Swing trading is one of the most common means of trading in the stock market. Whether you realize it or not, you almost certainly have been swing trading all 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). This type of price increase or decrease is recognized as a “Price Swing”, hence the term “Swing Trading “.
Most beginners to options trading occupy options as an application of leverage for their swing trading. They would like to buy call options when prices are low and then quickly sell them a couple of days or weeks later for a leveraged gain. Vice versa true for put options. However, many such beginners quickly learned the hard way that in options swing trading, they might still make an amazing loss even if the stock eventually did relocate the direction that they predicted.
How is that so? What’re some problems associated with swing trading using options that they didn’t pay attention to?
Indeed, even though options can be used basically as leveraged substitution for trading the underlying stock, there are a few reasons for options that a lot of beginners fail to take notice of.
1) Strike Price
It doesn’t take long for anyone to appreciate that there are numerous possibilities across many strike charges for all optionable stocks. swing-trading.net The obvious choice that beginners commonly make is to buy the “cheap” out from the money options for higher leverage. Out from the money choices are options that have no built-in value in them. These are call options with strike prices higher compared to prevailing stock price or put options with strike prices below the prevailing stock price.
The issue 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 might still lose ALL your hard earned money if the stock didn’t exceed the strike price of the options you got! That’s right, this is recognized as to “Expire Out Of The Money” helping to make all of the options you got worthless. This is also how most beginners lose almost all their money in options trading.
Generally speaking, the more out from the money the choices are, the higher the leverage and the higher the risk that those options will expire worthless, losing you all the money placed into them. The more in the money the choices are, the lower more costly they’re because of the value built into them, the lower the leverage becomes but the lower the risk of expiring worthless. You’ll need to take the expected magnitude of the move and the quantity 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 from the money options would needless to say give you tremendous rewards if the move fails to exceed the strike price of the options by expiration, a nasty awakening awaits.
2) Expiration Date
Unlike swing trading with stocks which you may retain perpetually when things fail, options have a definite expiration date. Which means if you’re wrong, you will rapidly lose money when expiration arrives without the advantage of being able to retain 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 are 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’re certain that the underlying stock will move quickly, you might trade with nearer expiration month options or what we call “Front Month Options”, which are cheaper and therefore have an increased leverage. If you want to provide additional time for the stock to move, you might select a further expiration month which will needless to say be more costly and therefore have a lower leverage.
As a result, the choice of expiration month for swing trading with options is essentially a selection between leverage and time. Be aware that you could 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 known as “premium”, could 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 we mentioned above expires worthless by expiration. Because their entire price consists only of Extrinsic Value and no built-in value (intrinsic value).
The one 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 recognized as “Time Decay “.The longer you hold a choice that’s not profitable, the cheaper the possibility becomes and eventually it might become worthless. For this reason swing trading with options is a battle against time. The faster the stock you select moves, the more sure of profit you are. It is unlike swing trading with the stock itself where you make a gain provided that it moves eventually, regardless of the length of time it takes.
Eroding of extrinsic value when the “excitement” or “anticipation” on the stock drops is recognized as a “Volatility Crunch”. When a share is expected to produce a significant move by an definite time later on such as an earnings release or court verdict, implied volatility accumulates and options on that stock becomes more and more expensive. The extra cost built up through anticipation of such events erodes COMPLETELY once the function is announced and hits the wires. It’s this that volatility crunch is focused on and why lots of beginners to options trading wanting to swing trade a share through its earnings release lose money. Yes, the extrinsic value erosion by volatility crunch could be so high that even if the stock did move powerfully in the predicted direction, you may not make any profit as the purchase price move has been priced in to the extrinsic value itself.
As a result, when swing trading with options, you will need to consider a more technical strategy when speculating on high volatility stocks or events and manage to choose stocks that move before the consequences of time decay takes a big mouth full of this profit away.
4) Bid Ask Spread
The bid ask spread of options could be significantly larger compared to bid ask spread of their underlying stock if the choices are not heavily traded. A sizable bid ask spread introduces a massive upfront loss to the positioning especially for cheap out from the money options, putting you right into a significant loss from the start. As a result, it’s imperative in options trading to trade options with a restricted bid ask spread to be able to ensure liquidity and a small upfront loss.