
To interpret these results accurately, the call and put values are pershare values, so to calculate the contract cost, they must be multiplied by100. The method by which option premium values are shown in listingsis using this method. So a call listed with a value of $5.30 will cost you$530. As a swing trader, you may be able to recognize the value in usingoptions rather than shares of stock as soon as these values are compared.The following is a summary of the call or put costs compared to the costof buying 100 shares in each case:Stock and Trading SymbolSherwin-Williams (SHW)Aug 45 call $5.30Aug 55 put $4.80Procter & Gamble (PG)Aug 50 call $6.70Aug 60 put $3.60Johnson & Johnson (JNJ)Aug 60 call $2.95Aug 65 put $2.40
MarketValue
Cost of100 Shares
$50.31
$5,031
Cost perOption$530480
56.56
$5,656$670360
62.67
$6,267$295240
These comparisons demonstrate the value of using options ratherthan buying 100 shares (on the buy setup) or going short 100 shares (onthe sell setup). When you consider the return on your investment, thedifference is even more significant. For example, a three-point move onthe buy setup for each of these stocks looks like this (without includingtransaction costs):
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Sherwin-Williams (SHW)100 shares of stock, $200 profit ($200 ÷ $5,031) = 4.0%1 August 45 call, $200 profit ($200 ÷ $530) = 37.7Procter & Gamble (PG)100 shares of stock, $200 profit ($200 ÷ $5,656) = 3.5%1 August 45 call, $200 profit ($200 ÷ $670) = 29.9Johnson & Johnson (JNJ)100 shares of stock, $200 profit ($200 ÷ $6,267) = 3.0%1 August 45 call, $200 profit($200 ÷ $295) = 67.8For a sell setup, using long puts instead of selling short 100 sharesof stock, and assuming a two-point move on the trade, the comparisonlooks like this:Sherwin-Williams (SHW)100 shares of stock, $200 profit ($200 ÷ $5,031) = 4.0%1 August 55 call, $200 profit ($200 ÷ $480) = 41.7Procter & Gamble (PG)100 shares of stock, $200 profit ($200 ÷ $5,656) = 3.5%1 August 60 call, $200 profit ($200 ÷ $360) = 55.6Johnson & Johnson (JNJ)100 shares of stock, $200 profit ($200 ÷ $6,267) = 3.0%1 August 65 call, $200 profit ($200 ÷ $240) = 83.3A two-point move in the option therefore produces a double-digitreturn in each of these examples. It works with calls in the buy setup andit works with long puts in the sell setup. Assuming you select stocks withadequate midrange volatility, swing trades will be practical. All three ofthese stocks qualify as reasonable swing trading candidates.Figure 8.2 shows a 30-day chart for Sherwin-Williams. Note that atpoint 1 there is an apparent reversal signal. After four downtrend days, a
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Key PointClearly, you will only want to swing trade using options onstocks which provide clear buy or sell setup signals. The difference is that instead of buying or selling stock, you either buycalls (for buy setups) or buy puts (for sell setups).
narrow range day on the upside appears. This is confirmed two days laterwith a strong engulfing line day. The stock then rose five points to theend of the chart. The comparisons of stock prices to option values wereprovided for the day on which this chart ended.The case is strong but not as strong for Procter & Gamble. Figure8.3 shows the 30-day period preceding the day on which stock and option values were shown. The large engulfing line at point # 1 foretold atwo-point rise in the stock’s market value. The smaller engulfing line dayCandlestickchart.com50.4049.8049.2048.6048.00
1
47.4046.8046.20
245.6045.0044.40
2.5 M2.0 M1.5 M1.0 M0.5 M07
14
Jul
FIGURE 8.2 30-Day Chart: Sherwin-WilliamsSource: Candlestickchart.com.
