the first and most obvious type of economy.Multiple contracts also add great flexibility to your swing trading strategy. Multiple contract strategies may include:1. Partial profit-taking, partial hold. You can add great flexibility toyour swing trading strategy when you employ multiple contracts.For example, you may respond to a buy setup by going long onfour calls for a stock. After an exceptionally strong uptrend, youcan close out the position at a profit. Or, as an alternative, if youexpect the momentum to carry the stock even higher, you canclose out two of the calls, covering your cost and producing aprofitable result; and hold onto the remaining two calls. For example, the 60-day chart for Diebold (DBD) provides an exampleof momentum in both directions, as shown in Figure 9.1
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Key PointYou can tie in profits with multiple options by closing some positions and keeping others open. When trend turns to momentum, this creates much greater profits.
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FIGURE 9.1 60-Day Chart with Momentum in Both Directions: DieboldSource: Candlestickchart.com.
The movement in this stock showed momentum in both directions, the first three in downtrends and the final in an uptrend.In this situation, a swing trade using multiple contracts couldhave produced additional profits due to the momentum trend.You could, for example, have reacted to the sell setup at the verybeginning of the chart by buying four puts. The downtrend appeared to end at note 1. However, the downtrend was quitestrong and in only five days produced a five-point fall in thestock’s price. If it were possible to cover your investment and produce a profit by selling two of the puts and continuing to holdthe remaining two, you could have gained an additional point ofprofit by observing the sell setup at note 2, or the other at point
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3. You may have also noted the buy setup at the extremely narrow spinning top signaling the bottom of the downtrend. At thatpoint the remaining two puts could have been closed out andeven replaced with the purchase of four calls (in response to thestrong buy signal). While the sell signal occurred nine days later,the uptrend was strong; so you could have sold two of the callsand held the remaining calls to ride out the upward momentumin the stock.This example provides a clear view of how you can modify yourswing trading strategy with a multiple option approach. At thosetimes when the trend is especially strong (either upward ordownward), it makes sense first to cover your investment andproduce a small profit; and second to continue holding throughthe momentum to produce additional profits.2. Partial profit-taking, partial exercise. Some swing traders decidethat they want to buy and keep shares of a particular stock. Oneform of diversification that makes a lot of sense is to identify holdstocks and invest in them; and also swing trade on the short-termprice changes in the same stock. The traditional method for buying stocks is acceptable for this, of course. However, so many opportunities are lost because investors hesitate. Options can solvethis problem as part of a swing trading strategy.For example, you may identify a limited number of stocks thatyou believe would provide worthwhile long-term investments aswell as profitable swing trade candidates. On a buy signal, youpurchase four calls and the strong moves upward strongly. At thispoint, many swing traders face a dilemma. If you swing trade using stocks, do you sell shares after the uptrend and take profits?
Key PointFor anyone combining swing trading with a long-term holdstrategy, options enable you to pursue both strategies in thesame trades. This gives you far greater flexibility than a complete separation of strategies.
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Or if the stock will continue to rise, should you just hold ontothose shares? In many respects, the goals of long-term investingand swing trading contradict one another. However, using callsyou can accomplish the goals of both strategies: profiting fromshort-term upswings and creating discount basis in stocks.This is the result of selling two of the calls to take profits at thetop of the upswing; and exercising the remaining two calls topurchase 200 shares below current market value. At this point, ifyou also believe that a sell setup has occurred in the stock’s price,you can also purchase puts as part of your on-going swing trading strategy. That creates two strategic advantages. First is theswing trade setup; second is the downside protection it providesfor your long-term stock investment. Every loss in the stock willbe offset by gains in the puts. If you buy two puts and hold 200shares, the offset is equal. If you buy four puts per 200 shares,your swing trading profit on a downtrend will be double the lossin the long stock.A six-month chart for Anheuser-Busch (BUD) demonstrateshow this works out. The chart is shown in Figure 9.2.Candlestickchart.com© 2006 The RediNews Network
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FIGURE 9.2 Swing Trading Profit on Downtrend: Anheuser-BuschSource: Candlestickchart.com.
