Selling short options as part of a swing trading strategy is a higher-risk strategy than the opposite focus on long options only; but the degree of risk might not be as severe as you think at first glance. This is true for seven reasons:
- You can cover the short call with ownership of stock. When you combine a covered call strategy with an uncovered put, you have a conservative short strategy, since the call is covered, and the short put has the same market risk as the covered call.
- 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.
- 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.
- The question every option trader must ask: Is the option risk greater than the market risk of stock ownership? This often leads to a realization that uncovered options are 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.
- Risk exposure is mitigated by option premium. In the short strategy, you are receiving income when you open short calls or puts, so profits are taken with 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.
- Risk exposure is further limited by picking the right strike proximity. Clearly, you don’t want to sell options deep in the money. 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 attractive, especially if you are executing swings in and out of several stock positions.
- 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 therefore you need the best reversal indicators and confirmation. A disconnect is found, however, among swing traders using stock and option traders. Options people tend to rely exclusively on implied volatility tests before deciding to trade positions and may easily overlook the great value to the six ranges of reversal indicators above.
On the downside, uncovered short options require collateral on deposit in the margin account. To learn more about collateral, download the free CBOE Margin Manual at CBOE Margin Manual
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.