Options: Four Ways To Exploit Price Changes

SPCFD:SPX   S&P 500 Index
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 may lead to potentially large net 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-to-open a long option, you should know going in that 75% of options held until expiration will expire worthless, so setting goals to sell and close make sense. These goals include getting out of the position before expiration, whether at a profit or a loss.

For example, you buy-to-open a long option for 4.00 per share ($400) and set the following two goals: Sell when net value grows to 6.00 or above, representing a 50% profit; or sell when the value falls to 3.00 or below, a 25% loss. You know going in that time decay works against you, so you face the strong possibility of incurring losses. This means you have to select long options with some additional goals:

1. Buy calls or sell 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.

2. Buy puts or sell calls after the upside swing. This suggestion does not contradict the one before. It is the opposite. Prices may 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 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, it also reduces risk if you own shares so that those option short positions are covered.

3. Be aware of earnings dates. When earnings surprises occur, 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 announcements.

4. 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, is a valuable technical factor in identifying how stock prices react to market movement.
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