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At note 1, a buy setup occurs. At this point, you could purchasefour calls in the stock. By point 2, you may determine that theswing trading upswing is exhausted; however, you also believe thelong-term prospects for this stock make it a worthwhile buy. Soyou cover your investment by selling two calls and exercising theremaining two, buying 200 shares. Because a sell signal has occurred, you also buy four puts. The stock immediately falls nearlytwo points. However, your swing traded four puts would have increased by twice the amount of the loss in the 200 shares. The putscould be closed out profitably at any time in the “uncertainty”range of trading that dominates the middle section of the chart.A similar pattern emerged at point 3. Here a clear buy setup occurred, so you may have purchased four calls at about the 45level. Note the price gap taking place three days later on a stronguptrend. That uptrend continued through eight days in total. Atpoint 4, a sell setup appeared. The stock peaked at nearly $49 pershare. You could sell all of the calls and take a nice swing tradingprofit; or you could sell two of the calls and cover your position,and exercise the remaining two. Exercise would get you 200shares at $45 per share at a point where the stock was trading between $48 and $49.3. Incremental additions to momentum situations. Referring onceagain to Figure 9.2, another swing trading strategy involves theuse of multiple contracts when a trend shows momentum. Forexample, the price gap occurring right after note 3 shows a strongupward trend. If you had picked up calls at the buy setup at note3, you could buy additional calls at any time during the eightday uptrend, ultimately closing the position upon seeing the sellsetup at note 4.
Key PointBuying long-position stock or increasing short-position stock isexpensive and high-risk. But with options, it is an affordableand often viable strategy to increase open positions based onprice trends.
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This example demonstrates that swing trading does not have toconsist of a single opening position and a single closing position.You can modify your positions at any time. Using stock on eitherlong or short side, this can become quite expensive; but optionbrokerage fees are so low that you have much greater flexibility tomodify positions. Figure 9.2 shows a good example of how incremental additions can be made to augment your swing tradingprofits.
Covered Calls and Swing TradingThe use of multiple options in a swing trading strategy provides you withgreat flexibility, while enabling you to invest far less capital. Because options cost only a fraction of stock, you can afford to use multiple contracts, improving the potential for much greater profits as well. Becauseswing trades often involve only a point or two of price movement, multiple contracts make sense. If you open a swing trading position, for example, with 100 shares of stock, a one-half point change in price barelycovers your transaction fees. Yet if you purchase four options instead, aone-half point change in the right price direction is the same as a twopoint move for 100 shares of stock.The potential for profits with reduced risks is even greater if youswing trade on stocks you already own. The covered call is a way to goshort using options, but without the significantrisks that involves when you don’t own 100 sharesper option contract.covered callA covered call is so named because you ownan option strategyin which a call is100 shares of stock for each call sold. So the marketsold, but the sellerrisk is protected by the ownership of those shares.also owns 100For example, you buy 100 shares of stock and sell ashares of thestock. In the eventcall. If the buyer on the other side exercises, you arethe call is exerrequired to deliver 100 shares at the strike price.cised, the 100shares are used toThe risk is eliminated entirely because you have thesatisfy the call.shares. A covered call makes sense when the net investment in 100 shares of stock is lower than thestrike price. So if you buy stock at $52 per share and sell a 55 call, thisexercise would produce $55 per share, a profit of three dollars per share.In addition, you keep the premium you are paid when you sell the call.
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Key PointProperly placed, the covered call is one of the most conservativestrategies you can use in the market, whether as a swing trading strategy or simply as a method for increasing current income and discounting your basis in stock.
