The Perfect Swing Trading Alternative for Option Traders

Options, those high-risk, short-lived, and speculative instruments, can be used as a valuable alternative in swing trading strategies. The flexibility of options allows you to use either calls or puts, to go long or short, vary the number of contracts, or combine different approaches based on market conditions. The “swing trader” moves in and out of stock positions based on very short-term price movement (swings). The strategy relies on the tendency of prices to overreact to both good and bad news, creating exaggerated short-term price movement that will correct quickly, normally within a few trading sessions. In other words, short-term price movement is erratic and chaotic and cannot be relied upon for long-term timing. For the short term, however, this chaotic tendency is a great advantage for swing traders.

A wise swing trader recognizes that these price swings occur due to the emotional aspect of short-term trading. Most traders react to news about a company in ways that cause these chaotic short-term movements. The predominant emotions at play for traders are greed (when prices are moving up), panic (when prices are moving down), and uncertainty (when prices pause). Swing traders rely on a few “setup” signals to time their trades, allowing them to completely avoid those troubling emotional reactions and rely instead on an unemotional analysis of price action.

Swing trading is a contrarian approach to trading in one respect. Swing traders act based on specific timing signals instead of emotions. This often results in acting against the “herd mentality” of the market, buying when others are selling and vice versa. The basic advantage to swing trading is not that the contrarian approach is always well timed. The whole idea is to increase the percentage of well-timed decisions over the average.

A SWING TRADING OVERVIEW

A swing trading strategy is based on the premise that price movement is chaotic and exaggerated in the short term, and that this overreaction will be corrected very quickly. This is what creates those infamous swings. So a company’s earnings beat estimates by one penny and the stock jumps four points, only to retreat three points over the next two days. Or a planned merger falls through and, even though the company’s earnings have been reported at record high levels, the stock price falls five points on the disappointing news. It recovers immediately and moves upward by six points over the next three days.

Everyone who tracks the market has seen this kind of price inefficiency and understands that price movement is unreliable in the short term. This brings up the second strategic theory swing traders rely on: Price tops and bottoms are recognizable in chart patterns and predicting reversals is based on that recognition.

Swing traders buy at the bottom of a downtrend and sell at the top of an uptrend. These trends are specifically defined. A downtrend is three or more days of consecutively lower highs and lower lows. For example, over a three-day period, the trading ranges of a company’s stock are between 35–33, then 34–31, then 32–29. The declining high price levels are 35, 34, and 31; and the declining lows are 33, 31, and 29.

–Michael C. Thomsett. Excerpted from The Perfect Swing Trading Alternative for Option Traders (FT Press).