So many traders start out with a sensible plan, only to abandon it because of the way the markets move. This abandonment of a smart plan invariably leads to potentially large net losses. Here are five thoughts about how underlying price changes can be timed and exploited:
- Pick long calls or short puts after the downside swing. This means you enter the long position on sessions when the price drops so it is at or near support. Stocks tend to follow the broader market, so when an otherwise well-managed quality stock falls several points, you know it is part of the index drop and not a problem for the company alone. This may be the best time to buy a call or sell a put for a fast swing trade turnaround. However, also look for strong reversal signals and confirmation. These show up as candlestick reversals, double bottoms, inverse head and shoulders, gaps below support, volume spikes, or momentum moving into oversold.
- Buy puts or sell calls after the upside swing. Prices often rise just as irrationally as they fall. So when the index values jump sharply, stocks tend to go along for the ride; but you may see a retreat in the following two or three sessions. When the overall market prices rise quickly, buy puts on the upside swing, anticipating a drop back to “normal” levels of trading. This is smart timing to open covered calls or long puts. When you sell calls at the top, build in a buffer zone to avoid going in the money. Rely on reversal signals and confirmation to time this move, especially when you see big gaps above resistance, confirmed by volume spikes or candlestick reversals.
- Be aware of earnings dates. When earnings surprises pop up, stock prices often overreact, only to return to “normal” trading within a few sessions. This presents an opportunity for swing trading with options. At such times, avoid short positions because you do not know which direction the surprise will take prices. A low-cost long straddle or spread could make the most sense when timed just before earnings surprises.
- Be aware of collateral requirements and time trades on the short side with this in mind. Use buffers between current price and lower put strikes or higher call strikes to increase manageability of unexpected price swings. The buffer is especially effective on higher-priced stocks or indexes, but this also translates into higher collateral.
- Be aware of the “weekend effect” on options expiring the following Friday. From the Friday a week before last trading day, to Monday (three calendar days, but only one trading day), options tend to lose about one-third of time value. So timing for short positions opened on Friday increases profitability.