Problems swing trading options

Swing trading is one of the most common ways to trade in the stock market. Whether you know it or not, you’ve probably been swing trading all along. Swing trading is buying now and 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 called a “price swing”, hence the term “swing trading”.

Most novice options traders use options as a form of leverage for their swing trading. They want to buy call options when prices are low and then quickly sell them a few days or weeks later for a leveraged profit. The reverse is true for put options. However, many of these beginners quickly found out the hard way that swing trading options could still result in a significant loss even if the stock eventually moved in the direction they predicted.

How is that? What are some issues related to options swing trading that you haven’t taken note of?

Although options can easily be used as a leveraged substitute for trading the underlying stock, there are some things about options that most novice traders don’t realize.

1) Exercise price

It doesn’t take long for someone to realize that there are many options at many strike prices for all optional stocks. The obvious choice that beginners often make is to buy the “cheap” options for higher leverage. Out-of-the-money options are options that have no built-in value. These are call options with strike prices above the current stock price or put options with strike prices below the current stock price.

The problem with buying options in swing trading is that even if the underlying stock moves in the direction of your prediction (up for buying call options and down for buying put options ), could still lose ALL your money if the stock hasn’t exceeded the strike price of the options you bought! That’s right, this is known as Expire Out Of The Money, which renders all the options you’ve bought worthless. This is how most beginners lose all their money in options trading.

In general, the more out of the money the options are, the higher the leverage and the higher the risk that those options will expire worthless and you will lose all of your invested money. The more in-the-money options are, the cheaper they are because of the built-in value, the less leverage you get, but the less risk there is of expiring worthless. You need to consider the expected size of the movement and the risk you can take into account when deciding what strike price to buy for swing options trading. Of course, if you’re expecting a big move, out-of-the-money options would bring you huge rewards, but if the move doesn’t exceed the strike price of those options to expiration, you’re in for a rude awakening.

2) Expiration Date

Unlike swing trading in stocks, which you can always hold onto if something goes wrong, options have a specific expiry date. This means that if you’re wrong, you’ll lose money very quickly when the expiration date arrives, without the benefit of being able to hold onto the position and wait for a return or dividend.

Yes, options swing trading is a race against time. The faster the stock moves, the more certain you are of making a profit. The good news is that all option stocks also have options with many expiration months. Nearer month options are cheaper and one more month options are more expensive. So if you are confident that the underlying stock will move quickly, you can trade shorter expiration month options or trade what we call “front month options” which are cheaper and therefore have higher leverage. If you want to give the stock more time to move, you can choose another expiry month, which is of course more expensive and therefore has much less leverage.

Therefore, choosing an expiration month for options swing trading is largely a choice between leverage and time. Note that you can sell profitable options long before their expiry date. Therefore, most swing traders choose options with at least 2 to 3 months remaining.

3) External value

The extrinsic value, or commonly known as the “premium,” is that part of an option’s price that disappears entirely when expiration arrives. For this reason, the out-of-money options mentioned above expire worthless by expiration. Because their entire price consists only of extrinsic value and no built-in value (intrinsic value).

The thing about external value is that it erodes under two conditions; Over time and through Volatly Crunch.

Erosion, or extrinsic value, over time as the expiration date approaches is known as “time decay.” The longer you hold an option that isn’t profitable, the cheaper the option becomes and may eventually become worthless. Because of this, options swing trading is a race against time. The faster your chosen stock moves, the more confident you are of your profit. It’s unlike swing trading the stock itself, where you make a profit as long as it eventually moves, no matter how long it takes.

The erosion of external value when “excitement” or “anticipation” about the stock wanes is referred to as a “volatility crisis.” If a stock is expected to make a significant move by some point in the future, such as When a stock, such as an earnings release or a court decision, comes up, implied volatility builds up and options on that stock become increasingly expensive. The additional costs of anticipating such events FULLY erode once the event is announced and hits the lines. That’s what the volatility crisis is all about and why many novice options traders who try to swing a stock by posting their earnings lose money. Yes, the extrinsic value erosion from volatility crunch can be so high that even if the stock has moved strongly in the predicted direction, you may not make a profit because the price movement has been priced into the extrinsic value itself.

Therefore, swing trading options requires you to consider a more complex strategy when speculating on high volatility stocks or events, and be able to pick stocks that move before the effects of time decay get a big mouthful of take away that profit.

4) bid-ask spread

The bid-ask spread of options can be significantly larger than the bid-ask spread of their underlying stock if the options are not heavily traded. A large bid-ask spread results in a huge upfront loss on the position, especially for cheap out-of-the-money options, putting you at a significant loss from the start. Therefore, in options trading, it is imperative to trade options with a tight bid-ask spread to ensure liquidity and a small upfront loss.

Swing trading options can be an extremely rewarding and profitable endeavor if you consider all of the above and choose your options wisely.