The problem for swing traders in the selection and use of options is based entirely on the time value premium and how it behaves. If you attempt to swing trade with options containing a large portion of time value, you will spend less for the options, but you face a more serious problem: Option premium will not change or move in the same way that the stock’s price changes and moves.
With this in mind, swing traders need to develop some standards for the use of options. The standards should consider two goals: optimiz-ing intrinsic value. These standards should include:
1. Use only those options that are in the money. Swing traders need the point-for-point interaction between option premium and stock price. In-the-money options have intrinsic value, and that por-tion of the oppor-tion premium will rise or fall point for point in tracking the stock. So when you see the buy or sell setup, you can respond using long position options. Rather than going long or short in the stock, you can buy calls for buy setups and buy puts for short setups.
extrinsic value the value of an option not count-ing any intrinsic value; the time value premium, given this alter-nate name to consider the non-time elements of volatility within the stock, and of proximity between stock’s current market value and the option’s strike price.
Swing traders using options have to contend with the cost of time value versus the actual amount of time to expiration.
Key Point
This gives you numerous advantages over going long or short in stock. The cost of buying options is significantly less than that for buying stock. On the short side, the cost factor affects you as well, since margin requirement demands that you place at least 50 percent of the stock’s value on margin when you sell stock short. With options, the cost will average 10 percent of the stock price. This 10 percent is not a hard-and-fast rule, but an analysis of actual option premium values on various stocks reveals that the cost may even be far less.
2. Limit swing trading options to those as close as possible to strike price. The biggest problem in buying options for swing trading involves paying for time value. But fortunately, when expiration date is quite near, time value is reduced to an absolute minimum.
This is especially true when the intrinsic value of options is quite close to the strike price. If you are responding to a buy setup, look for calls that are in the money but also within five to 10 points below current market value. That provides the least amount of time value for the smallest cost.
Although time value may be a factor when the strike price is close to current market value of the stock, it is minimal when
A S t r a t e g i c A p p r o a c h t o S w i n g Tr a d i n g 147
In-the-money options are the only practical ones for swing traders to use. You need the responsiveness of intrinsic value to make the strategy work.
Key Point
Work with options that are in the money and as close as possi-ble to current market value. This gives you the most responsive price action for the least cost.
Key Point
expiration will occur within the near future. While most option speculators consider pending expiration a problem, swing traders do not because they intend to hold positions open only for the short term. This raises an issue of risk as well. When you go long on stock or sell short, you assume a market risk equal to the po-tential change in a stock value. For example, if you buy shares at
$55 and the market value falls to $48 per share, you lose $7 per share, or $700 on a 100-share trade. When you go short, you have the same risk. If a stock’s price rises four points, your 100 short shares are worth $400 more, and you will have to pay that to close the position. But with options, your maximum risk is al-ways limited to the cost of the option. When you assume a long position in either calls or puts, the most you can ever loose is the premium amount you pay upon opening that position.
Swing traders do have losses, just as all traders and investors. So swing trading is a timing strategy intended to improve your odds and to increase profitability in trading. However, the market risk cannot be ignored and losses are painful. For short sellers, the po-tential losses are unknown so many swing traders simply avoid the short side. Options solve the market risk problem by limiting losses to the cost of the options. And using options for swing trading also limits the possible losses from both long and short positions in stock. Because options cost only a fraction of stock purchases, you can also diversify your swing trades among many more stocks than you could buying or going short on 100-share increments.
3. Avoid long-term options and use only those that will expire within the next month. While most option buyers have to struggle to off-set option cost with time, as a swing trader you are not con-cerned with time windows beyond the usual two- to five-day window. This means that you can deal strictly with options that will expire within the next month’s cycle. If you buy calls and puts that expire within the next four weeks or less (close to strike price and in the money) the risks are manageable. As long as the majority of your swing trade setup signals are accurate, you will be in and out of the position in less than one week. In those situ-ations where you lose money, your loss will be limited to the cost of the option.
That cost is held down by two important aspects. First, there is vir-tually no time value to contend with because expiration is imminent and the closer the time to expiration, the less time value will remain. Second, because the option will be as close as possible to strike price, intrinsic value will be very low. For example, if your call is three points below strike price, intrinsic value will be only 3 ($300). And if your put is two points above strike price, intrinsic value will be only 2 ($200).