Swing pricing avoids decay

September 28, 2015 09:00 AM

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 small added gains, but large added losses.

In entering a trade, it is sensible to set two goals: The point where profits will be taken, and the bail-out point where losses will be cut. If you buy a long option, you should know going in that 75% of options expire worthless, so setting goals to sell and close make sense.

This does not mean that 75% of long options will lose, because a majority will be closed or exercised before expiration. Even so, the closer to expiration, the more accelerated the time decay, so taking profits or cutting losses determines how well you will end up. According to the Chicago Board Options Exchange (CBOE), the actual numbers are quite different. About 55% to 60% of all options are closed before expiration, and another 10% are exercised. This means that only 30% to 35% of all options are likely to expire worthless. The big question is: How many of the early closed options are profitable? This depends on whether or not you take profits or cut losses when you are able to. Because too many long option holders do not act in time, they are likely to lose. 

For example, you buy a long option position for 4 ($400) and set the following two goals: sell when net value grows to 6 or above (representing a 50% profit) or sell when the value falls to 3 or below (a 25% loss). You know going in that time decay works against you, so you face the possibility of incurring losses from which recovery is unlikely. This means you have to select long options with some additional goals:

  1. Pick long calls at the downside swing: Enter the long position on sessions when the market drops dramatically. Stocks tend to follow the broader market, so when an otherwise well-managed quality stock falls several points, you know it is not always a factor of the company. This may be the best time to buy a call for a fast swing trade turnaround, especially following a negative earnings surprise (see “Bear trap”). At such times an over-reaction takes the stock down on the announcement session, but prices tend to recover within two to three sessions.
  2. Pick long puts at the upside swing: This suggestion does not contradict the one before. It is the opposite. Prices often rise just as irrationally as they fall, especially after a positive earnings surprise. When the 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 overall market prices rise quickly, buy puts on the upside swing, anticipating a drop back to “normal” levels of trading.
  3. Know your stock beforehand: Every stock exhibits particular trading tendencies and rhythms. Some tend to over-react to broader markets while others hardly react at all. This tendency, called beta, is a valuable technical factor in identifying how stock prices react to market movement. Stocks may tend to exaggerate news as well. For example, a disappointing earnings report of only a penny per share may cause the stock price to plunge, only to get back most of its decline in the following session or two. While the volatility of a particular stock is usually priced into the options, knowing how a stock tends to act and react to earnings and broad market volatility helps the trader pick options with better market intelligence.

About the Author

Michael Thomsett is author of 11 options books and has been trading options for 35 years. He blogs at the CBOE Options Hub and several other sites.