21Jul
28
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153
at point 2 preceded a one-point drop in value. (Recalling that the PG putproduced a 55.6 percent return on a two-point move, it is reasonable toassume that a corresponding put move at this point would have easilyyielded 25 percent or more.)Finally, Figure 8.4 summarizes the 30 days preceding the previousexample for Johnson & Johnson. Here a narrow range day at point 1 followed three down days and accurately anticipated a three-point uptrendin the stock, to the end of the chart. At that point, a narrow range dayprovides a sell setup after an extended uptrend on the day the stock andoption values were shown.The usual problem for option buyers is the double issue of declining time value and pending expiration. These two factors make it quitedifficult to simply buy and sell options as a speculative market play. Eventhough the relatively low cost of options is attractive at first glance, itmay be quite deceptive as well. The majority of first-time option buyerslose more than they earn in option outcomes.
Candlestickchart.com57.3057.1056.9056.7056.5056.3056.10
2
55.9055.7055.5055.3055.10
1
54.9020.0 M16.0 M12.0 M8.0 M4.0 M07
14
Jul
FIGURE 8.3 30-Day Chart: Procter & GambleSource: Candlestickchart.com.
21Jul
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OPTIONS FOR SWING TRADING: THE BASICS
154Candlestickchart.com63.0062.6062.20
1
61.80
2
61.4061.0060.6060.2059.8059.4059.0015.0 M12.0 M9.0 M6.0 M3.0 M07
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Jul
21
28
Jul
FIGURE 8.4 30-Day Chart: Johnson & JohnsonSource: Candlestickchart.com.
Swing traders make use of options as a device for achieving thesame outcome as they do using shares of stock. The significant differences, though, include two primary points:1. Better return on the investment. The previous example makes thepoint that options yield far better swing trading returns. In fact,using options vastly changes the landscape for swing trading.Most investors will have to view swing trading from the point ofview that capital is limited. Even using a 50 percent margin limitation, you cannot take part in very many swing trades at thesame time. A portfolio of $10,000 will enable you to buy 100shares each of Sherwin-Williams, Procter & Gamble and Johnson & Johnson, or go short on 100 shares of each (or a combination of each), using the 50 percent margin allowance the rulesallow. But that would be all you could do with $10,000.In comparison, you could buy or sell as many as 400 calls orputs with the same $10,000 without using the margin account atall. If you compare the use of 100-share increments of stock to
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Key PointThe double-digit returns possible on swing trading with optionsare compelling reasons to prefer short-term options over sharesof stock.
1-contract options, it is clear that swing trading strategies can bevastly expanded. For example, you could buy single options on400 different stocks; or 40 groups of 10-option contracts on 25different stocks. That raises your potential profits considerably.With 10-option groups, your transaction costs will be lower on aper-contract basis, while potential profits will be vastly improved.Options give you not only a better return on your investment,but much better diversification as well.2. Much lower market risk in terms of dollars invested. The problemin using shares of stock for swing trading is that it involves market risks on both sides. Buying 100 shares of stock in groups of$5,000 or more at a time is risky because if the stock’s price falls,you lose money—possibly a large portion of your money. With acall, however, your maximum loss is limited to the premium forthe call. In the three-stock example, the closest calls to strikeprices cost only a fraction of the stock value for each case.On the short setup side, you will be required to go short on thestock. If your timing is off or the sell setup was simply inaccurate and thestock rises, you would need to buy out the position at a loss or continueplacing more and more money on margin to keep your ratio with the
Key PointRisks are much lower using in-the-money options for two reasons. First, you can never lose more than the option premium.Second, you never have to sell short.
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brokerage firm. Short selling is complex and risky. In comparison, whenyou buy a put you are going long to respond to the sell setup, an elegantsolution to the problem of short-side risk. The most you can lose is thepremium value of the put. In the three-stock example, put premiumranged from $240 to $480, a small portion of the stocks whose price per100 shares was between 10 and 26 times higher than using puts.
