Swing trading is one of the very common ways of trading in the stock market. Whether you realize it or not, you probably have already been swing trading each one of these while. Swing trading is buying now and then selling several 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 occupy options as a form of leverage due to their swing trading. They want to buy call options when prices are low and then quickly sell them several days or weeks later for a leveraged gain. swing-trading.net Vice versa true for put options. However, many such beginners quickly discovered the hard way that in options swing trading, they may still make an amazing loss even if the stock eventually did move in the direction which they predicted.
How is that so? What are some problems related to swing trading using options which they failed to take note of?
Indeed, although options may be used basically as leveraged substitution for trading the underlying stock, there are a few reasons for options that a lot of beginners neglect to be aware of.
1) Strike Price
It doesn’t take really miss anyone to realize that there are lots of possibilities across many strike charges for all optionable stocks. The obvious choice that beginners commonly make is to get the “cheap” from the money alternatives for higher leverage. Out from the money choices are options which have no built in value in them. They’re call options with strike prices higher compared to prevailing stock price or put options with strike prices less than the prevailing stock price.
The situation with buying from the money options in swing trading is that even if the underlying stock move in the direction of your 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 got! That’s right, this is known as to “Expire Out Of The Money” which makes all of the options you got worthless. This really is also how most beginners lose each of their profit options trading.
Generally speaking, the more 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 cash put into them. The more in the cash the choices are, the reduced more costly they are due to the value constructed into them, the reduced the leverage becomes but the reduced the risk of expiring worthless. You will need to take the expected magnitude of the move and the total amount of risk you are able to consider when deciding which strike price to get for swing trading with options. If you anticipate a large move, from the money options would needless to say offer you tremendous rewards if the move doesn’t exceed the strike price of these options by expiration, a nasty awakening awaits.
2) Expiration Date
Unlike swing trading with stocks which you can retain perpetually when things fail, options have an absolute expiration date. Which means if you’re wrong, you’ll very quickly lose money when expiration arrives without the benefit of to be able to retain the positioning and wait for a return 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’re certain that the underlying stock will probably 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. Should you desire to provide additional time for the stock to move, you can choose a further expiration month that will needless to say be more costly and therefore have a reduced leverage.
As a result, the decision of expiration month for swing trading with options is basically a choice between leverage and time. Take notice as you are able to 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”, is the the main price of an option which goes away completely completely when expiration arrives. For this reason from the money options that people mentioned above expires worthless by expiration. Because their entire price consists only of Extrinsic Value and no built in value (intrinsic value).
Finished about extrinsic value is so 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’s not profitable, the cheaper the option becomes and eventually it may become worthless. For this reason swing trading with options is a race 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 profit 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 stock is expected to make a significant move by an definite time in the foreseeable future like an earnings release or court verdict, implied volatility builds up and options on that stock becomes more and more expensive. The excess cost built up through anticipation of such events erodes COMPLETELY once the event is announced and hits the wires. This is exactly what volatility crunch is about and why plenty of beginners to options trading wanting to swing trade a stock 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, may very well not make any profit as the price move has been priced into 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 have the ability to choose stocks that move before the effects of time decay has a big mouth full of that profit away.
4) Bid Ask Spread
The bid ask spread of options can be significantly larger compared to bid ask spread of these underlying stock if the choices are not heavily traded. A sizable bid ask spread introduces a huge upfront loss to the positioning specifically for cheap from the money options, putting you in to a significant loss right from the start. As a result, it’s imperative in options trading to trade options with a limited bid ask spread to be able to ensure liquidity and a tiny upfront loss.