Doc Maher completes his series on Swing Trading.
In an earlier post titled Swing Trading GOOG Options I showed how to swing trade options with a highly-leveraged, short-term, out-of-the-money (OTM) put. As you may recall, the set-up was bearish, trying to capitalize on a downward move in Google stock. This post will use the same scenario, but the option chosen will be less-leveraged, longer-term and in-the-money (ITM). Please visit TradeKing's Education Center to read about the Long Put in the online version of The Options Playbook.
THE PLAY - Long Put
TRADE FORMATION
On July 9, the following scenario occurred in GOOG stock:
Open: $550.76
High: $555.68
Low: $540.73
Close: $541.55
Most recent swing high: $555.19 (July 8)
Most recent swing low: $515.09 (June 27)
Pertinent information: Earnings after market close (July 17)
ACTION POINTS
Strike A: Buy to open 10 GOOG September 570 puts at $50.00
Stock at potential entry: GOOG near $540
Day to enter: July 10th if below July 9th low
Profit point using option price: $75.00 (50% gain)
Profit point using stock price: $515.09 (recent swing low)
Stop-loss using option price: $40.00 bid or lower
Stop-loss using stock price: $556 or higher
Stop using time: July 17 before market close
Time duration of trade: Up to 7 days
REWARD-TO-RISK RATIOS
Target gain using option price: $75.00 - $50.00 = $25.00 per contract
Loss limit using option price: $50.00 - $40.00 = $10.00 per contract
Reward-to-risk ratio on option price: $25.00 / $10.00 = 2.5
Stock movement target: $540 - $515 = $25
Stock movement stop: $556 - $540 = $16
Reward-to-risk ratio on stock movement: $25 / $16 = 1.5
Maximum gain: $520 per contract per share (Strike A - debit)
Maximum loss: debit paid of $50.00 per contract per share
Break-even point at expiration: GOOG = $520 (Strike A - debit)
Click here for a larger GOOG chart.
ALL-STAR COMMENTARY
Above is a chart of Google on July 9, 2008. As we can see there is a downtrend in place and a bear-rally. For more on bear-rallies, please read Frustrated by Getting Stopped Out. In this post I will be using the same techniques described in Swing Trading with Stocks. These guidelines would have me enter only if GOOG breaks below the July 9th candle, around $540. I would then set my stop at the swing high ($556) and use the last swing low ($515) as my target. These stock points give me a reward-to-risk ratio of 1.5 (see Trade Formation). This is not the 2:1 ratio that I like to have for stock trades; however it should serve as a good example anyway.
When it comes to swing trading with options there are additional choices to make. Do I buy shorter or longer term? Do I buy in-the-money (ITM) or out-of-the-money (OTM)? The answers depend on how much leverage I want to employ and how much risk I want to take. In general if there is more leverage, there is more risk. In my earlier post, Swing Trading GOOG Options, I examined using the more leveraged shorter term OTM option. To contrast that approach here I will examine using a longer term ITM option.
All long options (options you own) provide leverage because they allow you to use a small amount of money to control a stock which is typically much more expensive. Deeper ITM options provide less of this leverage; further OTM options provide more. Today I'm going to look at the lower-leverage, lower-risk approach - a longer term ITM option. I am going to select the September 570 strike put. At the end of the day on July 9 the bid-ask was $50.00-$51.25. The delta was probably around 0.60Δ. This will improve the dollar gain over the last example which used an option with a delta around 0.30Δ.
As noted in my earlier posts a swing trade generally last two to six days, however it may last longer. Using the September expiration date instead of the July expiration date of the previous example will allow us the option of staying in the trade longer. In this particular case GOOG announced it's earnings on July 17 after the bell. Since we don't want to hold this position through earnings it would not matter that much in this instance. If things go as planned we will be entering on July 10, and we would not hold it through July 17 which means we won't be holding this position longer than 7 days. However there may be cases where we would want the ability to stay in the trade longer.