Swing Trading for Options SpeculatorsAnother aspect of this to consider is that, from the option speculator’spoint of view, swing trading can be viewed as a method for timing longoptions. The dilemma most novices face is deciding how much to payand how far out to go with options. The cost factor is ever present; option speculators naturally want to find the most attractive option bargains with the greatest time to expiration. But the longer the time, thehigher the time value will be.For example, consider the further-out options for the previous examples:Sherwin-WilliamsAug 45 callSep 45 callDec 45 callJan 45 call
$5.306.007.107.60
Aug 55 putSep 55 putDec 55 putJan 55 put
$4.805.105.906.10
Aug 60 putOct 60 putJan 50 put
$3.604.005.50
Aug 65 putSep 65 putOct 65 putJan 65 put
$2.402.803.003.50
Procter & GambleAug 50 callOct 50 callJan 50 call
$6.707.207.90
Johnson & JohnsonAug 60 callSep 60 callOct 60 callJan 60 call
$2.953.103.704.70
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The longer out these options go until expiration, the higher thetime value. Those that expire the soonest (italicized) have very little timevalue, which is what makes them most attractive for swing trading; thosegoing out five months have far more time value. So from the point ofview of the option speculator, this is a dilemma. Do you pay $100 to$200 more for an option and buy time? Or do you buy options with almost no time value and hope for a strong price movement within a fewweeks?An option speculator is continually seeking bargains and opportunities and, most of the time, not being able to profit from long positionoptions. Based on the volume of option trades, it is also clear that tradersprefer calls over puts. This may be true because investors tend to be optimists, and will think about options only in terms of stock prices rising,rarely in terms of those prices falling. So like swing traders who do notwant to short stock, option traders who look only to calls miss half theirpotential market.Table 8.1 summarizes call and put activity for 20 stocks in a singlemonth, which makes this point. It seems to not matter that many of thestocks whose call volume was a clear majority, actually fell in value. Thefact remains that most option traders prefer calls over puts.
Key PointOptions make a lot of sense for swing traders. And for the samereasons, the clarity in setup signals for swing trading couldmake it a valuable strategy for option speculators and traders.
Key PointMost people prefer to think stocks are going to rise in the nearfuture. This explains why calls outsell puts. But as every swingtrader knows, stocks rise and fall in predictable patterns. Callsand puts are equally valuable.
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158
TABLE 8.1 Put Activity for 20 Stocks in a Single MonthCallVolume
TotalVolume
Call
Altria
519,468
795,552
65%
Microsoft
428,122
706,904
61%
General Motors
203,291
651,568
31%
Company Name
Sprint
114,490
588,158
19%
Apple Computer
357,361
572,880
23%
Google
313,144
563,112
56%
Intel
350,788
497,960
70%
Hewlett-Packard
215,526
365,752
59%
General Electric
200,276
294,440
68%
Chevron
182,352
276,798
66%
Exxon Mobil
165,992
275,678
60%
ConocoPhillips
191,329
252,635
76%
Newmont Mining
124,012
242,625
51%
Pfizer
136,031
236,711
57%
Goldman Sachs
145,626
229,432
63%
Yahoo
147,654
220,701
67%
Bank of America
95,123
215,326
44%
Wal-Mart
130,971
211,941
62%
JPMorgan Chase
115,831
201,297
58%
Citigroup
120,952
194,443
62%
4,258,339
7,593,913
TotalAverage
56%
The next chapter expands on this discussion to demonstrate howswing traders can employ some specific strategies using options—notonly to reduce losses, but also to improve on gains.
9Chapter
Option Strategiesfor Swing Trading
he potential uses of options are richly varied. They can be employed as high-risk, very speculative, and leveraged plays; or theycan be used as an ultra-conservative method for building income ina methodical manner. Swing traders at all risk levels can make good useof options as a smart alternative to the expensive strategy of buyingshares of stock in round lots, or the high-risk strategy of shorting stock.Swing trading as a strategic approach to short-term trading opensup many possibilities—however, by using stocks, it also comes with severe disadvantages. Specifically, these include limitations on how muchswing trading can be done because capital is limited; and the serious levels of risk in using stock, especially selling short. So options solve theseproblems—as long as you use only long strategies such as buying calls forbuy setups and buying puts for sell setups. However, many additional,advanced strategies are also possible using options.It is important to recognize exactly how calls and puts work asswing trading devices. The call is a substitute for buying shares of stock,and each call grants you the rights to 100 shares of stock. This means youcan buy 100 shares at a fixed price before expiration, or you can sell thecall at a profit (this is what swing traders are most likely to do). A put ismore confusing. When you buy a put, you are taking up a long position,but it acts as a substitute for selling 100 shares of stock. The put grants
T
159
160
OPTION STRATEGIES FOR SWING TRADINGKey PointOptions can be used in a large array of different low-risk andhigh-risk configurations. For swing traders, options can be theideal vehicle.
