a view of risks involving short selling, however, the disadvantage that short sellers do not receive or earn dividends may be considerable.
Key PointShort sellers do not earn dividends, a point that becomes important if you end up owning the stock for more than a few days.
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The market risk for short sellers is similarlynot limited to the swing trade itself. Even whencoveryou time your transactions based on setup signalsa short seller’son charts, outside influences often distort stockaction in buyingprices. For example, if a large number of short sellto close, in whichthe exposed shorters cover their positions at the same time—meaningposition is covbuying shares to close the short—this may createered throughcancellation.an artificial demand, driving up share prices andnullifying the swing trade’s timing.The sudden cover of many short positionsmay be caused by normal supply and demand forces within the marketfor those shares; or it may be deliberately brought on by institutional investors, notably by hedge funds. For example, fund management maytrack what is called short interest—the volume of short sales in a particular stock—and may observe a rise in short positions on a particular stockand, in response, buys many shares. This drives up the share price andpanic by short sellers, resulting in high volume of cover. The hedge fundthen profits from the higher price of the stock. This represents a variationon market risk for swing traders in short positions. One market theory,called the “short interest theory,” is based on thebelief that a rapid growth in short interest foretellsa rise in price.short interestA distinction is worth remembering regardinga market indicashort selling risk. Many short sellers are merelytor, reporting thenumber of sharesspeculating on the market and attempting to profitof a specific stockfrom a general decline in the stock’s price. In comthat are sold shortparison, swing traders would go short only if andand open, andoften used bywhen an appropriate setup appears. So, althoughinvestors to timethese two traders have dissimilar attributes andmarket decisions.methods for making decisions, they are subject to
Key PointSwing traders act on the premise that specific setup signals leadto timing decisions. But when you sell stock short, the price couldbe manipulated by other investors, distorting the swing trade.
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SELLING SHORT: ENTERING A SWING TRADE WITH A SHORT ORDER
the same market forces. The actions among speculators in short positionsmay affect swing traders negatively, even when they respond to the clearest of setups.
Short Selling VariationsIf you own shares of a stock, this makes it easier to trade on the shortside. Swing trading is normally associated with fast in-and-out positions,but some swing trading also takes place among investors who also ownshares.There are often sound reasons for this. For example, if you ownshares of stock that you want to hold for the long-term, you may swingtrade to offset momentary price declines on the downside, and to takeprofits on the upside without needing to sell shares. Swing trading is, infact, an appropriate and acceptable strategy when you do want to takeprofits but you don’t want to sell the stock.In this situation, you can sell short against thebox. Because you already own the shares, you don’tneed to borrow them in order to sell short. Theagainst theterm derives from the past when share certificatesboxwere issued and kept in a safe deposit box. Thea strategy forgoing short whenagainst the box strategy allows you to go shortthe trader ownswithout (1) borrowing shares and paying interestshares. The shortto your brokerage firm; and (2) selling shares you’dsale is madeagainst the sharesrather keep in your portfolio.in the portfolioOne problem with any form of short selling israther than borrowed from anthat it easily invites manipulation of stock prices.other investor.The previous example—when large investors buyshares upon observing increase in short interest—
Key PointSwing trading is usually perceived as a strategy not includingownership of stock. But for those who do own shares, swingtrading can be used to protect or to even take paper profits.
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Key PointLong investors have to look out for the “pump and dump.” Andshort sellers have to be on guard against the short equivalent,the “short and distort.”
may have the effect of driving prices up as shortsellers panic and cover their positions. Many inpump andvestors are familiar with the pump and dump—dumptechniques for artificially inflating the price of aa strategy to buystock after buying shares in order to drive upshares and thenspread rumorsprices—when speculators take long positions. Theintended to driveoffsetting strategy on the short side, often called theup prices, afterwhich shares areshort and distort—involves going short and thensold at a profit.taking actions to scare other investors, with the intent of driving down the stock price. Anyone goingshort should be aware of the potential for attempted price manipulation on the part of unethishort andcal traders.distorta short positionBoth the SEC and NASD have drafted reguvariation of thelations to curtail manipulation of stock pricespump and dumpthrough pump and dump and through short andstrategy; speculators open shortdistort types of practices. But with investment chatpositions andlines widely available online, it is difficult to capthen spread rumors intended toture all of the abuses. Swing traders are wise to refrighten investorssponds to setup chart signals and to ignore rumorsinto selling theirpassed around on the Internet.stock to driveprices down. AfterThe next two chapters propose an alternativethe price falls,to short selling, involving the use of options inshort positionsare covered at aplace of both long and short stock positions. Withprofit.options, a limited amount of capital can be used tovastly expand your swing trading portfolio, butwith much less risk. While options are not appropriate for everyone,their wise but limited use involves lower risks than both long and shortstock positions—and they can produce the same level of profits.
