Complications with Swing Trading By using Options.

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Swing trading is one of the very common ways of trading in the stock market. Whether you understand it or not, you almost certainly have now been swing trading all these while. Swing trading is buying now and then selling several days or weeks later when costs are higher, or lower (in the case of a short). This kind 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. They would like to buy call options when costs are low and then quickly sell them several 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 could still make a substantial loss even though the stock eventually did move in the direction they predicted.

How is that so? What are some problems related to swing trading using options they didn’t pay attention to?

Indeed, although options can be used basically as leveraged substitution for trading the underlying stock, there are a few things about options that many beginners don’t take notice of.

1)      Strike Price

It doesn’t take really miss anyone to understand that there are lots of possibilities across many strike costs for all optionable stocks. Well-known choice that beginners commonly make is to get the “cheap” out of the money options for higher leverage. From the money options are options that have no integrated value in them. They’re call options with strike prices higher than the prevailing stock price or put options with strike prices below the prevailing stock price.

The situation with buying out of the money options in swing trading is that even though the underlying stock move in the direction of one’s prediction (upwards for buying call options and downwards for buying put options), you might 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” making most of the options you purchased worthless. This really is also how most beginners lose almost all their profit options trading.

Generally speaking, the more out of the money the options are, the bigger the leverage and the bigger the danger that those options will expire worthless, losing you all the amount of money put into them. The more in the amount of money the options are, the lower more expensive they are because of the value constructed into them, the lower the leverage becomes but the lower the danger of expiring worthless. You’ll need to take the expected magnitude of the move and the total amount of risk you can consider when deciding which strike price to get for swing trading with options. If you anticipate a big move, out of the money options would needless to say give you tremendous rewards however, 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 go wrong, options have an absolute expiration date. Which means that if you are wrong, you’ll 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. Therefore, if you are confident that the underlying stock will move quickly, you might trade with nearer expiration month options or what we call “Front Month Options”, which are cheaper and therefore have a higher leverage. Should you desire to give more time for the stock to maneuver, you might select a further expiration month that’ll needless to say be more expensive and therefore have a lower leverage.

Therefore, the decision of expiration month for swing trading with options is largely a selection between leverage and time. Be aware that you could sell profitable options way before their expiration dates. Therefore, most swing traders select options with 2 to 3 months left to expiration at least.

3)      Extrinsic Value

Extrinsic value, or commonly referred to as “premium”, could be the area of the price of an option which disappears completely when expiration arrives. This is the reason out of the money options that people mentioned previously expires worthless by expiration. Because their entire price consists only of Extrinsic Value and no integrated value (intrinsic value).

The one thing about extrinsic value is that 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 option that is not profitable, the cheaper the possibility becomes and eventually it may become worthless. This is the reason swing trading with options is a race against time. The faster the stock you choose moves, the more sure of profit you are. It’s unlike swing trading with the stock itself where you make a profit so 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 an inventory is expected to create a significant move by an definite time in the foreseeable future like an earnings release or court verdict, implied volatility accumulates and options on that stock becomes more and more expensive. The extra cost built up through anticipation of such events erodes COMPLETELY once the big event is announced and hits the wires. This is what volatility crunch is about and why a lot of beginners to options trading wanting to swing trade an inventory through its earnings release lose money. Yes, the extrinsic value erosion by volatility crunch may be so high that even though the stock did move powerfully in the predicted direction, you may not make any profit as the price move has been priced to the extrinsic value itself.

Therefore, when swing trading with options, you need to think about a more technical strategy when speculating on high volatility stocks or events and be able to choose stocks that move before the effects of time decay requires a big mouth full of this profit away.

4)      Bid Ask Spread

The bid ask spread of options may be significantly larger than the bid ask spread of these underlying stock if the options are not heavily traded. A big bid ask spread introduces a huge upfront loss to the positioning particularly for cheap out of the money options, putting you in to a significant loss right from the start. Therefore, it’s imperative in options trading to trade options with a restricted bid ask spread in order to ensure liquidity and a tiny upfront loss.

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