Swing trading is one of the very common methods for trading in the stock market. Whether you realize it or not, you most likely have been swing trading every one of these while. Swing trading is buying now and then selling a couple of 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 word “Swing Trading “.
Most beginners to options trading take up options as a form of leverage for his or her swing trading. They want to buy call options when prices are low and then quickly sell them a couple of days or weeks later for a leveraged gain. swing trading strategies Vice versa true for put options. However, many such beginners quickly found out the hard way that in options swing trading, they might still make a substantial loss even if the stock eventually did relocate the direction which they predicted.
How is that so? What’re some problems associated with swing trading using options which they failed to pay attention to?
Indeed, although options can be utilized simply as leveraged substitution for trading the underlying stock, there are a few things about options that many beginners don’t take note of.
1) Strike Price
It doesn’t take long for anyone to understand that there are many options available across many strike costs for all optionable stocks. Well-known choice that beginners commonly make is to buy the “cheap” out from the money options for higher leverage. From the money choices are options which have no integrated value in them. These are call options with strike prices higher compared to the prevailing stock price or put options with strike prices lower than the prevailing stock price.
The situation with buying out from the money options in swing trading is that even if the underlying stock relocate the direction of one’s prediction (upwards for buying call options and downwards for buying put options), you can still lose ALL your cash if the stock didn’t 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. That is also how most beginners lose almost all their money in options trading.
Generally, the more out from the money the choices are, the higher the leverage and the higher the chance that those options will expire worthless, losing you all the money put in them. The more in the money the choices are, the lower higher priced they are due to the value constructed into them, the lower the leverage becomes but the lower the chance of expiring worthless. You need to take the expected magnitude of the move and the total amount of risk you can take into account when deciding which strike price to buy for swing trading with options. If you anticipate a large move, out from the money options would needless to say offer you tremendous rewards however, if the move fails to exceed the strike price of the options by expiration, an awful awakening awaits.
2) Expiration Date
Unlike swing trading with stocks which you may hold on to perpetually when things go wrong, options have a definite expiration date. Which means that if you are wrong, you’ll rapidly lose money when expiration arrives without the benefit of to be able to hold on to the positioning and await a reunite or dividend.
Yes, swing trading with options is fighting against time. The faster the stock moves, the more sure you’re of profit. Good news is, all optionable stocks have options across many expiration months as well. Nearer month choices are cheaper and further month choices are more expensive. As a result, if you are certain that the underlying stock will move quickly, you can trade with nearer expiration month options or what we call “Front Month Options”, which are cheaper and therefore have a greater leverage. If you wish to offer more time for the stock to go, you can select a further expiration month that will needless to say be higher priced and therefore have a lower leverage.
As a result, the choice of expiration month for swing trading with options is basically an option between leverage and time. Take notice that you can sell profitable options way before their expiration dates. As a result, most swing traders select options with 2 to 3 months left to expiration at least.
3) Extrinsic Value
Extrinsic value, or commonly called “premium”, may be the area of the price of a choice which goes away completely completely when expiration arrives. For this reason out from the money options that people mentioned above expires worthless by expiration. Because their entire price consists only of Extrinsic Value and no integrated 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 with time as expiration approaches is known as “Time Decay “.The longer you hold a choice that’s not profitable, the cheaper the option becomes and eventually it might become worthless. For this reason swing trading with options is a battle against time. The faster the stock you choose moves, the more sure of profit you are. It’s unlike swing trading with the stock itself where you make a gain provided that it moves eventually, irrespective of how long it takes.
Eroding of extrinsic value when the “excitement” or “anticipation” on the stock drops is known as a “Volatility Crunch”. When an inventory is expected to make a significant move by an definite time as time goes on like an earnings release or court verdict, implied volatility builds and options on that stock becomes more and more expensive. The extra cost developed through anticipation of such events erodes COMPLETELY once the function is announced and hits the wires. It’s this that volatility crunch is about and why a lot of beginners to options trading attempting to swing trade an inventory 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 cost move has been priced to the extrinsic value itself.
As a result, when swing trading with options, you’ll need to consider a more complicated strategy when speculating on high volatility stocks or events and be able to choose stocks that move before the results of time decay requires a big mouth full of the profit away.
4) Bid Ask Spread
The bid ask spread of options can be significantly larger compared to the bid ask spread of these underlying stock if the choices are not heavily traded. A large bid ask spread introduces a huge upfront loss to the positioning particularly for cheap out from the money options, putting you in to a significant loss from the comfort of the start. As a result, it’s imperative in options trading to trade options with a limited bid ask spread in order to ensure liquidity and a tiny upfront loss.