8Chapter
Options for SwingTradingThe Basics
any people have only heard about the negative side of options—as high-risk, exotic instruments that are only for themost experienced speculators. This is an inaccurate descriptionof the options market. In fact, swing traders find that using optionsmakes perfect sense for several reasons.An option is an intangible contract that grantsits owner specific rights to either buy or sell stock.optionEvery option is tied to 100 shares of a specific stockan intangibleand cannot be transferred. The option’s life is limcontract grantingited and it ceases to exist at a known date in the fuits owner specificture. After that date, the option becomes worthless.rights to eitherbuy or sell 100Swing traders face a triple dilemma in usingshares of a spestocks directly for swing trading:cific stock, on or
M
before a specificdate, for a specificprice per share.
1. The high risk of short selling. First, half of allyour swing trading opportunities begin asselling setups, meaning you need to goshort. And short selling is a high-risk move in the market, somany swing traders limit themselves to only acting on buy setups, which cuts out half of the entire market.
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OPTIONS FOR SWING TRADING: THE BASICSKey PointWhen you use stocks for swing trading, you are naturally limitedin how much trading you can do, and in how much risk you canafford.
2. Capital is limited. The second problem is that with limited capital, you can only enter a small number of swing trades at any onetime; this means that robust market movement cannot be fullyexploited. If you buy 100 shares in any one trade, you cannot exceed your cash and margin capabilities while pursuing swingtrades.3. You may suffer losses. When you buy 100 shares of stock as part ofa swing trade, you respond to setup signals and, if all goes well,the price rises and you sell at a profit. But there are times whenthe signals will not work, and you will lose money. When thishappens, you have to sell and accept the loss, or hold on to thoseshares hoping that the price will rebound.All of these problems and limitations can be solved using options.
A Few DefinitionsBuying stock is the best-known form of equity investment. Each share ofstock is a very small piece of ownership in a much larger whole, the corporation. A swing trader is less concerned with thelong-term ramifications of equity investment, including the earning of dividends and voting rights.equityinvestmentHis or her concern is far more immediate. Ownera form of ownership is taken up in the hopes of a fast short-termship in a corporaprofit. The swing trader does not buy stock becausetion, the bestof an admiration for the company or its product;known form ofwhich is stock.stock is merely the vehicle for creating those twoto five-day opportunities.
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137
So stock ownership is usually associated withtaking an equity stake in the company, and the norround lotmal trading increment is 100 shares. This round lot isthe usual tradingefficient because trading costs are tied to that numincrement forber; buying fewer than 100 shares usually involves astocks, which is100 shares.higher cost-per-share to complete the transaction.A swing trader usually deals in rounds lots because of the trading cost of odd-lot trading. Butwere it possible to trade for the same costs, there is no doubt that swingtraders would prefer a set amount over a fixed number of shares. Thatwould allow the swing trader to quantify risk, spread capital more efficiently, and calculate potential profits. Many swing traders end up working only in stocks with relatively low price per share because capital islimited. This means that bigger point movement often seen in higherpriced stocks is another form of missed opportunity. You can actually setlimits on each trade by finding appropriately priced options for one ormore of a stable of stocks you track.When you buy options instead of stock, capital limitations are notas much of an issue. As a general guideline, you can find and buy optionsat about 10 percent or less of the stock’s current value. For example, youcan find and buy options on a $60 stock for $600 or less. That $600gives you complete control over the 100 shares of stock; fixes the price ofthe stock; and costs far less than outright purchase of 100 shares. This isthe great advantage for swing traders.With the use of stocks, you have to go either long or short; andshort selling is where you run into risk issues and potentially unacceptable levels of loss. With options, you are either buy or sell into a position,make the swing trade, and act on both the buy and sell setup—all withlimited risk and using long positions.Key PointWhen using options instead of round lots of stock for swingtrading, you can have greater control over the dollar amount ofeach transaction—because your investment is based on optioncost and not on share price.
