Learning to trade sophisticated securities can both boost your returns and protect your portfolio from a decline. Not only do derivatives make great hedges for stock investments, but futures contracts allow traders to place bets on pretty much everything.

You can buy contracts based on the price of gold, oil, coffee, or even livestock. So yes, if your best insight is into the future price of cattle, you can find a trading instrument to work to your edge. 

Of course, most of us don’t have connections in the farming community, but that doesn’t mean we can’t use derivatives to our advantage. Specifically, options trading can give investors access to profits far beyond the potential of stock trading.

With a relatively small amount of capital, you can build a large brokerage balance with some well-timed buys and a little volatility. But options do carry unique risks not found in stocks and swing traders need to fully grasp these concepts before diving in.  

How to Swing Trade Options 

Swing traders take a risk no day trader likes to endure – holding overnight. Holding options overnight exposes you to the market’s biggest moves, especially if you don’t have access to pre and post-market trading.

Options are often held by long-term investors to offset stock holdings during volatile times, but swing traders using options are usually after one thing: outsized profits. Options contracts are cheap and the returns can be exponentially better than the underlying securities. 

Swing trading with options allows you to take advantage of short-term stock shocks, regardless of the depth or range. A particular stock facing a relatively minor bout of volatility could still see the value of its options skyrocket.

It’s not unusual for out-of-the-money options to triple or quadruple up overnight during the most exposive trading sessions. Additionally, swing trading options can help keep daily profit goals in line when the market trades flatter than an IHOP pancake.  

Options contracts can be purchased for a little as a few pennies depending on how far away you get from the underlying asset price, but you need to buy at least 100 contracts and purchase in multiples of 100.

The closer to “the money” (ie. current share price) you get, the more expensive the options will be. Many brokers offer commission-free options trading now, but still charge a fee per contract or side. 

Options traders still have to abide by pattern day trader rules with accounts valued under $25,000. Pattern day trader rules are enforced by brokers and they won’t allow you more than three day trades in a five day period if capital requirements aren’t met.

But if you’re swing trading, you’ll negate this rule by holding positions overnight. Swing traders do still have to worry about Good Faith Violations if they buy and sell options with unsettled funds.

Picking a Side 

The two types of options contracts are calls and puts.

Buying a call option provides a trader with the option to ‘call on’ shares should the underlying security reach a certain pre-set price.

A put option is the exact opposite – purchasing a put allows a trader to ‘put’ the shares on their counterparty (usually their broker) should the underlying security hit that pre-set price.

You can also write options for other investors to buy, but these strategies are usually used to hedge stock holdings. Writing options opens you up to potentially unlimited losses while buying options limits losses to the premium only. 

If you think a certain stock is going to decline in the short-term, you’d look to buy a put option that’s out-of-the-money (OTM). An OTM option, whether a call or a put, means the strike price has yet to be reached by the underlying asset.

If you buy a 20 BAC put when shares are trading at $25, your put is considered out of the money.

Likewise, a 30 BAC call option is out of the money when shares are trading at $25. In-the-money (ITM) options can be used in certain complex hedging strategies, but swing traders usually concentrate on OTM options. 

How to swing trade options

BAC Option Chain

Here’s an easy starting point to remember – buy calls if you think the underlying stock is going up and puts if you think the underlying stock is going down.

You’ll need to identify a trend in a certain stock just like trading normal shares. Using technical analysis can pinpoint trends and help identify good places to execute trades.

If you think a stock in a downtrend will continue to move down, buy puts. If you think the downward trend will reverse, buy calls. Once you’ve established whether you want calls or puts, you can move on to choosing a strike price and expiration date. 

For further info on options you can check out our essential options trading guide.

Choosing Expiration and Strike Price 

One of the tricky things about executing options trades is you not only need to guess the right direction, but the stock needs to move that way within a certain timeframe. When buying options, you’ll need to decide on a strike price and expiration date.  

