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Day Trading - Swing Trading Options - Strategy and Examples

"Day Trading, Swing Trading, And Options?… Maybe!"

By Ron Ianieri

Have you ever bought a stock that you “knew” was breaking out of its trading range? Have you ever had to sell that stock out at the end of the day because you were unable to hold it overnight, only to see that exact stock gap open $2.00 the next day? Has missing this type of opportunity left you frustrated?

What about bottom fishing? Have you ever bought a stock on the way down, then had to sell it out at the end of the day for even-money or maybe a small profit… only to wake the next morning to see the stock gap open dollars up? Tired of watching these available profits hit someone else’s account instead of yours?

Too often, day traders and swing traders are forced out of these opportunities. Typical day traders and swing traders who look for stocks with quick, short term movements are not in the business of holding positions overnight, let alone a week or two. Therefore, the use of options is not a component of their trading strategies.

Now, however, new opportunities for profit are becoming available as many day trading firms are allowing their traders to trade options. Unfortunately, many option strategies do not apply to the quick in and out nature of day trading or swing trading.

For instance, neither day traders or swing traders are normally in a single stock long enough for the strategy of premium collection. However, there is a strategy that will provide the protection necessary for these traders to carry positions through overnight risk, fully protected, but still allow them to take optimum advantage of the two scenarios mentioned above.

As a result, you can now put dollars in your own pocket instead of watching them go to somebody else, and do so without putting your firm’s capital at risk overnight. This particular strategy is a premium purchasing strategy. It can allow day traders and swing traders the capital security to exploit two potentially explosive profit scenarios … breakouts and bottom fishing.

Since day traders and swing traders have had no reason to deal with options until now, we’ll explain options, detail a specific option strategy, and give examples of when it can be used and the outcomes that can be expected.

Options

Options are a wasting asset, meaning they have a limited life and lose value over time. Therefore, you want to use them quickly and then sell them out to avoid as much decay loss as possible.

There are two kinds of option philosophies: premium collecting (selling options) and premium purchasing (buying options). The latter may fit into some of the strategies used by day traders and swing traders. There are several premium purchasing strategies, and each can be used in several ways.

Some are very sophisticated and take time and effort to master. Others, like the protective put, are not as sophisticated and can be learned and implemented in a reasonably short amount of time. Strategies like the protective put require a rudimentary understanding of options, as opposed to time intensive expertise.

This is because the protective put strategy is purely defensive in nature. It functions as strict hedging, not profit capturing. Profit capturing can involve more risk than a hedging position, and requires a greater level of knowledge. In the case of the protective put, the determination of when to use it is the crucial element for its success. With our focus on breakouts and bottom fishing, the “Protective Put” is the strategy we‘ll detail.

THE PROTECTIVE PUT

The Protective Put, also referred to as the “married put,” the “puts and stock” or “bullets,” is a strategy that is ideal for a trader who wants full hedging coverage. This strategy is very effective with stocks that normally trade under high volatility or stocks that may be involved in an event-driven, high-volatility situation.

The put option gives the owner of the option the right, but not the obligation, to sell a certain stock, at a certain price, by a specified date. For this right, the owner pays a premium. The buyer, who receives the premium, is obligated to take delivery of the stock should the owner wish to sell at the strike price by the specified date. A put, strategically used, offers protection against substantial loss since the stock will be taken by the buyer before heavy losses set in.

The Protective Put Strategy involves the purchase of put options in conjunction with the purchase of stock and, as stated above, works well in situations where a stock is prone to rapid, volatile movements.

For day traders and swing traders, this strategy can allow the capital security to exploit two potentially explosive profit scenarios…. breakouts and bottom fishing. These two opportunities can be very profitable but also very dangerous. With these two scenarios, timing is the key element. Enormous profits can be had if your timing is right.

However, if the timing is wrong, the effects can be devastating. If a trader can take advantage of the full profit potential of these two scenarios without having the full risk associated with them, logic dictates that the trader stands a much better chance of seeing a substantial profit.

BUYING THE PUT

When traders purchase a stock that they expect will make a sudden upward move, they can buy the put (protective put) to provide a proper hedge. The construction of this position is actually quite simple. You buy the stock and you buy the put in a one-to-one ratio, meaning one put for every one hundred shares. Remember, one option contract is worth 100 shares. So, if 400 shares of IBM are purchased, then you would purchase exactly four puts.

From a premium standpoint, we must keep in mind that by purchasing an option, we are paying out money. This means that our position must “outperform” the amount of money that we paid out for the put.

If the put costs $1.00, then the stock would have to increase in price by $1.00 just to break even. The protective put strategy has time premium working against it, thus the stock needs to move up to a greater degree and more quickly to offset the cost of the put.

However, the price of the put can be adjusted depending on whether it is at-the- money or out-of-the-money. The choice of whether to purchase the at-the-money put or an out-of-the-money put simply comes down to how much protection you want to have versus the amount of money you want to spend. If you are willing to spend more money for your protective put in order for it to start providing downside protection at an earlier price, then you may want to buy the at-the- money put.