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OPTIONS FOR SWING TRADING: THE BASICS
callan option granting its owner theright (but not therequirement) tobuy 100 shares ofa specific stock ata fixed price pershare.
putan option granting its owner theright (but not therequirement) tosell 100 shares ofa specific stock ata fixed price pershare.
expirationthe deadline foran option and thedate on which itloses all of itsvalue.
underlyingstockthe stock onwhich options arewritten andbought or sold.
strike pricethe fixed buy orsell price of stockspecified in theoption contract.
This is possible because there are two kinds ofoptions, the call and the put. A call grants you theright (but not the requirement) to buy 100 sharesof a specific stock at a fixed price per share; a put isthe opposite, granting you the right to sell 100shares of a specific stock at a fixed price per share.This arrangement remains in effect until expirationof the option.However, it is crucial to remember that an option does not need to be used to buy or sell stock.Based on stock price changes, options gain or losevalue; thus, options can themselves be bought andsold to create swing trading profits.The option itself increases or decreases invalue based on movement of the underlying stock,and this is where swing trading can use options togreat advantage. The fixed price of the option isalso called the strike price and it gives you the rightto buy or sell 100 shares at that exact price, no matter how the market price of the stock changes. Thefarther the stock moves away from the strike price,the more the option value changes.The value of the option, also called its premium, changes as the stock price moves, since thestrike price is fixed. For example, if you purchase a35 call, it means your strike price is $35 per share.So before expiration, if the stock were to rise to $42per share, or seven points above the strike price,that call would have $700 of increased value abovestrike price. For the swing trader, this is the same asa seven-point rise in the stock—yet at a fraction ofthe cost and risk.The situation works in reverse for the put. Asa stock’s value falls below the strike price of the put,the put’s premium value grows. If you purchase a$35 put, for example, and the stock falls to $29 pershare before expiration, the put’s value grows sixpoints, representing the price difference between$35 and $29 per share. The fact that calls and puts
The Status of Options
139
Key PointOptions are specifically identified with individual stocks and withthe price you can buy or sell shares of that stock. But option profits are not derived solely from buying or selling stock; becauseoptions gain or lose value—they can be traded on their own.
Key PointWhen the stock moves in the desired direction (up when youown a call, or down when you own a put) the value of the optionincreases as well. So the option can be traded in place of stock.This is an incredible opportunity for swing traders.
grow in value based on stock price movementdemonstrates the value of options to swing traders.You can trade in a much greater number of different stocks for less capital at risk.
The Status of OptionsThe option premium does not necessarily track thechanges in stock value dollar for dollar. Actualmovement of option premium value depends onthe distance between current value and strike price,and on whether the strike price is higher or lowerthan market value. When an option is at the money,it means that the strike price of the option andmarket value of the stock are identical.Options also have descriptive terms explaining where the strike price is in relation to currentmarket value:
premiumthe value or costof an option,which variesaccording to thedistance betweenstrike price andcurrent marketvalue; and thetime remaininguntil expiration.
at the moneya situation wherean option’s strikeprice is identicalto the stock’scurrent marketvalue.
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OPTIONS FOR SWING TRADING: THE BASICS
• When the call’s strike price is below current market value of thestock, the call is in the money.• When a put’s strike price is above current market value of thestock, the put is in the money.• When the call’s strike price is above current market value of thestock, the call is out of the money.• When the put’s strike price is below current market value of the stock, the put is out of thein the moneymoney.condition of anA comparison of these situations is providedoption when theinFigure8.1strike price of acall is lower thanThe degree to which an option is in thecurrent stockmoney(strike price of the call is lower than currentprice, or when thestrike price of amarket value of the stock, or strike price of a put isput is higher thanhigher than current market value of the stock) isthe current stockwhere swing traders will find the most interestingprice.attribute of options. The number of points in themoney is referred to as intrinsic value. For example,if your call’s strike price is 45 and the current marout of theket value of the stock is $48 per share, there aremoneythree points of intrinsic value in this option. Thecondition of anoption when thesame works in the opposite direction for puts. Ifstrike price of ayour put’s strike price is 50 and the current marketcall is higher thanthe current stockvalue of the stock is $46 per share, there are fourprice, or when thepoints of intrinsic value in that put.strike price of aSo if you have an in-the-money option, someput is lower thanthe current stockportion of the premium represents intrinsic value.price.Any additional premium above and beyond intrinsic value is called time value. For example, if yourcall’s strike price is 45 and the current market valueintrinsic valueof the stock is $48, but your call is current worth 5the premium($500), that is made up of three points in intrinsicvalue of an optionequal to the numvalue and two points in time value. When an opber of points it istion is at the money or out of the money, the entirein the moneypremium is made up of time value. The time value(current marketvalue higher thanis going to be highest when a long time remains bea call’s strike pricetween today and expiration of the option.or lower than aput’s strike price).
