This article demonstrates how options can be used to reduce swing trading risks, avoid needing to short stock, and employ leverage to expand a swing trading strategy. It further displays the versatility from options for swing trading.
The strategy of swing trading is a short-term strategy designed to take advantage of three- to five-day market movement. It takes advantage of the tendency of price movement to over-react to immediate news before price levels correct. A set-up is the signal for either entry or exit swing traders use for timing of decisions. A narrow-range day (NRD) is a day trading in an exceptionally small price range between opening and closing prices.
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Swing trading — contrarian emotional trading:
In most market, buy and sell decisions are made based on two primary emotions: fear and greed. Fear drives prices down, often far below the price justified by current news. Greed drives prices up, often above a logical or reasonable level. The swing trader recognizes the tendency for prices to move erratically in a three- to five-day cycle.
Options are well suited for swing trading because risk levels are very limited and option contracts can be either long or short. The safest method — using only long contracts — does not prohibit trading on downside trends. Unlike having to short stock (a fairly high-risk strategy), the long put is a low-risk alternative. Puts rise in value as their underlying stock’s value falls.
A swing trading overview
Swing traders rely on extremely short-term trends to spot both entry and exit signals. The idea is to take advantage of market over-reaction to news about the company or the entire market. For example, an exceptionally strong and unexpected earnings announcement above estimates might cause a stock’s price to jump several points. This often is followed by a price retreat. The jump in price is an over-reaction, telling the swing trader to enter a short position and expect a downturn in the next three to five days. The same kind of cause and effect works when stock prices fall; swing traders recognize that markets over-react and the likelihood is that price will rebound in coming sessions.
The set-up signals swing traders seek come in at least three popular varieties and when two (or even all three) appear together, it is a strong confirming factor. The three popular signs are:
1.A specific trend: Three or more consecutive uptrend or downtrend days. An uptrend consists of each day’s opening price at a level above the previous day’s opening price, and its closing price higher than the prior close. So an uptrend is three or more days of higher highs and higher lows. A downtrend is the opposite. It consists of three or more days in which the day’s opening price is lower than the previous day’s opening, and a closing price lower than the previous day’s close: lower highs and lower lows.
2.A narrow-range day (NRD): One of the strongest set-up signals is the NRD, a day in which the opening and closing price are very close together. Candlestick chartists call this a doji, a Japanese word that is translated as “mistake.” This formation indicates indecision in the market. However, an NRD can also have a wide trading range even though opening and closing prices are close to one another. This indicates that buyers (for upside trading movement) or sellers (for downside) were not able to move the price in the desired direction. When you see an NRD after a clearly identified uptrend or downtrend, it signals the end of the trend and a reversal.
3.Exceptionally high volume: When a day’s volume spikes far above the average, it also signals a reversal. This tells you that traders were very active in the stock, which often occurs just before price turns around
All three set-up signals were found in the chart for Caterpillar (CAT), which is shown in Figure 1.
Chart courtesy of StockCharts.com
Note the highly visible uptrend and downtrend, narrow-range day and volume spikes. All of these signal the end of the trend and likelihood of reversal.
When you see combinations of these three signals, it is a strong sign. If you are already in a swing trade, it is an exit signal. If you are waiting for an entry point, any two of the three popular signals will tell you it’s time to take action.
Short-term options as a good alternative to stock
Swing traders face a problem, however, even when they are able to spot very clear entry and exit signals. At the top of the trend, the signal foreshadows a downward trend. However, many traders are hesitant to sell stock short due to the high risks of shorting. As a consequence, many swing traders only play the long position, looking for entry at the bottom and exit at the top. Consequently, they only take part in half of all swing trading opportunities.
Options solve this problem without adding risk. In fact, using options in place of stock reduces the market risks of swing trading. For example, if you are swing trading a $50 stock and you trade in increments of 100 shares, your long-side risk is always 50 points. If your timing is off and the stock falls 12 points, you lose $1,200. On the short side, you need to expose yourself to the market risk that the stock’s price will rise rather than fall. In that outcome, you have to cover the short position at a loss.
