Swing trading is going to depend on the movement and change in stock prices. Even if you end up trading options on a stock, you will continue to rely on setup in the stock price to time your trades. This is true be-cause option premium levels may change in ways separate from stock prices. Time value itself—the portion not specifically restricted to time, but including proximity and investor interest—can and does move in ways not related to actual changes in the stock itself.
So, if your swing trading strategy involves the use of options, you will do best when you track the stock and make decisions based on setup
Some people view short selling as sophisticated and high-level in terms of investor “smarts.” In fact, you reduce risks when you use long puts instead of shorting stock, and it requires much less capital.
Key Point
trends; and then make your trades using the related options. The guide-lines continue to apply: The options you pick should be short-term, as close as possible to strike price, and in the money.
The question of how to pick stocks for swing trading should de-pend on the same criteria as you use when your strategy involves buying or selling shares. Picking swing trade stocks based on the relative value of options is a mistake. Option pricing reflects varying degrees of change in time value premium or, to be more precise, extrinsic value of those op-tions. Because this value has nothing to do with the relationship between stock market value and option premium value, it is dangerous to pick stocks based on option values. The extrinsic valuation of options relates more to investor perceptions about companies than actual value.
If you go back to swing trading basics, you will recall that swing trading is a method for capitalizing on the emotions that rule the market:
greed, fear and uncertainty. The cool-headed swing trader, recognizing which emotion is ruling at the moment, times trades to profit from the emotional over-reaction between buyers and sellers. So variations in an option’s extrinsic value have to be viewed as yet another aspect of this same phenomenon. The market is ruled by emotions, which are seen in short-term stock price movement and in the distortion of option pre-mium value.
This is a profound bit of market intelligence. The emotional actions and reactions of the market are not limited to stock prices, but include option premium value as well. Intrinsic value is an absolute, representing one point for each point in the money. Time value or, more accurately, extrinsic value is far more complex and troubling for you as a swing trader. This is why it is so important to remember the guideline: Track stock prices but trade options.
S t o c k S e l e c t i o n v e r s u s O p t i o n s 165
Just as emotions rule the markets in short-term stock price move-ment, they also affect extrinsic value of options. Knowing this gives you a great advantage in using options for swing trading.
Key Point
Nothing changes as far as following trends and looking for buy and sell setups. The only difference is the use of long calls in place of long stock; and the use of long puts in place of short stock.
Option traders eventually learn that simply picking options to buy or sell is an expensive approach to the market. They are better off picking stocks based on sound analysis and comparison of risks. The same rule applies to swing traders. The decision about which stocks to include or exclude should be based on a traditional analysis of a range of stocks, and development of a short list of criteria. These should include position of the 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 divi-dends. These are simply examples of methods you can use to narrow your list of likely swing trading stocks from thousands, down to less than 20 stocks. If you go long or short in stocks, you are likely to be able to swing trade in only a handful of stocks; with options, you can easily con-sider a range of 20 stocks and perhaps even more.
You may also use technical considerations to pick appropriate stocks. The criteria for swing trading are a good match for options crite-ria. Technical analysis includes comparisons of the trading range and his-torical volatility; you need and want stocks that are moderately volatile to create strong setup signals for swing trading. Those same stocks also tend to exhibit a healthy range of options and premium values.
However, one thing is sure about time value. When the option is within two to four weeks of expiration, the time value premium rapidly declines to zero. This occurs even when the extrinsic factors remain in play. So investor interest and proximity between strike price and market value may play a role right up to the week preceding expiration; but from your swing trading point of view, expiration will ultimately mean that the option premium is going to consist primarily of intrinsic value.
You need to divide time value into two components: time itself and other extrinsic factors. It is certain, however, that as expira-tion nears all forms of non-intrinsic value will evaporate from the option premium.
Key Point
To get an idea of how critical the timing of expiration is, review some option listings that are about to expire. Even those with strike prices within a few points of market value will have very little value right before expira-tion, often only 0.05, which is five dollars. This is only a token value serv-ing the purpose of givserv-ing some minimal value to the option because it remains alive, if only for a few days. Few speculators will invest in such op-tions because they are about to expire and they are out of the money. It is certainly possible that the stock will surge in the last minute and the option will move suddenly in the money, creating some last-minute profit. This is the exception rather than the rule. From a swing trading perspective, even in-the-money options on the verge of expiration have very little time value remaining. This is your great advantage. By limiting your swing trading to the appropriate placed options, you pay primarily for that intrinsic value, and you are more likely to see the point-for-point movement in value that makes options so desirable for swing trading.