The risk is virtually eliminated as long as you own shares. In comparison, an uncovered call is extremely risky. Also called a naked call, thisis a short position opened when you do not own 100 shares of stock. It ispossible that the stock’s price could rise significantly, creating a large loss. When an uncoveredcall is exercised, the seller is required to deliver 100uncoveredcallshares at the strike price. So if you sell an uncoveredan option positioncall at 55 and the stock rises to $62 per share, theinvolving a shortcall will be exercised; and you will lose $700 ($62call and no ownper share minus strike price of $55 per share). If theership of stock tooffset the risk.stock were to rise to $72 per share, your loss wouldbe $1,700.The covered call is a very strong swing tradingstrategy. Although it involves a short position in thenaked callcall, the risks are eliminated because you own 100alternative nameshares of stock. The covered call is a valuable alterfor an uncoveredcall.native to buying puts at a sell setup, for three reasons. First, because you sell the call, you receivepayment of the premium when you open the covered call position. Second, when the stock’s price declines, the coveredcall is closed with a purchase transaction, so that point drop in the stockis offset by profit in the covered call. Third, when you go short on a call,it does not matter if a lot of time value is involved. The higher the timevalue, the greater the premium you receive and the higher the prospectsthat you will make a profit. Remember, 75 percent of all options expireworthless. This is a disadvantage for the buyer, but a significant advantage for the seller. As a swing trader, you can also afford to leave a coveredcall open as long as you wish, because time works to your advantage.If you check Figure 9.2 once more, you can see that at notes 2 and4, selling a covered call would produce the same profits you realize by
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OPTION STRATEGIES FOR SWING TRADINGKey PointDon’t overlook the fact that when you sell an option, you keepthe premium, even if it is exercised. For that reason, coveredcalls are not only conservative—they can also be profitable.
buying puts. You can sell one option for every 100 shares of stock thatyou own. The only point to remember is that you need to ensure a profitin the event the call is exercised. This means the strike price for the shortcall should be higher than your basis in the stock.Because you keep the call premium paid when you open the shortposition, the actual net basis in stock is reduced. For example, if you sella 55 call and receive a premium of 3 ($300), that premium is yours tokeep if and when the call is exercised. So if you purchased stock at $54per share, your profit upon exercise of the covered call would be $400 before brokerage fees:Option premium for covered callProfit on stockTotal profit
$300$100$400
The larger the gap between your original purchase price of stockand the strike price of the covered call, the greater the potential profitupon exercise. In the preceding example, the capital gain on the stockwas only $100. But if the stock had been purchased at $44 per share, theprofit on a 55 call upon exercise would have been:Option premium for covered callProfit on stockTotal profit
$300$1,100$1,400
The annualized return on these kinds of transactions can be in thedouble digits. For example, a $1,400 profit on a covered call could bequite significant on a percentage basis. If you consider the cost of $55 pershare, discounted by three points in the stock, the net basis in the transaction was $5,200. A $1,400 profit is 27 percent. However, if the entire
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Key PointDouble-digit returns with covered calls are not only possible,but probable as well. As a device for the sell setup, they aremore profitable than buying puts and safer than shorting stock.
transaction took only three months, that would be an annualized 104percent profit. There is absolutely no guarantee that you can consistentlymake a 100 percent profit on swing trading and covered call writing.However, this example is reasonable and such returns can and do occurusing covered calls.As part of a swing trading strategy, covered calls are interesting because they are exceptionally conservative; they produce a cash inflow instead of an outlay with long puts; and they also offset the basic swingtrading risks in responding to a sell setup.
Advanced Strategies: Short Optionsfor Swing TradingThe world of options provides a broad range of conservative and speculative strategies. You can swing trade in various configurations on both thelong and the short side. While the primary emphasis here has been to reduce risks, you can also take much higher than average risks with optionsif you want. The reduction of risk is achieved by using long puts in placeof shorting stock at sell setups. However, other risk considerations shouldbe kept in mind as well. These include:1. Discounted stock basis with covered calls. The actual net cost ofstock is reduced when you write covered calls. Thus, as a swingtrading strategy, the covered call provides you with immediate income and lower market risk in the stock itself.2. Reduced capital exposure with long calls and puts. You can achievethe same profit from point movement with options that you getin buying stocks. But the amount of capital you put at risk ismuch lower.
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Key PointDiversification is one of the great advantages in using optionsfor swing trading, in four ways: expansion of stocks for swingtrading, the use of multiple option contracts, less capital at risk,and the combined use of calls (long as well as short) and puts.