The same 100-share exposure can be traded on both sides, and always with long positions. Using calls to enter at the bottom and puts at the top solves the problem. For a fraction of the cost of 100 shares, you can expose yourself to the same market opportunities of swing trading 100 shares. But you can never lose more than the cost of the option. You may be able to find a long call or put for $300 to $600, for example, depending on time to expiration, proximity between market value and strike, and the overall volatility of the stock.
Using options allows you to trade long on both sides of the swing, while leveraging your exposure and reducing market risks. All forms of swing trading contain some risk, but using options is a lower risk than using stock. Options also allow you to trade many more stocks in a swing trading strategy because you only need a small fraction of the share cost to control 100 shares of stock. For example, if you can find calls and puts for $300, that is much lower than the cost of buying or selling 100 shares of a $50 stock.
Another interesting aspect of option-based swing trading is the benefits of impending expiration. In most option strategies, expiration is the ever-present problem. Traders have to balance the premium cost with the time issue. However, swing trading is based on a very short cyclical price swing of three to five days. Because you expect the short-term trend to play out very quickly, the best bargains are calls and puts that expire within a couple of weeks.
Soon to expire options have little or no time value remaining, so their intrinsic value is at the most responsive point possible. Both calls and puts are most likely to mirror price movement of the underlying stock, increasing in value point for point. An in-the-money call with increase point for point with stock as its price rises (or will fall as it declines). An in-the-money put will do the opposite, rising one point for each point of decliner in the underlying stock (or will lose one point for each stock point to the upside).
Variations using options
The most basic option-based swing trading strategy involves buying calls at reversal points after downtrends; and buying puts at reversal points after uptrends. But at least four variations of this basic strategy can also be used:
1.Long and short calls: One variation is to use only calls for swing trading, so that one side (long) costs money and the other side (short) produces immediate income. A long call is bought at the end of the downtrend and sold after a price run-up. A short call is employed at the top-side reversal set-up.
Using uncovered calls in this strategy makes the short side of the swing very risky. However, if you also own 100 shares of the underlying stock, the short call is covered and is a very safe strategy.
2.Long and short puts: You can also use only puts in a swing trading strategy. Like the call-based strategy, a long put costs you and a short put produces a profit. Like the call-only strategy, the uncovered short put is higher-risk than the long put. You go long at the top of the price swing, selling at the bottom. And you go short at the bottom, closing out the position after the uptrend ends.
3.Short calls and short puts: Swing trading can also be designed using short calls at the top and short puts at the bottom. Risks are reduced on the short call side if you own 100 shares for each short call.
4.Opening varying numbers of options on one side or the other of the swing: If a swing trader believes the potential for strong price movement is greater on one side or the other, another approach is to open a higher number of positions. For example, if a swing trader believes upside movement is going to stronger than downside, a mixed strategy might involve buying three long calls at the bottom of the swing and buying only two puts at the top. Many other variations of this varied number of contracts are possible.
You may also leave options open for different times. For example, if you have been riding a trend with three contracts and made a good profit, you may be able to take most of your profits by closing two positions. By leaving the third contract open, you continue to benefit if the current trend continues.
Options turn the relatively automatic programming of swing trading into a more interesting strategy. It combines high leverage and reduced market risk; helps avoid having to short stock; and introduces a lot of variation into the strategy itself.
As an options play, swing trading is one of the rare examples in which using soon-to-expire, in-the-money contracts provides you a benefit, even using long contracts. Because swing trade trends and reversals tend to take place over only a handful of trading periods, the time issue present in so many option strategies is not a disadvantage to swing traders.
The whole philosophy behind swing trading is to take advantage of the tendency of prices to over-react to news, both good and bad. The swing trader plays the movement anticipating reversal and, with the help of set-up signals and confirmation, often is right more frequently than the average trader.
Michael C. Thomsett is author of over 60 books. His latest book is Put Option Strategies for Smarter Trading: How to Protect and Build Capital in Turbulent Markets. He also wrote the best-selling Getting Started in Options (John Wiley & Sons), which has sold over 250,000 copies and was recently released in its 8th edition; Winning with Options (Amacom Books); The LEAPS Strategist(Marketplace Books); and both Options Trading for the Conservative Investor (recently released in its second edition) and The Options Trading Body of Knowledge (Financial Times/Prentice Hall). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes full time.