Swing Trading Options - Part 1

Buying calls and puts are the most basic options strategies, and Markus Heitkoetter of Rockwell Trading explains the nuts and bolts below.

Lately, I've been getting a lot of questions around swing trading options.

When swing trading options, there are two basic approaches:
You can BUY options, or
You can SELL options

Both approaches have pros and cons, and in this blog post we will focus on buying options.

Buying Options
There are two main reasons why a trader considers buying options:

Reason 1 For Buying Options: "Home Run Trades"
You are trying to buy a so-called "out-of-the-money" call or put option cheap-often only a few cents-and hope for an explosive move in your direction. If this happens and the option gets "in-the-money," you can easily double, triple, or even quadruple your money.

Here's an example:
As I am writing this blog post, AAPL is trading around $440. If you think that AAPL will move $40 and trade at $480 in the next three weeks, you could buy a call option with a strike price of $475 and 18 days to expiration (slightly less than three weeks). The option is currently trading at $1.24, and since you have to buy options in multiples of 100, you would pay only $124.

If AAPL stays below $475 until the expiration, then you lose all of your investment-a whopping $124. But if AAPL is moving to $480, then your option will be worth at least $5. Since you bought 100, you would make $500 - $124 = $376.

That's more than 300%! And if AAPL keeps moving high, you could make even more.

The problem: The odds are against you. Even though it is possible that AAPL makes an explosive move from $440 to $480 in only 18 days, it might not happen and you lose your initial investment. However, as you can see only ONE of these trades needs to work in your favor to give you a very nice return.

Reason 2 For Buying Options: "Buying Stocks Cheap"
You want to buy a stock, but your account is rather small and you don't have enough money to buy the stock.

Here's an example:
Let's say you would like to buy 100 shares of AAPL. The stock is trading at $440, so you need at least $44,000 to buy 100 shares. If AAPL is then trading from $440 to $450, you would make $10 * 100 shares = $1,000. That's 2% based on your $44,000 investment.

If you are trading options, you can simply buy an "in-the-money" call option with a strike price of $435. The option is currently priced at $10.30 and has a "delta" of 0.60. This means that for every dollar that the stock moves, the option only moves $0.60. If the option had a delta of 0.5, it would move $0.50 for every dollar that the underlying stock moves.

NEXT PAGE: Advantages of Swing Trading Options

The delta should increase in your favor as AAPL is trading higher, but let's keep in simple: Let's say AAPL moves $10 from $440 to $450. You bought one option for $10.30 * 100 = $1,030 (instead of $44,000 for buying the stock outright). Note: one option contract represents 100 shares of the underlying stock or ETF.

In our example, the stock is moving $10, so the option price should move $6.00 (at this point we won't consider factors like "time decay" to keep it simple).

So your initial investment of $1,030 is now worth $1,630. That's $600 based on an initial investment of $1,030, i.e. 58%.

The problem: The so-called "time-decay" of an option. The price of an option consists of a "intrinsic (real) value" and a "extrinsic (time) value." The "intrinsic value" is the difference between the stock price and the strike price of the option. In our example, the stock price is $440 and the strike price is $435. Therefore the "intrinsic value" of the option is $440 - $435 = $5.

Since the option is trading at $10.30, the difference between the price of the option and the "intrinsic (real) value" is the "extrinsic (time) value". In our example, it's $10.30 - $5.00 = $5.30. As we are getting closer to the expiration date of an option, the "time value" will decrease, reaching ZERO at expiration.

If in a worst-case scenario, AAPL makes the jump from $440 to $450 the day the option expires, then your option would only be worth $1,500. You would still make money, but as you can see, time is working against you.

The advantage: If AAPL moves against you, then your loss is limited. You can't lose more than the $1,030 that you paid for the option. However, if you owned the stock outright, then you can lose much more than $1,030! Therefore trading options can help you limiting your risk.

Summary
As you can see, swing trading options has three main advantages:

• You could multiply your initial investment if the underlying stock moves in the right direction
  
• You can trade "expensive" stocks with a rather small account
  
• You can limit your risk

Note: Buying calls and puts are the most basic options strategies, and in the next part we'll talk about selling options, first, before we then talk about more advanced options trading strategies.

By Markus Heitkoetter, Founder and CEO, Rockwell Trading