Time to expiration, and cost of the option - these are the two factors every options traders struggles with and has to balance. Close to expiration, it's difficult to get the kind of price movement you need for profits, given offsetting time decay. Far from expiration, option premium is quite high.
Close-to-expiration options are quite advantageous for swing trading, however. If you use ATM or even slightly ITM contracts, you get the best of both worlds: high leverage with low cost.
Swing traders usually employ shares of stock to play short-term price movement. Long stock is bought at the bottom of the swing and sold at the top; and shorted stock is sold at the top of the swing and then bought to close at the bottom.
Because shorting stock is expensive and risky, many swing traders only play the upswing side, meaning they miss out on half of all swings. Options solve this problem. In its most basic form, long calls and long puts provide low risk and high leverage, also letting you play upswings and downswings. Risk is limited to the relatively low cost of each option.
Because swing trading is based on a three- to five-day short-term price movement, soon-to-expire ATM options are ideal. If expiration is going to take place within a couple of weeks,. Most of the time value is gone and option premium value is most likely to mirror stock movement in the money.
The strategy is based on the observation that in general, the market over-reacts to news. So if an earnings report is short by one penny, a stock might lose three or four points. Equally, if the earnings come in five cents above, prices could soar. But in both cases, the price move only lasts a day or two before giving back some of the move. This is where swing traders can do well. Recognizing the greed and panic in the market, swing traders remain cool and collected, and play off the exaggerated price movements caused by crowd mentality.
The tendency to overreact is the key to swing trading. Traders who swing trade work opposite of the majority and take advantage of the emotional way others trade. They look for clear reversals of four types:
1. Narrow-range days (NRDs), those days with little or no distance between open and close. The NRD often shows up after a short-term uptrend or downtrend, and often precedes a sharp reversal.
2. Reversal days, those sessions that go up after three or more down days, or that go down after three or more up days.
3. Volume spikes, days in which the trading volume is abnormally high. This is a sign that something is changing, usually the direction of price.
4. Price gaps. Gaps in one direction often signal a new move in the same direction.
When any two of these signals happen at the same time, it is a strong reversal signal. This is made even stronger when the turnaround is near resistance (for uptrends about to turn) or support (for downtrends about to turn).
Options close to expiration deserve a close look. Anyone trading options should know exactly how they work; however, options provide many benefits and expose you to potentially fast profits for very little risk.
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