you the right to sell 100 shares at a fixed price before expiration. So onceyou own the call, you could exercise it and sell 100 shares at a pricehigher than current market value; or, as a swing trader, you can sell theput at a profit following a downtrend.With these basics in place, you can expand your use of options beyond their use as buy or sell setup responses. You can do more with options within your swing trading strategy.
Strategic Considerations and RiskThe use of options has to be studied in terms of risk, because—as withall strategies—the ultimate success or failure depends on whether it is appropriate for you. Every trader is willing to accept some risk, but howmuch? For some, swing trading using any method is simply too risky, especially if your orientation is toward a buy-and-hold preference withwell-established, low-volatility companies. If this describes you as an investor, then swing trading will not be considered seriously as an alternative. Neither will options.Some traders are willing to take higher risks and even highly speculative risks. The idea is that if an exceptionally high profit is possible, itjustifies the equal possibility of a complete loss. Such a speculator may findswing trading too methodical, too low-risk, and—even with options—notprofitable enough.Somewhere in between these extremes are most traders. A startingpoint for anyone considering using options as a swing trading deviceneeds to identify their appropriate risk level. Most people will be farmore comfortable staying on the long side of transactions than on theshort side, so options certainly double up your trading opportunities.One possibility in devising your own swing trading strategy is to buy
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161
Key PointWhile personal risk level should be the deciding point for usingoptions, the short-term nature of swing trading makes options agood match for the strategy.
shares of stock for buy-in signals, but to use puts for sell setups. Thiskeeps you away from short selling of stock. However, it does require buying either round lots of shares, or paying higher trading fees for odd-lotpurchases of stock. It begs this question if you intend to keep swing tradepositions open for only a two- to five-day window: Why not use optionson both sides of the transaction?One of the primary advantages in using options rather than stocksis the leverage they provide. This is a feature swing traders have to puthigh on their list. The comparison has been provided in the last chapter,but it bears emphasizing again here. Option cost is a fraction of stockcost, and yet each option contract produces the same profit as 100 sharesof stock. For example, if you are comparing a $50 stock to an option onthat stock at 10 percent of the stock’s price, and your swing trade produces a three-point profit:
Initial investmentThree-point moveValue excluding brokerage feesReturn on investment
Stock
Option
$5,000300$5,3006%
$500300$80060%
The rate of return is higher, and the capital at risk is lower. Nowconsider what happens if you hold the stock for a period of time equal tothe time to go until option expiration, and the option expires worthless.The most you lose on the option is $500. With a $5,000 investment instock, your potential loss is far greater. If the stock falls eight points, yourpaper loss would be $800. If it fell 12 points, your loss would be $1,200.So leverage, combined with the limitation on potential loss, makes agreat difference in the use of options for swing trading.
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The combined point of view should allow for the pro and con ofthe option as an alternative to buying and selling shares. The leveragefactor should be the strongest of all considerations, even if the marketrisk is discounted. Most traders object to options for several reasons, including:1. Expiration factor. The fact that options expire at some point inthe future is troubling for many. This would be a key problem ifit were merely a matter of speculating on option values, butswing traders expect (and want) a fast turnaround in their transactions. That two- to five-day window makes options the perfectalternative to buying and selling stock. The lack of time value inextremely short-term contracts is an advantage, because the majority of intrinsic-value premium will track stock values exactly.2. Exotic reputation. Options have always been thought of as highrisk, very exotic instruments. Many serious traders with considerable market experience reject options out of hand based on onlya partial knowledge of how the options market works and on risklevel perceptions, which may also be false. In fact, options are exotic in the sense that they are not tangible, have no specific equity, and are strange and foreign to traditional thinking; but theyare not high-risk. In fact, swing traders reduce their risks in theuse of options, while expanding their field of play.
