lower the risk of expiring worthless. You need to take the expected magnitude of the move and the amount of risk you can take into consideration when deciding which strike price to buy for swing trading with options. If you expect a big move, out of the money options would of course give you tremendous rewards but if the move fails to exceed the strike price of those options by expiration, a nasty awakening awaits.

2) Expiration Date

Unlike swing trading with stocks which you can hold on to perpetually when things go wrong, options have a definite expiration date. This means that if you are wrong, you will very quickly lose money when expiration arrives without the benefit of being able to hold on to the position and wait for a return or dividend.

Yes, swing trading with options is fighting against time. The faster the stock moves, the more sure you are of profit. Good news is, all optionable stocks have options across many expiration months as well. Nearer month options are cheaper and further month options are more expensive. As such, if you are confident that the underlying stock is going to move quickly, you could trade with nearer expiration month options or what we call "Front Month Options", which are cheaper and therefore have a higher leverage. If you wish to give more time for the stock to move, you could choose a further expiration month which will of course be more expensive and therefore have a much lower leverage.

As such, the choice of expiration month for swing trading with options is largely a choice between leverage and time. Take note that you can sell profitable options way before their expiration dates. As such, most swing traders go for options with 2 to 3 months left to expiration at least.

3) Extrinsic Value

Extrinsic value, or commonly known as "premium", is the part of the price of an option which goes away completely when expiration arrives. This is why out of the money options that we mentioned above expires worthless by expiration. Because their entire price consists only of Extrinsic Value and no built in value (intrinsic value).

The thing about extrinsic value is that it erodes under two conditions; By time and by Volatily crunch.

Eroding or extrinsic value over time as expiration approaches is known as "Time Decay". The longer you hold an option that is not profitable, the cheaper the option becomes and eventually it could become worthless. This is why swing trading with options is a race against time. The faster the stock you pick moves, the more sure of profit you are. It is unlike swing trading with the stock itself where you make a profit as long as it moves eventually, no matter how long it takes.

Eroding of extrinsic value when the "excitement" or "anticipation" on the stock drops is known as a "Volatility Crunch". When a stock is expected to make a significant move by an definite time in the future like an earnings release or court verdict, implied volatility builds up and options on that stock becomes more and more expensive. The extra cost built up through anticipation of such events erodes COMPLETELY once the event is announced and hits the wires. This is what volatility crunch is all about and why a lot of beginners to options trading attempting to swing trade a stock through its earnings release lose money. Yes, the extrinsic value erosion by volatility crunch can be so high that even if the stock did move powerfully in the predicted direction, you may not make any profit as the price move has been priced into the extrinsic value itself.

As such, when swing trading with options, you need to consider a more complex strategy when speculating on high volatility stocks or events and be able to choose stocks that move before the effects of time decay takes a big mouth full of that profit away.

4) Bid Ask Spread

The bid ask spread of options can be significantly larger than the bid ask spread of their underlying stock if the options are not heavily traded. A large bid ask spread introduces a huge upfront loss to the position especially for cheap out of the money options, putting you into a significant loss right from the start. As such, it is imperative in options trading to trade options with a tight bid ask spread in order to ensure liquidity and a small upfront loss.

Swing trading with options can be an extremely rewarding and profitable venture when you take all of the above issues into mind and choose your options wisely.

My Star Trading System is one such options swing trading system which has all of these considerations and MORE covered in its rules so that beginners to options swing trading may simply follow and profit.

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