I intend to buy the September $570 put on July 10 if GOOG falls below $540. If I am watching it this is not going to be a problem, however I may want to go do something else, like go to work. To accomplish this without being there I need to use an advanced order called a contingent order. Contingent orders are found under the Advanced Orders pull down menu. This allows me to place an order contingent on the price of the stock. Below is the picture of the order screen.
Click here for a larger order entry screen.
The top part is the order for the put (GOP UQ) and the bottom part is where I put in the contingent parameters. In this case I used a market order. If I use a limit order, I risk not getting filled. Before I place this order, I need a plan for this trade so I'll know how to manage it.
Plan for GOOG Swing Trade:
Entry: Buy 10 GOOG September 570 puts at market if stock goes below $540
Expected cost approximately $52 per contract per share
Exits for Profit
Option target: If the option price increases by 50% I'll sell half of the option position.
Stock target: If GOOG goes below $515 sell half of the option position.
Note: I usually put in the stop for the option price only. If I see at the end of the day that my stock price target has been hit and the profit target hasn't, I will manually put in an order to sell half the next morning.
Exit for Loss
Price Stop: If the option price drops $10.00 I will exit the option trade.
Stock Stop: If GOOG goes higher than $556 I will exit the option trade.
Time Stop: I must be out of this trade before the market closes on July 17.
Note: I usually place a stop order for the option price only because I want to combine the option limit order from my profit exit and the option stop order by using an advanced order - One Cancels Other (OCO). I will manage the stock price stop manually because I do not have a "one cancels all" order.
Click here for a larger image for trade entry.
Now that I have my plan in place, above is a chart of what happened the next day. GOOG went below $540 around 14:15. According to the bid-ask prices, my market order would have been executed at $50.00. By the end of the day the bid ask was $50.50 and $52.00. The high for the day was $55.50 and $56.75.
My plan is to move the stops as GOOG drops just keeping the $10 as a trailing stop. I will also place a limit order to sell five of the puts if the put price reaches $75.00, because that is the 50% target I set.
Click here for a larger image.
Above is a chart of GOOG on July 15. On this day the bid and ask went as high as $78.00-$79.75. Five of my puts would have been sold at $75.00 due to my limit order. By the end of the day the bid ask was $67.50-$69.00. The stock target was also hit but since I already sold half using the limit order I will ignore it. I would now move my option price stop from $40.00 to $58.00.
Click here for a larger image of trade exit.
On July 16 (above), I would have been stopped out and sold my remaining five puts for $58.00.
In summarizing this hypothetical trade: the cost was ten puts at $50.00 for total of $50,000. I sold five at $75.00, and five at $58.00 for a total of $66,500. The total profit was $16,500 not counting commissions. That's a 33% profit in four days ($16,500/$50,000). If I had tightened up my stop this would have made more however it still made more than the OTM put from the last example ($16,500 compared to $12,500). The percent profit is lower due to the much larger investment (33% compared to 71%).
This approach doesn't require the underlying to cooperate as quickly as the short term OTM strategy does and so sometimes is considered more conservative. It also would have allowed us to stay in this trade longer if the circumstances were different. Even with using the ITM put, we still would have a considerable amount of leverage over shorting the stock. With that leverage goes more risk as we had our stop at a $10 loss which would have been 20% of the investment. If GOOG had gapped up I might have lost even more. The main thing that made this worth while was that I had a plan and I knew where my exits were.
This post ends my series on Swing Trading using stock or options. I hope I have shed some light on this subject and given you some key ideas on how to better manage your risk in the market.
"Income Trader"
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Doc's previous posts: The Basics of Fundamental Analysis and Lehman, mortgage defaults, and the FED
Click here for a list of previous TradeKing All-Star blogs.
Nicole Wachs contributed to this post.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.The theoretical return for this trade is not actual and does not guarantee future results.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