Key PointExpiration is a problem for most long option positions. Forswing trading, however, pending expiration is not a problem because it is preferable to buy options with little or not time value.
Key PointMost people consider all options to be high-risk. When properlyused, however, options fill a wide range of needs—from speculative to ultraconservative.
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163
3. Knowledge and experience. The fear factor dominates most traderobjections to options. The lack of specific knowledge, coupledwith the negative reputation that options have in the equity markets, explains why so many people want nothing to do with thismarket. Some well-publicized abuses among speculators andhedge funds have only bolstered the negative reputation of theoptions market. But in fact, swing traders do not need to livewith those high-risk strategies associated with short-side optionplays, or with excessive long position uses involving long shots.They can devise a strategy that is not only low-risk and even conservative in many instances; and avoid the high risk of the wilder,more commonly held view of options.4. Traditional preference for equity position. The intangible nature ofoptions is also troubling to anyone who has not actively traded inthe past. Traders, even with limitations of capital for swing trading, are likely to feel more comfortable owning shares than owning options in their place. On the short side, it becomes a strugglebetween risks. Short selling stock is risky and demands marginlevels be maintained; in comparison, long puts are fairly inexpensive and risks are limited. However, overcoming the traditionalpreference to the desire for stock ownership is a large obstacle.
Key PointNo strategy should be employed unless you thoroughly understand the risks. This demands experience and knowledge as afirst step.
Key PointA common bias against options is their intangible nature. Investors like equity positions. But as a swing trader, it is worthlooking beyond this bias since, even when trading with stock,the goal is not to accumulate equity but to produce income.
164
OPTION STRATEGIES FOR SWING TRADINGKey PointSome people view short selling as sophisticated and high-levelin terms of investor “smarts.” In fact, you reduce risks when youuse long puts instead of shorting stock, and it requires muchless capital.
5. Attraction to short selling. Even though short selling is quite riskyand thus problematical for most people, there is a certain attraction to it that cannot be ignored. The idea of selling short is associated with sophisticated investors who somehow know morethan the average investor. This perception is quite real, but dangerous. There is nothing especially sophisticated about short selling, especially when you compare its features to buying puts.Although puts expire, the risks of remaining in a short positionfor stock over an extended period of time are significant. Just aspeople are attracted to sophisticated investing (including notonly short selling, but buying tax-free bonds, futures, and indexfunds, for example), there may be a certain appeal. Yet thosechoices are not always appropriate in terms of knowledge, experience, tax status, or investing goals. By the same argument, youmay avoid short selling if the risks are far too great for you. Usingput options as an alternative solves many problems.
Stock Selection versus OptionsSwing trading is going to depend on the movement and change in stockprices. Even if you end up trading options on a stock, you will continueto rely on setup in the stock price to time your trades. This is true because option premium levels may change in ways separate from stockprices. Time value itself—the portion not specifically restricted to time,but including proximity and investor interest—can and does move inways not related to actual changes in the stock itself.So, if your swing trading strategy involves the use of options, youwill do best when you track the stock and make decisions based on setup
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165
trends; and then make your trades using the related options. The guidelines continue to apply: The options you pick should be short-term, asclose as possible to strike price, and in the money.The question of how to pick stocks for swing trading should depend on the same criteria as you use when your strategy involves buyingor selling shares. Picking swing trade stocks based on the relative value ofoptions is a mistake. Option pricing reflects varying degrees of change intime value premium or, to be more precise, extrinsic value of those options. Because this value has nothing to do with the relationship betweenstock market value and option premium value, it is dangerous to pickstocks based on option values. The extrinsic valuation of options relatesmore to investor perceptions about companies than actual value.If you go back to swing trading basics, you will recall that swingtrading is a method for capitalizing on the emotions that rule the market:greed, fear and uncertainty. The cool-headed swing trader, recognizingwhich emotion is ruling at the moment, times trades to profit from theemotional over-reaction between buyers and sellers. So variations in anoption’s extrinsic value have to be viewed as yet another aspect of thissame phenomenon. The market is ruled by emotions, which are seen inshort-term stock price movement and in the distortion of option premium value.This is a profound bit of market intelligence. The emotional actionsand reactions of the market are not limited to stock prices, but includeoption premium value as well. Intrinsic value is an absolute, representingone point for each point in the money. Time value or, more accurately,extrinsic value is far more complex and troubling for you as a swingtrader. This is why it is so important to remember the guideline: Trackstock prices but trade options.
