Buying stock is the best-known form of equity investment. Each share of stock is a very small piece of ownership in a much larger whole, the cor-poration. A swing trader is less concerned with the long-term ramifications of equity investment, in-cluding the earning of dividends and voting rights.
His or her concern is far more immediate. Owner-ship is taken up in the hopes of a fast short-term profit. The swing trader does not buy stock because of an admiration for the company or its product;
stock is merely the vehicle for creating those two-to five-day opportunities.
When you use stocks for swing trading, you are naturally limited in how much trading you can do, and in how much risk you can afford.
Key Point
equity investment a form of owner-ship in a corpora-tion, the best-known form of which is stock.
So stock ownership is usually associated with taking an equity stake in the company, and the nor-mal trading increment is 100 shares. This round lot is efficient because trading costs are tied to that num-ber; buying fewer than 100 shares usually involves a higher cost-per-share to complete the transaction.
A swing trader usually deals in rounds lots be-cause of the trading cost of odd-lot trading. But
were it possible to trade for the same costs, there is no doubt that swing traders would prefer a set amount over a fixed number of shares. That would allow the swing trader to quantify risk, spread capital more effi-ciently, and calculate potential profits. Many swing traders end up work-ing only in stocks with relatively low price per share because capital is limited. This means that bigger point movement often seen in higher-priced stocks is another form of missed opportunity. You can actually set limits on each trade by finding appropriately priced options for one or more of a stable of stocks you track.
When you buy options instead of stock, capital limitations are not as much of an issue. As a general guideline, you can find and buy options at about 10 percent or less of the stock’s current value. For example, you can find and buy options on a $60 stock for $600 or less. That $600 gives you complete control over the 100 shares of stock; fixes the price of the stock; and costs far less than outright purchase of 100 shares. This is the great advantage for swing traders.
With the use of stocks, you have to go either long or short; and short selling is where you run into risk issues and potentially unaccept-able levels of loss. With options, you are either buy or sell into a position, make the swing trade, and act on both the buy and sell setup—all with limited risk and using long positions.
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round lot the usual trading increment for stocks, which is 100 shares.
When using options instead of round lots of stock for swing trading, you can have greater control over the dollar amount of each transaction—because your investment is based on option cost and not on share price.
Key Point
This is possible because there are two kinds of options, the call and the put. A call grants you the right (but not the requirement) to buy 100 shares of a specific stock at a fixed price per share; a put is the opposite, granting you the right to sell 100 shares of a specific stock at a fixed price per share.
This arrangement remains in effect until expiration of the option.
However, it is crucial to remember that an op-tion does not need to be used to buy or sell stock.
Based on stock price changes, options gain or lose value; thus, options can themselves be bought and sold to create swing trading profits.
The option itself increases or decreases in value based on movement of the underlying stock, and this is where swing trading can use options to great advantage. The fixed price of the option is also called the strike price and it gives you the right to buy or sell 100 shares at that exact price, no mat-ter how the market price of the stock changes. The farther the stock moves away from the strike price, the more the option value changes.
The value of the option, also called its pre-mium, changes as the stock price moves, since the strike price is fixed. For example, if you purchase a 35 call, it means your strike price is $35 per share.
So before expiration, if the stock were to rise to $42 per share, or seven points above the strike price, that call would have $700 of increased value above strike price. For the swing trader, this is the same as a seven-point rise in the stock—yet at a fraction of the cost and risk.
The situation works in reverse for the put. As a stock’s value falls below the strike price of the put, the put’s premium value grows. If you purchase a
$35 put, for example, and the stock falls to $29 per share before expiration, the put’s value grows six points, representing the price difference between
$35 and $29 per share. The fact that calls and puts
call
an option grant-ing its owner the right (but not the requirement) to buy 100 shares of a specific stock at a fixed price per share.
put
an option grant-ing its owner the right (but not the requirement) to sell 100 shares of a specific stock at a fixed price per share.
expiration the deadline for an option and the date on which it loses all of its value. the fixed buy or sell price of stock specified in the option contract.
grow in value based on stock price movement demonstrates the value of options to swing traders.
You can trade in a much greater number of differ-ent stocks for less capital at risk.