7 Reasons Short Options Aren't That Risky

04/24/2014 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Swing trading relies on your ability to time your entry and exit, which is why you need the best reversal indicators and confirmation, says Michael Thomsett of ThomsettOptions.com.

Selling short options as part of a swing trading strategy is a higher-risk strategy than the opposite focus on long options only, although the degree of risk might not be as severe as you think at first glance. This is true for seven reasons:

  1. You can cover the short call with ownership of stock. In this case, you combine a covered call strategy with an uncovered put.

  2. The short put risk is not as severe as the short call risk, especially on lower-priced stocks, where the distance between strike and tangible book value per share is lower than for higher-priced stock. If you time entry and exit with one eye on the volatility of the positions, you can also make your swing play a volatility play.

  3. Applying reversal signal use with strong confirmation vastly improves timing, so the risk of short-option swing trading can be much lower than just selling uncovered options.

  4. The question every option trader has to ask: Is the option risk greater than the market risk of stock ownership? This often leads to a realization that uncovered options are actually a leveraged form of market risk exposure; it often is a more substantial risk, especially on the short call side, but if you accept that risk knowing its extent, then swing trading with options makes sense.

  5. Risk exposure is somewhat mitigated by option premium. In the short strategy, you are receiving income when you open short calls or puts, so profits are taken by a buy to close order, or by waiting out expiration. Given the fact that profits are difficult for long positions due to time decay, the same decay works in your advantage when you sell.

  6. Risk exposure is further limited by picking the right strike proximity. Clearly, you don’t want to sell options deep in-the-money, and even those at-the-money are quite risky. But at the right moment in the option cycle (within one month of expiration, for example) slightly out-of-the-money strikes can produce desirable returns. Remember that these positions are ideally open for only a few days, so the annualized return can be very nice, especially if you are executing swings in and out of several stock positions and quite frequently.

  7. Candlestick reversals. The candlestick chart is one of the most important of technical tools. Dozens of reversal signals involving one, two, or three sessions are likely to lead to better than average timing of both entry and exit. Swing traders benefit greatly by using these.

Swing trading relies on your ability to time entry and exit, and this is why you need the best reversal indicators and confirmation. A disconnect is found, however, among swing traders using stock vs. options. Options people tend to rely exclusively on implied volatility tests before deciding to trade positions, and may easily overlook the great value to the seven ranges of reversal indicators above.

On the downside, uncovered short options require collateral equal to 100% of the strike. So if you open a 50 naked option, you must have at least $5,000 on deposit in your margin account. Many traders have adequate funds for a limited swing trading program, but this requirement also limits how much exposure you can adopt in your swing trading program. For example, if you want to open 10 of the 50 strikes, you need $50,000 to satisfy the collateral requirement.

Options used for swing trading allows great leverage and reduced risk. However, the most powerful swing trading system combines ATM or slightly ITM soon-to-expire options, with the full range of reversal signals. These two in combination—and based on smart confirmation steps—greatly increases the rate of success in a swing trading program.

By Michael Thomsett of ThomsettOptions.com

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