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Option Trading for the Day and Swing Trader
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Use of option trading is the best when the volatility is at high levels and the stop
loss point on a particular stock is about the same price as the cost of an option.
In this manner, if an options position is used instead of a stock position, even if
the trade goes wrong, the swing trader will have a second chance. Also, it's not
how expensive or undervalued the option is relative to the Black-Scholes model
that makes the option attractive or not, it is getting the direction right regardless
of the price of the option. Both of these theories underpins our day and
swing trading strategies.
Our first definition of "call options" is a contract giving the holder the right to
buy 100 shares of the underlying security within a certain time frame. The concept
is like leasing a car or the underlying security. You have the right to buy this
car at the end of the term so instead of paying the whole car up front, you pay it
to the financing company by monthly installments. This is analogous to buying a call
option on IBM for 30 days instead of buying 100 shares of the stock. Your car lease
expires at the end of the term and just like an option, you may exercise it,
(buy the car or buy the stock), or just let it expire, (give back the car or do
nothing on the options side.) It is that simple.
"Put options" are the opposite as it gives you the right to sell 100 shares of the
underlying stock also within a certain time frame and at a certain price. This is
like term insurance in that if the stock falls below this price, (called "strike
price"), you will be guaranteed to sell at your strike price. Obviously the shorter
the time you buy protection, the cheaper you pay. A one month premium is less
expensive than two months and so on. Theoretically, if you want downside protection
for an infinite time frame, then the premium will equal the price of the shorted stock.
Both these definitions are for buying calls and puts as the buyer has the right to
exercise or sell their options at any time prior to the options expiration, (the period
one has purchased for.) On the flip side, someone has sold these options to you.
The seller is "obligated" or will guaranteed the other side of the trade. So if you
happened to buy an Intel Nov 25 call option giving you the right to buy 100 shares of
Intel at $25 till the third Friday of November, the person that sold you this option has
to sell you this 100 shares at $25 at any time you come knocking prior or on the
expiration date, (which is once again, the third Friday of the contract month which
in this case is November.) Please remember that a buyer has the right while a
seller is obligated as this is a very important distinction.
Option pricing depends on several factors. The first factor is time. The longer the
time, the more expensive it is. An option with a one year expiration cost more than
a one week option. Just as you lease a car for a year, the payments will be more than
leasing it for a week.
The second thing to know about option trading is the strike price. The further away
the strike price is from the stock price, the less expensive it is. You will pay more if
you buy an option giving you the right to purchase 100 shares at $25 when the stock is
at $25 than if you buy an option giving you the right to buy at $30 with the stock
at the same $25 level. This is analogous to renting a house with a right to buy.
If the house is worth $300,000 and your right to buy is at $300,000, then your option
is a lot more expensive than if your option gave you the right to buy at $600,000. The
reason is that at $300,000 the house could appreciate much quicker, (hence option price
goes up), while to get to $600,000 could take a couple of years. And who knows, maybe
the time will run out or expire if your option is only good for a year. And similarly,
a put option with a lower strike than the market price will cost less than one that
is closer to the market price. If someone guarantees to buy your car for $1000 while
the car is worth $10,000, this option wouldn't be worth much. After all, we all know
the car's value cannot drop that fast. But the option that will cost a lot more is
one that allows you to sell your car at $10,000. It is only fair that the cost is
higher as you have the flexibility to sell your car or keep it during this time frame.
And the third factor is the volatility, (beta), of the stock. The higher the volatility,
the more expensive the option. Insuring waterfront property in a hurricane area will cost
more than a ranch in Montana. The options on a utility company that hardly moves is much
cheaper than a comparable option in both time and strike of a dotcom stock as movement with
the latter could be a 10% move in one day while the utility stock could take one
year for a similar move. So if money could be made faster, the option will cost more.
These are the basis for option trading.
A strategy that is considered conservative in option trading is by selling put options
or being "naked" puts. As you can remember, buying puts gives you the right to
sell 100 shares of stock at a certain strike price within a certain time frame. The
seller of these put options that you have bought are "obliged" to buy these shares
whenever you decide to exercise this right. For this bullish obligation, (since
they are ultimately buyers of stock), they receive a premium which they pocket. Let's
say that INTC's price is 25.00 and has a 52-week range of 18.75 to 27.54. Suppose that
we think that the stock is currently consolidating and prices might take several weeks
to move higher. Then by selling puts, we can try to buy it at a discount to the prevailing
market price. We can sell the Nov 25 puts uncovered or "naked" for $1.25. We are then
obliged to buy the stock at 25 but minus the 1.25 premium that we just received which
gives us a cost of 23.75 if we were exercised. If the stock is above 25 at expiration,
then we have only made $1.25 because who would sell it at 25 when the market price is
higher? But if the stock is below 25 and above 23.75, then we would be obliged to buy
the stock and have a better cost price than 25.00. A close at expiration of 25 would
yield our maximum profit potential. Obviously, if the stock descends past 23.75, we would
be losers and that brings us back to getting the direction right in the first place.
Naked puts would have given us a better cost than by buying at 25.00 a month before.
In option trading, both covered call writing and selling puts are not considered risky
strategies as you are sellers in both cases and only have the same downside risk as in
owing the stock.
"Day Trader" and "Swing Trader" uses option trading during the earnings reporting
period. If the earnings beats the analysts' estimates by wide margins and gets
some before-the-opening upgrades, selling naked puts is a viable strategy along with
being long the stock. If the stock continues higher, the put value depreciates. But
if the stock goes down, the cost is buffered with the premium received on the sale.
D E F I N I T I O N S
HVD: High Volume Day
Niagra: HVD Decline
BUG: HVD Rise
LRD: Long Range Day
NRD: Narrow Range Day
H&R: Hit & Run; Proprietary Bottom Fishing Signals
TFTF: "Too Far Too Fast" Trade Setups
Midpoints: Daily High and Low divided by Two
no-man's land: When a stock is between its TFTF and Midpoints
noise of the trade: The wiggle of a trade around the entry price
decisive break: A long vector that breaks out of a consolidation with
a high and low that corresponds to the opening and close, (or vice versa for bullish markets.)
Scratch trade: Plus or minus $0.25 cents
Revised Stops: If a stock opens at or higher than current stops on longs,
revised stops will be half a point added to the opening price. (Opposite for shorts.)
Oops! Trade: Big cap, big news, and big gap opening. Buy or Sell
on any reversal once the gap is closed at the previous day's close.
S&P 500 Futures: www.cme.com (go to: Delayed Intraday Quotes)
Nasdaq 100 Futures: www.cme.com (go to: Delayed Intraday Quotes)
VIX Market Volatility Index: Click for VIX quote
Nasdaq Volatility Index: QQV Explained
Market capitalization: Multiply the outstanding shares by its market price
Stops, Stop Limits, and other trading terms:
NYSE Glossary (and click on the "Glossary"
button)
Terms and definitions such as
HVD, LRD, H&R, TFTF are Copyright © 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007 daytrader1.com™.
Charts used for illustration purposes are Copyright © 2002 2003 2004 2005 2006 Quote.com LLC.
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