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Apply a Swing Trading Strategy to
Buying Options

 
     
 

On this page you will learn how to apply the swing trading stratgey to buying calls and puts, making the most use of gains in intrinsic value. You need to have mastered swing trading the underlying stock before trying this strategy, but once you get it right, you are on the road to incredible and fast profits!

 
     
 
 
     
 

 


     
 
 
     
 
 
     
 


Buying Calls and Puts is the next step to take your profits sky high, if you have mastered the concept of swing trading, and have practiced a bit using stocks. This is one of the most common options trading strategies, and the place where most people start. Unfortunately, a lot of people get burned at this point, giving options trading a bad name. I do recommend starting with another strategy, such as selling credit spreads, if you are just starting. To be successful, you really do need to have a good grasp of the underlying stock trading strategy (in this case, Swing Trading) that you intend to use.


Key Points:

  • Keep your losses to a minimum. The first rule of trading: don't lose money!
  • Don't be greedy. Never be scared to take a profit.
  • Keep it simple. You can always tell when options traders lose the plot - their system gets complicated.
  • Don't gamble. Stick rigidly to your plan.

So, with those in mind, here is the process for buying and selling options once you have determined that a stock is about to swing from a Pivot Point. You will have needed to have found a stock that is at a swing Pivot Point, or is in the “Trader's Action Zone”, and you would have confirmed this with candlestick patterns, and by checking resistance and support levels.

Set an ENTRY PRICE for your stock based on swing trading principles.

  • Choose your option

For an upward trend: Choose the call option strike price that is next above the entry price for your stock (i.e. just OTM). Buy it at market, or you may want to try and get it cheaper by buying just above the low of the day. For example, if your stock is at $46, and you expect it to go up, then buy a Call Option with a strike price of $47.50. This way, you are paying for time value only. As your option increases in price with the stock, and goes ITM, you will profit most from intrinsic value.

For a downward trend: Choose the put option strike price that is next below the entry price for your stock (i.e. just OTM). For example, if your stock is at $46, and you expect it go down, then buy a Put Option with a strike price of $45.

Buy options with at least 14 days time left before expiration, but not more than 45 days. Remember, swing trades usually happen within 10 days, so you do not need a long time value - minimise what you will pay for time. However, make sure that you have enough for the swing to work!

  • Stop Loss:

When you enter you trade, set an immediate stop loss for your preferred level of loss. I prefer to set a reasonably tight 25% loss, which means that I sometimes get knocked out of a trade just before it flies. However, I prefer this to having large losses. Some people prefer looser stops, but don't go above 50%. Don't use mental stops! Set it up on your trading software, and walk away!!!! If not, you will start second guessing yourself and the whole trading process becomes emotionally based. That is not trading, that is gambling!!!!

  • Set a Profit Target

This can get a little tricky, and it gets worse if you get greedy or expect too much.

REMEMBER: set your profit target on the movement on your stock. First set your stock price target, and then calculate what your likely option price will be at that price. Your option trading broker software will have that facility, but you can also download a free options calculator here. Go to the Position Analysis section and use this to simulate your trade.

TIP: You need to know that you are buying an option when it is cheap. The best software (you really should not be without this one!) is the Volcone Analyzer Pro, which instantly tells you whether an option is expensive or cheap, based on its implied volatility. You can learn about all the greeks and fancy models if you like the intellectual challenge, but this one does it all for you!

My favourite way to set a primary profit target is to impose Bollinger bands on my stock chart. If your stock is in an uptrend, and has just started a swing out of thepivot point, then the swing usually continues up until the price touches the upper band. Similarly, if the stock is in a downtrend, look for the stock to swing out of the pivot point down to the lower Bollinger band. If the stock is in a strong uptrend or downtrend, the price will sometimes ride the Bollinger band for even further profits! However, set your primary exit for the first touch of the band.

Another way is to impose Fibonacci lines on your chart, and look for an exit when the stock hits the 50% retracement.

You can set up a trailing stop, which can be done easily with most online broker software. As the stock moves up, so will your option price, and you can set the trailing to stop to lag 25% from the high, so that when the stock dips down, you can take your profit before it goes any further. It is not bad to set a protective stop like this anyway, but when trading options, a figure like 25% can mean a large chunk of your profit.

One swing trading website recommends setting a standard 7% profit target, and a 4% stop loss, for the underlying stock on a swing trade. I am cautious about setting such rigid targets, because the market is too dynamic, and you can sometimes make a good profit and exit on a 5% move.

A popular idea is to wait until your option price has doubled in value (i.e. 100% increase). At this point, you sell 50% of the option, so that your original investment is protected. Then you can let the remaining option run up even further.

NOTE: It is always best to take some good profit early rather than try to squeeze every drop of profit out and run the risk of your stock pulling back and killing your investment. It sometimes happens that the stock will continue riding the trend wave, but don't kick yourself if you got out early. Be happy with the profit you have taken and move on to the next trade.

SOME TIPS:

  • It is a good idea to set up your trade before the market opens. The first 30 minutes of trading are often pretty wild and irrational, so don't get caught in the early frenzy.
  • Once you have set an entry, never chase the price - if you missed it, move on! Otherwise you will be trading into your potential profit.
  • Before entering a trade, look about two weeks ahead. If a stock has an earnings date coming up, it will often increase in price up to the earnings report. This can be very useful for options, as long as you get an entry inside the TAZ. Never, ever hold the option until after the earnings report - stock directions are totally unpredictable once a report has been issued!
  • The week before expiration is often a good time for buying calls, because the stock price often rises during that week, as traders anticipate the expiration of calls. Again, make sure that your entry is within the TAZ.
  • Never gamble, guess or hope. When you swing trade stocks, you can make a loss, but it does not have to be huge (usually in the order of 2-4%). When you buy calls and puts, you can lose 100% of your investment in a very short time. Stick to your system, and the simpler your system, the more reliable it will be. Leave complicated systems for unhappy, ulcerated day traders!
  • If your trade doesn't move within 5 days, dump it. The swing has failed, the conditions for a good entry have changed, and Time Decay will start eating into your investment. Move on to the next trade - there will always be plenty!

Stock Picking

Almost any optionable stock is useful for this simple system. You can use any of the stock scanning programmes to find suitable trades. My preferred method is to have a few stocks that I know really well, and follow them. I will keep an eye on the news and earnings season, and trade the swings. Index options (QQQQ, DIA and SPY) are always good, because they are not as wild as individual stocks. Profits are possibly not as thrilling, but they are a lot more predictable when following a trend - swings are much easier to set up. Otherwise any of the big stocks are good, but it is important to diversify within industries.

 

 

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