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141
Call
In theMoney
Strike PriceAt theMoneyOut of theMoney
PutOut of theMoney
At theMoneyStrike Price
In theMoney
FIGURE 8.1 Call and Put: In and Out of the Money
Key PointThe in-the-money status is opposite for calls and for puts basedon proximity to strike price. When strike price of the call islower than market value, or when strike price of the put ishigher, the option is in the money.
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OPTIONS FOR SWING TRADING: THE BASICSKey PointThe option consists of intrinsic value (equal to the number ofpoints it is in the money) and time value. The time value is anyvalue other than intrinsic value. When the option is at or out ofthe money, its premium is all time value.
Why is it important to know all of theseterms? As a swing trader, you can capitalize on thetime valuecost of options, which is far lower than the underthe portion of anlying stock’s price. It will be cheaper to buy optionsoption’s premiumthan it would be to buy shares of stock. Becauseexcluding anyintrinsic value.each option gives you control over 100 shares, thelower cost of the option gives you considerableleverage, lower risk, and potentially greater return on your money. In order to effectively use options for swing trading, you will need to formulate an effective strategy with these important distinctions in mind(intrinsic and time value, in and out of the money, and expiration).You have three primary advantages in swing trading with options.The attributes most important to remember include the following:1. The option premium consists of both intrinsic value and timevalue. The intrinsic value equals the in-the-money point value,and time value decreases as expiration approaches.2. In-the-money options change dollar for dollar with changes inthe stock’s value. When a call is in the money, the call’s intrinsicvalue increases one point for each point the stock increases.When a put is in the money, the put’s intrinsic value increasesone point for each point the stock decreases.3. Because time value declines as expiration approaches, options getcheaper toward the end of their terms.
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A Realistic View of Time Value PremiumJust a profitability of buying and selling stock is often a matter of timing,option premium value also evolves and changes over time. The interesting aspect of options is that valuation of options is a combination of twofactors: stock price movement and time.The option premium consists of time value and intrinsic value. Theintrinsic portion is easy to understand. It consists of the point value difference between strike price and current market value. When currentmarket value is higher than a call’s strike price, or lower than a put’s strikeprice, the difference is intrinsic value. If the current market value of stockis lower than the call strike price or higher than the put strike price, therecan be no intrinsic value. And the intrinsic value moves dollar for dollarwith the stock price.As far as intrinsic value is concerned, this is the key piece of information for swing traders. Knowing that in-the-money options move dollar for dollar with the stock, you can easily find the best options to usefor swing trading.With time value attributes brought into the equation, the selectionof the best possible options might at first seem to become more difficultbut in fact, it is easier. Most people who speculate in options face the everpresent problem of declining time value. When an option has a long timeto go until expiration, its time value will be maximized. When expiration isgoing to arrive within a matter of a few weeks, time value declines rapidly.When expiration is only a few days away, time value falls to near zero.
Key PointSwing traders are going to be most interested in tracking intrinsic value, which moves with the stock. This is where your profits will be found.
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OPTIONS FOR SWING TRADING: THE BASICSKey PointYou will notice that when option strike price is close to the current market value of the stock, they tend to be more responsiveto price changes; and when farther away, increasingly lessresponsive.