However, if you are willing to accept a little more downside risk in order to save money on your put purchase, then you may want to buy an out-of-the-money put instead. It will cost less than the at-the-money put but it will start its protection at a lower price, which means you will lose more money if the stock moves in the adverse direction.

HOW THE PUT WILL PERFORM

Let's take a look at the risks and rewards of the protective put strategy over three different scenarios. When we buy a stock, three potential outcomes exist. The stock can go up, go down, or remain stagnant.

Let's hypothesize results across these three scenarios. Say we buy the stock for $31.00 and buy the 30 strike put for $1.00. In the up scenario, we set the stock price up at $31.50. The results are that we have a $.50 gain from capital appreciation and a $1.00 loss from the purchase of the put, which when combined, gives us a $.50 loss overall.

It is important to realize that the up scenario will only produce a positive return if the stock gain is greater than the amount paid for the put. This being the case, you calculate the breakeven point for the protective put strategy by adding the purchase price of the stock to the price of the put. In our up scenario, add the stock price of $31.00 plus the option price of $1.00, and you get a breakeven of

$32.00. So, until the stock reaches $32.00, the position will not produce a positive return. Above $32.00, the position will gain.

In the stagnant scenario, the position will produce a loss. Since the stock hasn’t moved, there will be no capital gain or loss. Also, with the stock at $31.00 at expiration, the puts are worthless. The position lost $1.00, which is the amount you paid for the puts.

In the down scenario, the position will again produce a loss. Setting the stock at $30.00, down a dollar, we have a $1.00 capital loss. With the stock at $30.00, the 30 strike puts will be worthless, thus you incur a $1.00 loss because that is what you paid for them. Your total loss will be $2.00.

However, in any down scenario, the protective put will set a cap on your losses. Let’s see how that works. We’ll set the stock price down to $28.00. Since you purchased the stock at $31.00, there will be a capital loss of $3.00. The puts, however, are now in the money with the stock below $30.00. With the stock at $28.00, the 30 strike puts are worth $2.00. You paid $1.00 for them so you have a $1.00 profit in the puts. Combine the put profit ($1.00) with the capital loss ($3.00) and you have an overall loss of $2.00. The $2.00 loss is the maximum you can lose no matter how low the stock goes, even with the stock as low as zero. This is what is meant by maximum protection.

In every protective put position, it is possible to calculate your anticipated maximum loss. You can do so by using the following formula:

(stock price minus strike price) minus option price

For example, suppose you paid $30.00 for your stock, and you paid $1.00 for the 27.50 strike puts. Following the formula, you take your stock price ($30.00) and subtract the put’s strike price (27.50), which leaves you with $2.50. To this $2.50 loss, you then subtract the amount you spent on the option (-$1.25), which gives you a combined, maximum loss of $3.50 for this position.

This formula will work every time. Remember, stock loss (stock price paid - strike price) plus option cost equals maximum potential position loss.

Looking at the three hypothesized scenarios, we find that only the up scenario can produce a positive return, and that’s only when the stock increases more than the amount you paid for the puts. The other scenarios produced losses. If the stock is stagnant, you lose the amount you paid for the put. If the stock goes down, you lose again- but the loss is limited. It is the limiting of loss in highly volatile situations that makes the protective put an attractive and useful strategy.

PROTECTIVE PUT'S BEST SCENARIO

A stock that has the potential to rise quickly also has the potential to fall just as quickly. A stock that has substantial potential gain has an equal potential loss. A trader choosing to buy a stock like this should have more protection to the downside, and at the same time, ample allowance for a large upside potential move. This is a perfect time to use the protective put strategy. The purchase of an out-of-the-money put will be a relatively inexpensive investment, but will provide the kind of results that will best fit a bullish lean. You will have unlimited downside protection with all the room you need for your potential run up. Of course, this comes at a price. You must pay for the protection and freedom this position can provide.

The protective put strategy, when used correctly, will allow investors to take advantage of some opportunities that could provide large potential gains without being exposed to the severe risks the position would have posed without the use of protective puts

BOTTOM FISHING

Use the Protective Put in the case of a stock in the process of a steep decline. Quite often, stocks experience bad news or break down through a technical support level, and trade down to seek a new, lower trading range. Everyone wants to find the bottom in order to buy and catch the technical rebound.

Although this scenario sounds good, these types of trades are risky. The risk is in identifying the true bottom. A stock that is in a free-fall or rapid decline might give a false indication of a bottom, which could lead to substantial losses. The protective put will provide protection against this kind of substantial loss.

A stock that goes through a free-fall finally “exhausts” or works through the sellers. The stock proceeds down to lower levels where sellers are no longer interested in selling the stock.

At this level, the stock consolidates and buyers move in. Because the sellers are now done (exhausted), the pressure is lifted from the stock and it proceeds up as buyers out-number sellers.

There are models that are used to calculate where this bottom may lie, commonly referred to as “exhaustion models.” The problem is that the stock, on the way down, may stop and give the appearance of exhaustion but then continue further down. If you had bought at the false appearance of exhaustion, you could be looking at a big loss.