3. Reduced losses when false signals occur. While options expire andbecome worthless upon expiration date, the typical swing tradelasts from two to five days; so as long as you call the majority ofyour setups correctly, you risk less capital. At those times whenyou are wrong, losses are limited to the cost of the option.4. Better diversification. You can expand your swing trading with theuse of options and put your available capital to better use. This isachieved in several ways. First, you can use options to swing tradeon several different stocks, with each option giving you the sameprofit potential as 100 shares of stock. Second, you can use multiple options to expand potential profits and provide yourselfwith alternative strategies when trends turn into momentummoves. Third, you lower your risk of loss by limiting yourself tooptions rather than placing larger sums of capital into stock. Andfourth, you improve diversification with a combination of longcalls, long puts, and short covered calls.
combinationany option strategy involving theuse of two ormore options withdissimilar terms(call versus put,long versus short,strike price, orexpiration date).
Advanced option strategies include many additional combinations of long and short positions inboth calls and puts. These include the spread andthe straddle. A spread is the purchase and sale ofoptions with different strike prices, expirationdates, or both. A straddle is the purchase and saleof calls and puts with identical strike prices and expiration dates. Both of these strategies can be entered on either the long or short side.
Advanced Strategies: Short Options for Swing Trading
These advanced strategies are complex and involve varying degrees of risk. They are appropriatefor experienced options traders who can affordhigher risk levels, and are beyond the scope of thisbook. For swing trading, however, these conceptsoffer new dimensions to the strategy and enableyou to take many different and new positions thatare not possible using the relatively simple purchaseor sale of shares of stock. Ultimately, even the basicswing trading strategy is far less risky using longoptions than any other approach—with better diversification, flexibility, and leverage. Contrary tothe reputation of options as high-risk instruments,if properly used they can vastly expand the swingtrading universe with lower risks and higher profits.The next chapter expands on this conceptwith a broad view of how swing trading fits withinyour overall portfolio, your risk profile, and yourlong-term investment program.
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spreadthe purchase andsale of optionswith differentstrike prices,expiration dates,or both.
straddlethe purchase andsale of calls andputs with identical strike pricesand expirationdates.
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Swing Trading in YourInvestment Portfolio
veryone struggles to identify the most appropriate methods for investing and trading. The vast majority of investors cannot affordindefinite losses. With limited capital available—and knowing thatyou never achieve 100 percent success—the goal becomes one of tryingto move the odds, even slightly, in your favor.Swing trading is a method designed to make this happen. Specificsetups for buy and sell action help you to pick and time short-term cyclical changes in price. Selection of stocks appropriate for swing tradinglimits the field and also helps you to define your program in terms of riskand profit potential.Even with the identification of strategies to out-perform the market, is it enough to act as a contrarian? Swing trading is in many respectsthe ultimate contrarian strategy because it calls for calm when the marketmood is one of panic; for moderation when others are responding togreed; and for focus when the mood is uncertainty. Swing traders alsolearn to look for the right signals, requiring patience in a market whereattention spans are short and fast, easy profits are often the goal.
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Swing Trading GuidelinesSwing traders can profit when price moves up or down, and this is an important point worth remembering. Some additional guidelines includethe following:1. It does not matter which direction price moves. Swing trading is notgeared toward the common attitude that prices must move upward. Investors tend to be optimists, and upward trends are moreinteresting when long positions are held. The vast majority of individual investors invest solely on the long side. This means thathalf of all opportunities are being ignored. While long-term market values may grow, there are numerous opportunities to profitwhen the market is falling as well. Swing trading doubles yourprofit-making opportunities. You are trading market emotions,not stocks, and that is the entire key to swing trading.2. Your entry point is part of a continuum, not a beginning. The pricesof stocks are continually on the move, and nothing goes in onedirection indefinitely. Momentum trends are limited even whenthey are quite strong. A typical two- to five-day price swing isnormal in the short-term scheme of things. So you need to viewyour trade entry point as a matter of stepping onto a moving vehicle. The starting price is not a starting point, merely the currentpoint in an ever-changing series of uptrends and downtrends. Asa swing trader, you use setups to time your entry on either longor short side. Only one thing is certain: That price is going tochange.
Key PointSwing traders do not try to pick stocks specifically; they identifyinvestor mood and short-term trends, and exploit the emotionalaspects of the market and of investor behavior.
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Key PointSo many investors view price in unrealistic terms, thinking oftheir basis price as a starting point. If you view price as an unending struggle between buyers and sellers, your perspectivewill improve greatly.