To observe how time value acts and interacts with the stock price, itmakes sense to watch options whose strike price is close to current market value. The farther away from market value, the less time value will respond to short-term price changes. Time value is more likely torelentlessly depreciate over time; and the closer expiration is, the morerapid the loss in time value. So, as many option speculators have discovered, buying options with too much time value can be a losing proposition, even if the stock price moves in the desired direction.Let’s say a stock sells today at $38 per share and you are thinkingabout buying a 40 call that expires in four months. The premium is 4($400). You believe strongly that this stock is going to see increased pricevalue over the next four months, so buying the call seems like a wise idea.But because market value is lower than the call’s strike price, there is nointrinsic value in this call; it is all time value.You know that the time value will evaporate within the next fourmonths, and will be at zero on the day of expiration. In order for thispurchase to become profitable, you will need the stock to make a considerable move. If on the day of expiration, the stock’s price were to rise to$44 per share, you would only break even (actually you would lose because this example does not consider trading costs for buying and forselling the call). This breakeven occurs because your original $400 cost(all time value) will have disappeared, and the intrinsic value (the difference between $44 per share market value and strike price of 40) wouldonly replace that amount. So the call would still be worth only $400.This demonstrates why about three-fourths of all options expire worthless. Buying time value options is a difficult way to make money consistently. You have to fight not only the chance that the stock’s price mightmove in the wrong direction, but time as well.
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This is where options become too risky for most people. Buyingoptions with a large portion of time value (or, as in the example, with nointrinsic value) is quite difficult. If the stock does not accumulate intrinsicvalue quickly, the purchase is not going to be profitable. This is true evenif the stock were to move upward very quickly when still four monthsaway from expiration. For example, what if you bought the 40 call whenthe stock was at $38 per share and, the very next day, the stock jumped to$40 per share? Would you expect the option to also jump two points?Remember, intrinsic value tracks the stock dollar for dollar, so anygrowth above strike price level would create intrinsic value; and that isgood news. However, the time value (100 percent of the premium at orbelow the 40 strike level) is time value and it will not react on a pointfor-point level. Because the two-point move places the stock right at themoney, the option premium might grow to a degree, but it probably willnot increase by two points. You need to see the stock move into the inthe-money range before a point-for-point change will begin to occur.This brings up another aspect of time value premium: It is notstrictly related to time. The major effect of time value premium is time,of course. But this premium is also affected by two additional elements:investor interest, and proximity. Investor interest is seen in volume increasing, in the stock’s price rising, and in exceptionally high volatility.So the more volatile the stock becomes, the greater the likelihood thattime value will increase above other stocks with lower volatility. Second,as the current market value of a stock approaches the strike price, timevalue premium is more likely to be responsive. Therefore when a stock iswithin one or two points of strike price, the option premium may anticipate the possibility of its moving into the intrinsic range, and this maycreate more responsiveness in the time value premium. This means (1)for calls the stock price would be within close range just below strikeprice and (2) for puts the stock price would be just above strike price.
Key PointTime value is not strictly related to time. It is also affected by investor interest and by proximity between strike price and current market value of the stock.
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146
extrinsicvaluethe value of anoption not counting any intrinsicvalue; the timevalue premium,given this alternate name toconsider the nontime elements ofvolatility withinthe stock, and ofproximity betweenstock’s currentmarket value andthe option’s strikeprice.
Thus the market interest and proximity tostrike price make “time value” more complex than apredictable time measurement. Time value premium varies from one stock to another and, because time is not the only factor influencing theoption premium, time value is more accurately described as extrinsic value.
A Strategic Approach to SwingTrading
The problem for swing traders in the selection anduse of options is based entirely on the time valuepremium and how it behaves. If you attempt toswing trade with options containing a large portionof time value, you will spend less for the options,but you face a more serious problem: Option premium will not changeor move in the same way that the stock’s price changes and moves.With this in mind, swing traders need to develop some standardsfor the use of options. The standards should consider two goals: optimizing intrinsic value. These standards should include:1. Use only those options that are in the money. Swing traders need thepoint-for-point interaction between option premium and stockprice. In-the-money options have intrinsic value, and that portion of the option premium will rise or fall point for point intracking the stock. So when you see the buy or sell setup, you canrespond using long position options. Rather than going long orshort in the stock, you can buy calls for buy setups and buy putsfor short setups.
Key PointSwing traders using options have to contend with the cost oftime value versus the actual amount of time to expiration.
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Key PointIn-the-money options are the only practical ones for swingtraders to use. You need the responsiveness of intrinsic value tomake the strategy work.