  • Strike Price – The price at which the buyer of the option has the right to purchase the underlying security. Note that the option buyer doesn’t have to execute at the strike price – that’s why they’re called options. Options get more expensive the closer the strike price gets to the actual price of the underlying asset. If a strike price is reached, the option is said to be ‘in the money’. 
  • Expiration – Options trading is difficult due to the time value of the contract combining with the intrinsic value of the underlying security. Being right and being on time entitles you to greater rewards with options, but you need to pick the proper expiration for your trading strategy. All options lose value as they approach expiration and will expire worthless if the strike price isn’t reached. 

If you think a stock is heading for a heavy short-term decline, choosing a put option with an expiration close to the current date isn’t a bad idea.

If you think short-term declines will eventually turn into long-term gains, a call option dated several weeks or even months until the future will be your best bet.  

Remember, you can sell your options before they reach their expiration and you aren’t obligated to buy the underlying shares at any time.

A large majority of options will expire completely worthless, but that’s okay since we aren’t looking to execute contracts when swing trading.

Most of your profits will come from buying low and selling high, just like trading stocks. Just always be cognizant of your strike price and expiration date. Big gains can be missed if you don’t pay close attention. 

Examples of Option Swing Trades 

When your options are ‘in the money’, you’ll be able to exercise the contracts and purchase shares at the strike price.

Here’s a basic example: if you buy 25 BAC calls and the stock price rises from $22 to $29, you have the right (but not obligation) to purchase BAC shares at that $25 strike price.

The benefits of this are obvious – you’re buying a stock for $25 when it currently trades at $29. Since options contracts are sold in batches of 100, exercising a 25 BAC call option here nets a gain of $400. 

Since most swing traders won’t be exercising their options, here’s a more pertinent example. Let’s say you predict that oil price wars are imminent and want to profit off the short-term decline in the price of oil.

The US Oil Fund (USO) ETF is currently trading at $8.50 and you think the drop will be harsh, so you buy USO puts with a strike price of $6.50 and an expiration two weeks out. Since these puts are far ‘out of the money’, they only cost a few cents.

You purchase 10,000 contracts priced at 4 cents apiece – this $400 initial purchase is your premium and the maximum you can lose on the trade. The next day, oil prices crash and USO drops from $8.50 to $6.75.

You haven’t hit your strike price yet, but your 4 cent options are now priced at 40 cents – a 1000% gain. Your initial $400 investment is now worth $4,000, so you quickly sell the 10000 contracts and close the trade. 

Now the flipside: you think bank stocks have been unnecessarily punished by the shocks to oil prices. BAC shares decline from $35 to $22 in quick fashion, but you’re pretty certain the pain won’t last.

However, you aren’t sure when the rebound will occur and don’t want to hold BAC shares long-term. In this scenario, you could buy 35 BAC call options dated out a full 12 months.

Long-dated options hold their value with more steadiness since there’s so much time until expiration, but you can still profit from short-term price jumps.

If the share price jumps back near $35 at any point in the next year, you’ll be able to sell your calls for a profit. 

Drawbacks to Swing Trading Options

Now that we’ve covered some of the best aspects of swing trading options, it’s time to look at the drawbacks.

Options are an expiring asset. Meaning they lose value each day even if the underlying price stays the same. This is known as Theta.

What this means is that you have to be right in the direction you pick plus within a certain timeframe. If you’re right on the direction but it takes longer than you expect, you will likely lose money.

The key here is to make sure you pick expirations that are far enough out to give you enough time to see if you trade idea is correct. Of course, the more time you buy the more expensive the options will be.

And of course, never risk more than you are will to lose! Especially with a leveraged product like options where prices can move dramatically.

Bottom Line 

Swing trading options requires a hefty amount of risk tolerance. At some point, you’ll need to stomach seeing your account balance sway like a palm tree in a hurricane without panicking.

But if you don’t mind the volatility, options can be a vital part of your trading strategy. Buying options puts a limited amount of capital at risk and the gains can be far greater than the underlying stocks. 

You don’t need 100 Apple shares to take advantage of Apple volatility. Successfully swing trading options can turn a small portfolio into a big one, or keep a big portfolio big throughout even the darkest times.

Options trading isn’t for everyone, but if you have the appetite for risk, it’s a worthwhile addition to your trading toolbox.