Swing trading is one of the most common means of trading in the stock market. Whether you understand it or not, you probably have now 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 definition of “Swing Trading “.
Most beginners to options trading take up options as an application of leverage due to their swing trading. swing trading strategies 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 may still make a substantial loss even when the stock eventually did relocate the direction they predicted.
How is that so? What’re some problems associated with swing trading using options they didn’t pay attention to?
Indeed, although options may be used quite simply as leveraged substitution for trading the underlying stock, there are always a few reasons for having options that most beginners fail to take notice of.
1) Strike Price
It doesn’t take long for anyone to realize that there are many options available across many strike charges for all optionable stocks. Well-known choice that beginners commonly make is to buy the “cheap” out from the money choices for higher leverage. From the money options 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 less than the prevailing stock price.
The issue with buying out from the money options in swing trading is that even when 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 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 of the options you bought worthless. This really is also how most beginners lose almost all their money in options trading.
Generally, the more out from the money the options are, the higher the leverage and the higher the chance that those options will expire worthless, losing you all the money placed into them. The more in the money the options are, the reduced higher priced they are because of the value built into them, the reduced the leverage becomes but the reduced the chance of expiring worthless. You’ll need to take the expected magnitude of the move and the total amount of risk you are able to take into consideration when deciding which strike price to buy for swing trading with options. If you expect a huge 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 fail, options have an absolute expiration date. Which means if you should be wrong, you will rapidly lose money when expiration arrives without the main benefit of being able to hold on to the position and await a get back 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 options are cheaper and further month options are more expensive. As a result, if you should be 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 a higher leverage. Should you desire to provide more hours for the stock to maneuver, you might choose a further expiration month which will needless to say be higher priced and therefore have a reduced leverage.
As a result, the option of expiration month for swing trading with options is largely an option between leverage and time. Take notice 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 referred to as “premium”, may be the the main price of an option which goes away completely when expiration arrives. For this reason out from the money options that individuals mentioned previously 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 an option that is not profitable, the cheaper the option becomes and eventually it might become worthless. For this reason swing trading with options is a competition against time. The faster the stock you select moves, the more sure of profit you are. It’s unlike swing trading with the stock itself where you make a gain so long as it moves eventually, no matter the length of time it takes.
Eroding of extrinsic value once the “excitement” or “anticipation” on the stock drops is known as a “Volatility Crunch”. When a share is expected to make a significant move by an definite time in the future like an earnings release or court verdict, implied volatility accumulates and options on that stock becomes more and more expensive. The excess cost developed through anticipation of such events erodes COMPLETELY once the big event is announced and hits the wires. This is what volatility crunch is focused on and why lots of beginners to options trading trying to swing trade a share through its earnings release lose money. Yes, the extrinsic value erosion by volatility crunch may be so high that even when the stock did move powerfully in the predicted direction, you might not make any profit as the purchase price move has been priced into the extrinsic value itself.
As a result, when swing trading with options, you will need to take into account a more complex strategy when speculating on high volatility stocks or events and have the ability to choose stocks that move before the results of time decay takes a big mouth full of that profit away.
4) Bid Ask Spread
The bid ask spread of options may be significantly larger compared to the bid ask spread of their underlying stock if the options are not heavily traded. A sizable bid ask spread introduces a massive upfront loss to the position specifically for cheap out from the money options, putting you right into a significant loss right from the start. As a result, it is imperative in options trading to trade options with a restricted bid ask spread to be able to ensure liquidity and a tiny upfront loss.