This gives you numerous advantages over going long or short instock. The cost of buying options is significantly less than thatfor buying stock. On the short side, the cost factor affects you aswell, since margin requirement demands that you place at least50 percent of the stock’s value on margin when you sell stockshort. With options, the cost will average 10 percent of the stockprice. This 10 percent is not a hard-and-fast rule, but an analysisof actual option premium values on various stocks reveals thatthe cost may even be far less.2. Limit swing trading options to those as close as possible to strikeprice. The biggest problem in buying options for swing tradinginvolves paying for time value. But fortunately, when expirationdate is quite near, time value is reduced to an absolute minimum.This is especially true when the intrinsic value of options is quiteclose to the strike price. If you are responding to a buy setup,look for calls that are in the money but also within five to 10points below current market value. That provides the leastamount of time value for the smallest cost.Although time value may be a factor when the strike price isclose to current market value of the stock, it is minimal when
Key PointWork with options that are in the money and as close as possible to current market value. This gives you the most responsiveprice action for the least cost.
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OPTIONS FOR SWING TRADING: THE BASICS
expiration will occur within the near future. While most optionspeculators consider pending expiration a problem, swing tradersdo not because they intend to hold positions open only for theshort term. This raises an issue of risk as well. When you go longon stock or sell short, you assume a market risk equal to the potential change in a stock value. For example, if you buy shares at$55 and the market value falls to $48 per share, you lose $7 pershare, or $700 on a 100-share trade. When you go short, youhave the same risk. If a stock’s price rises four points, your 100short shares are worth $400 more, and you will have to pay thatto close the position. But with options, your maximum risk is always limited to the cost of the option. When you assume a longposition in either calls or puts, the most you can ever loose is thepremium amount you pay upon opening that position.Swing traders do have losses, just as all traders and investors. Soswing trading is a timing strategy intended to improve your oddsand to increase profitability in trading. However, the market riskcannot be ignored and losses are painful. For short sellers, the potential losses are unknown so many swing traders simply avoidthe short side. Options solve the market risk problem by limitinglosses to the cost of the options. And using options for swingtrading also limits the possible losses from both long and shortpositions in stock. Because options cost only a fraction of stockpurchases, you can also diversify your swing trades among manymore stocks than you could buying or going short on 100-shareincrements.3. Avoid long-term options and use only those that will expire withinthe next month. While most option buyers have to struggle to offset option cost with time, as a swing trader you are not concerned with time windows beyond the usual two- to five-daywindow. This means that you can deal strictly with options thatwill expire within the next month’s cycle. If you buy calls andputs that expire within the next four weeks or less (close to strikeprice and in the money) the risks are manageable. As long as themajority of your swing trade setup signals are accurate, you willbe in and out of the position in less than one week. In those situations where you lose money, your loss will be limited to the costof the option.
Examples of Options for Swing Trading
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Key PointLimit swing trading to only those options that expire within thenext month. Swing trading is short-term, so why pay for timevalue?
That cost is held down by two important aspects. First, there is virtually no time value to contend with because expiration is imminent andthe closer the time to expiration, the less time value will remain. Second,because the option will be as close as possible to strike price, intrinsicvalue will be very low. For example, if your call is three points belowstrike price, intrinsic value will be only 3 ($300). And if your put is twopoints above strike price, intrinsic value will be only 2 ($200).
Examples of Options for Swing TradingIs it possible to locate low-cost calls or puts close to expiration andwithin a few points of strike price? Yes. In fact, these selection criteria arenormally the most affordable options for swing trading. For speculativepurposes, out-of-the-money options are much cheaper; but as a swingtrader, you need and want the point-for-point price movement typical ofintrinsic value. Some examples:Calls
Puts
Stock andMarketTrading Symbol Value Expiration ValueSherwinWilliams(SHW)Procter &Gamble (PG)Johnson &Johnson (JNJ)
Expiration Value
$50.31
Aug 45
$5.30
Aug 55
$4.80
56.56
Aug 50
6.70
Aug 60
3.60
62.67
Aug 60
2.95
Aug 65
2.40
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OPTIONS FOR SWING TRADING: THE BASICSKey PointOption notation involves a dollars-and-cents expression for asingle share of stock, but this has to be multiplied by 100, sinceeach option involves right for 100 shares. For example, an option worth 5 sells for $500.