Key PointJust as emotions rule the markets in short-term stock price movement, they also affect extrinsic value of options. Knowing thisgives you a great advantage in using options for swing trading.
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OPTION STRATEGIES FOR SWING TRADING
Nothing changes as far as following trends and looking for buy andsell setups. The only difference is the use of long calls in place of longstock; and the use of long puts in place of short stock.Option traders eventually learn that simply picking options to buyor sell is an expensive approach to the market. They are better off pickingstocks based on sound analysis and comparison of risks. The same ruleapplies to swing traders. The decision about which stocks to include orexclude should be based on a traditional analysis of a range of stocks, anddevelopment of a short list of criteria. These should include position ofthe company within its stock sector; capital strength; and profitability.You may pick specific ratios such as the P/E to further narrow your list,or restrict your selection to those stocks paying higher than average dividends. These are simply examples of methods you can use to narrowyour list of likely swing trading stocks from thousands, down to less than20 stocks. If you go long or short in stocks, you are likely to be able toswing trade in only a handful of stocks; with options, you can easily consider a range of 20 stocks and perhaps even more.You may also use technical considerations to pick appropriatestocks. The criteria for swing trading are a good match for options criteria. Technical analysis includes comparisons of the trading range and historical volatility; you need and want stocks that are moderately volatile tocreate strong setup signals for swing trading. Those same stocks also tendto exhibit a healthy range of options and premium values.However, one thing is sure about time value. When the option iswithin two to four weeks of expiration, the time value premium rapidlydeclines to zero. This occurs even when the extrinsic factors remain inplay. So investor interest and proximity between strike price and marketvalue may play a role right up to the week preceding expiration; but fromyour swing trading point of view, expiration will ultimately mean thatthe option premium is going to consist primarily of intrinsic value.
Key PointYou need to divide time value into two components: time itselfand other extrinsic factors. It is certain, however, that as expiration nears all forms of non-intrinsic value will evaporate fromthe option premium.
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167
To get an idea of how critical the timing of expiration is, review someoption listings that are about to expire. Even those with strike prices withina few points of market value will have very little value right before expiration, often only 0.05, which is five dollars. This is only a token value serving the purpose of giving some minimal value to the option because itremains alive, if only for a few days. Few speculators will invest in such options because they are about to expire and they are out of the money. It iscertainly possible that the stock will surge in the last minute and the optionwill move suddenly in the money, creating some last-minute profit. This isthe exception rather than the rule. From a swing trading perspective, evenin-the-money options on the verge of expiration have very little time valueremaining. This is your great advantage. By limiting your swing trading tothe appropriate placed options, you pay primarily for that intrinsic value,and you are more likely to see the point-for-point movement in value thatmakes options so desirable for swing trading.
Swing Trading with Multiple-OptionContractsThe most obvious and immediate advantage to trading multiple optioncontracts is the savings in brokerage fees. For example, Charles Schwab& Company (http://www.schwab.com) charges $9.95 per trade plus 75cents per contract for online options trades. So a single option costs$10.70; two options cost $11.45; and 10 options traded at the same timecost $17.45, or less than $1.75 per contract.The savings are only