3. You will never achieve 100 percent perfect timing. Even with thebest information, some of your swing trades are going to result inlosses. Whether you trade in shares of stock or options, swingtrading is not a perfect system. You can only hope to improveyour percentages and swing trading is effective for that purpose.If you set a goal for yourself that every trade must be profitable,you are going to be unhappy with the results. You should consider your strategy a success if you improve the number of profitably timed moves over your previous record.4. A series of small profits are preferable to the risk of one big loss.Swing trading produces better than average profits, even thoughthis may occur in small increments. But if you are able to earnconsistent profits through swing trading, rather than the hit-ormiss approach so often practiced by speculators and other shortterm traders, your overall percentages are going to improve.There is no need to increase the capital at risk in an effort to improve the dollar amount of profits. Once you identify an appropriate investment dollar level per trade, you can create and
Key PointNo system can promise to deliver 100 percent profitable outcomesor perfect timing. Swing trading is designed to improve your decisions, not to give you absolute certainty about outcomes.
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maintain a steady flow of activity while managing risk levels aswell. Remember, there is no such thing as a 100 percent system,so as a swing trader you are wise to limit each trade to a manageable level.5. An open-minded attitude to the use of options broadens the potentialfor swing trading profits. The entire options market has a singularreputation of being too high-risk for the average investor. Thetruth is, options can be extremely risky or very conservative.They are the perfect vehicle for swing trading and, with a littlepractice, you can master the terminology as well as the tradingrules. Simply using long calls in place of long stock, and longputs in place of short stock, vastly expands your use of capitalwith less risk than using stock; it allows you to diversify intomore stocks; and you have greater flexibility using multiple option contracts. A more sophisticated strategy, covered call writing, is even more profitable and conservative for those investorswith options trading experience.6. Cutting losses is a wise way to trade. Every trader is going to experience losses due to poor timing or misread signals. Stock pricesmay also contradict the implied setup direction at time. There isa degree of random price change in the market, and setup signalsreduce the risk but can never eliminate it completely. You can cutlosses by closing positions as soon as you discover that prices are
Key PointSwing traders create better-than-average small returns ratherthan risking an all-or-nothing outcome. This makes sense andover time produces better outcomes.
Key PointWhen you study options in the context of swing trading, youdiscover that they actually reduce risks and expand your swingtrading field of play.
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Key PointJust as a wise chess player knows when to retreat, traders alsoneed to know when to cut their losses. If you manage risk by diversifying capital, you can better afford to cut losses; this iswhere options are useful.
Key PointA lot of emphasis is placed on eliminating or avoiding risk. Buton a practical level, risk cannot be avoided. However, it can bemanaged well.
not moving in the desired direction; and by using trailing stoporders to limit the amount of loss. Using long options instead oflong or short stock also limits your potential loss on any singletrade.7. All risks can be managed. Risks can never be eliminated completely, but they can be managed. Swing trading presents a practical alternative to the traditional buy-and-hold concept ofinvesting. In today’s rapidly changing market, buy-and-hold isnot always a practical way to beat market averages. More andmore, traders seek methods such as swing trading to avoid longterm value decline. The use of options in place of stock purchaseor sale enables you to manage risks effectively while expandingprofit potential.
Short-Term Trading and Long-TermInvestingEvery trader has to decide what market philosophy to adopt. Are you abuy-and-hold investor seeking stocks you can hold over many years? Ordo you want to move in and out of positions in a matter of days? Somepeople also want to diversify and do both.
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SWING TRADING IN YOUR INVESTMENT PORTFOLIOKey PointAs more investors trade in discount sites online and use the Internet for research, a growing belief has emerged: that longterm investing does not work as well as smart short-termtrading. In truth, a combination of both works well.