There is a potential for a very big reward if you pick the “right” bottom. However, with the big potential gain comes the big potential loss that is common in these types of risk/reward scenarios. Here is a perfect opportunity to employ the protective put strategy!

Remember, the protective put allows for a large potential upside with a limited, fixed downside risk. If you feel that the stock has bottomed-out and is starting to consolidate, you purchase the stock and purchase the put.

If you are right, and the stock runs back up, the stock profit will well exceed the price paid for the put. Once the stock trades back up, consolidates, and develops its new trading range, the need for the protective put is over.

Use the formula for maximum loss discussed earlier. Calculate the loss in the stock and the amount you paid for the put, and add them together for your maximum loss in this position. The protective put has limited your loss.

Maximum Loss = (Stock Price – Strike Price) – Option Price

BREAK OUTS

As seen with the exhaustion example, the protective put strategy is best used in situations where the stock has potential for an aggressive upside move and the chance of a big downside move.

Another potential opportunity for using the protective put is in combination with Technical Analysis. Technical Analysis is the study of charts, indicators oscillators, etc. Charting has proven to be more than reasonably accurate in forecasting future stock movements.

Stocks travel in cycles that can and do form repetitious patterns. These patterns are predictable and detectable by the use of any number of charts, indicators and oscillators.

Although there are many, many forms and styles of technical analysis, they all have several similarities. The one we want to focus on is the technical “break- out”. A break-out is described as a movement of the stock where its price trades quickly through and beyond an obvious “technical resistance” or resistance point.

For a bullish break-out, this level is at the very top of its present trading range. Once through that level, the stock is considered to have “broken out” of its trading range and will now often trade higher, and establish a new higher trading range.

The “break-out” is normally a rapid, large upward movement that usually offers an outstanding potential return if identified properly and acted upon in a timely fashion. However, if the break-out fails, the stock could trade back down to the bottom of the previous trading range.

If this were to happen, you would have incurred a large loss because you would have bought at the upper end of the previous trading range. As you can see, the “break-out” scenario is an opportunity that has large potential rewards, but can, on occasion, have a large downside risk.

However, if you were to apply a protective put strategy with the stock purchase, you can drastically limit your downside exposure. For instance, say you were to buy the 65 strike put for $2.00. If the stock trades up to $75.00, you would make $9.00 if done naked, but only $7.00 if done with the protective put.

This difference is the cost of the put. This $2.00 investment is more than worth it should the stock go down. If the break-out turns out to be a “false” break-out and the stock reverses and trades down, your 65 put will allow you to sell your stock out at $65.00 minus the $2.00 you paid for the put. This limits your loss to $3.00 instead of a potential $8.00 loss. This is a much better risk/reward scenario.

REMINDERS:

Use the Protective Put when you expect an aggressive, volatile, upward swing in the price of a stock.

Purchase one put for every one hundred shares owned.

Time and price the put for the maximum protection according to your risk parameters.

Choose a put that presents the best cost for the needed coverage that fits your risk tolerance.

Get out of the put quickly to diminish the effects of time decay.

Most professional traders, including day traders and swing traders can reap huge rewards from the protective put strategy. The reason is inherent in how most traders attain profits and experience losses.

Normally, successful traders make a little money on a consistent basis. They make a little bit day-in and day-out. But when it comes to losses, they lose in large chunks. They spend a month building up profits, only to lose that money in one day (and typically with only one stock). If a trader could figure out how to avoid even a handful of those large losses, then his or her profitability would soar.

To address this issue, I strongly recommend that you leverage the protective put when buying on breakouts and when bottom fishing.



Risk disclaimer:

U.S. Government Required Disclaimer - Commodity Futures Trading Commission. Trading financial instruments of any kind including options, futures and securities have large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the options, futures and stock markets. Don't trade with money you can't afford to lose. This training website is neither a solicitation nor an offer to Buy/Sell options, futures or securities. No representation is being made that any information you receive will or is likely to achieve profits or losses similar to those discussed on this website. The past performance of any trading system or methodology is not necessarily indicative of future results. Please use common sense. This site and all contents are for educational and research purposes only. Please get the advice of a competent financial advisor before investing your money in any financial instrument.

NFA and CTFC Required Disclaimers: Trading in the Foreign Exchange market is a challenging opportunity where above average returns are available for educated and experienced investors who are willing to take above average risk. However, before deciding to participate in Foreign Exchange (FX) trading, you should carefully consider your investment objectives, level of experience and risk appetite. Do not invest money you cannot afford to lose.

EARNINGS DISCLAIMER: EVERY EFFORT HAS BEEN MADE TO ACCURATELY REPRESENT THIS PRODUCT AND ITS POTENTIAL. THERE IS NO GUARANTEE THAT YOU WILL EARN ANY MONEY USING THE TECHNIQUES AND IDEAS OR SOFTWARE PROVIDED WITH THIS WEBSITE. EXAMPLES IN THIS PAGE ARE NOT TO BE INTERPRETED AS A PROMISE OR GUARANTEE OF EARNINGS.


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