Failures of Swing Trading Working with Options.
Swing trading is one of the very common ways of trading in the stock market. Whether you know it or not, you most likely have now been swing trading each one of these while. Swing trading is buying now and then selling a few days or weeks later when costs are higher, or lower (in the case of a short). This type of price increase or decrease is known as a “Price Swing”, hence the word “Swing Trading “.
Most beginners to options trading occupy options as an application of leverage due to their swing trading. swing-trading.net They wish to buy call options when costs are low and then quickly sell them a few days or weeks later for a leveraged gain. 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 when the stock eventually did relocate the direction which they predicted.
How is that so? What’re some problems associated with swing trading using options which they failed to pay attention to?
Indeed, although options may be used basically as leveraged substitution for trading the underlying stock, there are certainly a few reasons for options that many beginners fail to be aware of.
1) Strike Price
It doesn’t take miss anyone to realize that there are numerous options available across many strike charges for all optionable stocks. The most obvious choice that beginners commonly make is to get the “cheap” out from the money alternatives for higher leverage. Out from the money options are options that have no built-in value in them. These are call options with strike prices higher than the prevailing stock price or put options with strike prices lower than the prevailing stock price.
The issue with buying out from the money options in swing trading is that even when the underlying stock relocate the direction of one’s prediction (upwards for buying call options and downwards for buying put options), you may still lose ALL your money if the stock didn’t exceed the strike price of the options you purchased! That’s right, this is known as to “Expire Out Of The Money” which makes all the options you purchased worthless. This really is also how most beginners lose each of their money in options trading.
Generally, the more out from the money the options are, the higher the leverage and the higher the chance that those options will expire worthless, losing you all the amount of money placed into them. The more in the amount of money the options are, the lower higher priced they are due to the value built into them, the lower the leverage becomes but the lower the chance of expiring worthless. You need to take the expected magnitude of the move and the amount of risk you are able to consider when deciding which strike price to get for swing trading with options. If you expect a big move, out from the money options would obviously give you tremendous rewards if the move fails to exceed the strike price of the options by expiration, a nasty awakening awaits.
2) Expiration Date
Unlike swing trading with stocks which you may keep perpetually when things fail, options have a definite expiration date. Which means if you are wrong, you will quickly lose money when expiration arrives without the advantage of being able to keep the positioning and watch for a reunite 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 options are cheaper and further month options are more expensive. As such, if you are confident that the underlying stock will move quickly, you may 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 give more time for the stock to move, you may select a further expiration month that may obviously be higher priced and therefore have a much lower leverage.
As such, the option of expiration month for swing trading with options is largely a choice between leverage and time. Be aware as possible sell profitable options way before their expiration dates. As such, most swing traders select options with 2 to 3 months left to expiration at least.
3) Extrinsic Value
Extrinsic value, or commonly known as “premium”, could be the area of the price of an alternative which goes away completely completely when expiration arrives. This is why out from the money options that individuals stated earlier 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 as time passes as expiration approaches is known as “Time Decay “.The longer you hold an alternative that is not profitable, the cheaper the option becomes and eventually it may become worthless. This is why swing trading with options is a race against time. The faster the stock you pick moves, the more sure of profit you are. It is unlike swing trading with the stock itself where you make a profit as long as it moves eventually, regardless of just how long it takes.
Eroding of extrinsic value when the “excitement” or “anticipation” on the stock drops is known as a “Volatility Crunch”. When a stock is expected to create a significant move by an definite time in the future like an earnings release or court verdict, implied volatility builds up and options on that stock becomes more and more expensive. The additional 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 all about and why plenty of beginners to options trading trying 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 when the stock did move powerfully in the predicted direction, you may not make any profit as the cost move has been priced in to the extrinsic value itself.
As such, when swing trading with options, you’ll need to think about a more technical strategy when speculating on high volatility stocks or events and have the ability to choose stocks that move before the consequences of time decay has a big mouth full of the profit away.
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 sizable bid ask spread introduces an enormous upfront loss to the positioning particularly for cheap out from the money options, putting you right into a significant loss right from the start. As such, it is imperative in options trading to trade options with a small bid ask spread to be able to ensure liquidity and a small upfront loss.