The traditional stockbroker was set up as an advisor to people whowanted to build a permanent portfolio. By “permanent,” this means theemphasis was invariably on buy-and-hold approaches to the market.Within that definition, some stocks have always been considered saferthan others; so diversification among long-term hold stocks was the mostpopular method of portfolio management. Today, some people continueto subscribe to the buy-and-hold approach to investing. But a growingnumber of investors and traders are beginning to question whether it ispossible or practical to hold onto the stock of one company for years, ifnot for decades.The markets change more rapidly today than ever before. Traditional reliance on stockbrokers and financial planners is rapidly becoming obsolete. Today, those still in the business of earning commissions bymaking recommendations to people are becoming a threatened species.People have more information available today than ever before; thismeans that you no longer need to pay for advice.The combination of rapidly changing markets and the availabilityof free market information has created a smarter, better informed class ofinvestors. The brokerage business was always set up so that investorsneeded stockbrokers just to execute trades. Within a few years, the wholeconcept of paying people to give advice and place trades will be gone entirely. Why has this occurred?The big change has been the Internet. Today you can go directly tothe home page of virtually every listed company, and stock exchanges alllink directly to their member pages. In addition, discount brokeragefirms offer trading for a very low cost. They also provide free research tosubscribers as well as low-cost or no-cost accounts.
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Valuable ResourceTo find home pages or financial summaries for listed companies,the easiest route is the exchanges themselves. Check the followingwebsites to find links to member companies:• New York Stock Exchange at http://www.nyse.com. Click the linklabeled “Listed company directory.”• NASDAQ at http://www.nasdaq.com. Click the link labeled“Company financials.”
Many financial services have been vastly changed in the past twodecades. In the not so distant past, individuals with life insurance policiesused to visit local offices of insurance companies to pay monthly (andeven weekly) premiums in cash. Bond investors used to physically clipcoupons and remit them to issuers for interest payments. And of course,until online investing and home computers revolutionized the entiremarket, you could not place orders directly but had to rely on the telephone to reach your stockbroker.This revolution in technology has made all markets far more accessible to individual investors than ever before. Many other changes are occurring as well. The exchange-traded fund (ETF) is changing the waythat people invest in mutual funds. Under the old system, you had tobuy and sell shares directly with the fund’s management, taking time andmaking the process cumbersome. You also had no control over the buyand sell decisions of a fund’s management. The ETF identifies a basket ofstocks in advance and does not change it, meaning you know what youKey PointStockbrokers no longer play an essential role for most traders.With the Internet and online discount sites, it is not longer necessary to pay someone to place trades for you.
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are getting in advance. This also means there is virtually no need to paymanagers because no decisions need to be made. Shares of ETFs can bebought and sold like stocks on public exchanges, and many also offer options. This whole approach vastly changes mutual fund investing, whichhas been a primary emphasis for investors for many years.People also used to rely on stockbrokers for basic information likeannual reports or other analytical summaries. Today you can get free annual reports directly from any listed company or through links frommost financial news sites or online brokers. These brokerage firms alsoprovide members with free research that would cost a lot if subscribed toseparately. For example, Schwab subscribers pay no fees but get free S&PStock Reports, Reuters, Goldman Sachs, Argus, and Schwab ratings andanalysis for listed companies. Other brokerage services offer a similarrange of free and low-cost research to their members.Before the Internet, swing trading would have been impossible to doefficiently. The time lag between investors and stockbrokers (as well as between stockbrokers and the floor of exchanges) was too great to efficientlyor economically execute trades with a thin margin of profit. The fullcommission cost was too great as well, and in the days before online discount brokerage services, few people outside of the exchanges themselveswere able to execute any kind of short-term trading program effectively.The more the Internet expands the possibilities for investors, themore practical it becomes to perform many varieties of short-term trading strategies. The use of options is also a practical vehicle for many ofthese strategies, if only because access to current prices and order execution is simple and the cost of trades is so low.This broad availability of information has a negative side. Withtrading made so easy for everyone, it is also possible to trade withouthaving a lot of experience and without being aware of the risks. One service responsible stockbrokers used to provide was to guide novice investors into appropriate investing avenues. Today, anyone with a
Key PointThe Internet has speeded up trading, quotations, and access tofree information. It has also pointed out the value of short-termstrategies like swing trading.
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Valuable ResourceFree candlestick charts are available from several sites, includinghttp://www.candlestickchart.com.
computer can open and fund a trading account. So it is especially important today for anyone, especially swing traders, to ensure that they knowexactly what they are doing and what risks are involved. Even the availability of candlestick charts, a great advantage to swing traders, can be aproblem. If you do not know how to read and interpret setup signals, it isall too easy to make mistakes. However, free candlestick charting makesswing trading a practical strategy today