5 Tips for Short-Term Options Trading

From implied volatility to technical analysis, here's everything you need to know for quick options profits

by Elizabeth Harrow

    Published on Jun 23, 2017 at 9:36 AM
    Updated on Jun 23, 2017 at 9:36 AM

    One of the major attractions of options trading is the ability to turn a very healthy profit in a relatively brief period of time. Thanks to the profit-magnifying power of leverage, well-timed call and put plays can quickly yield triple-digit returns for the shrewd speculator. Of course, if you dive into an options position unprepared, you might just as quickly forfeit your upfront investment. To stack the odds in your favor with rapid-turnaround trades, simply follow these 5 simple steps to short-term profits.

    1.) Target stocks poised for a big move.

    This may seem obvious -- but if you're attempting a short-term options trade, you need to focus on a stock that has a history of making big moves in a narrow time frame. This is the kind of information you can glean by reviewing a stock's chart, and by looking up its historical volatility (HV). Simply put, a high HV reading suggests that dramatic price swings are business as usual.

    There are also technical indicators you can reference to inform your short-term trading decisions. For example, Bollinger Bands are a pair of trendlines typically plotted two standard deviations away from a central moving average (most frequently, the 20-day moving average). During periods of heightened volatility, the upper and lower Bollinger Bands will move away from each other. Then, during times of low volatility, the bands will draw closer together. By singling out a historically volatile stock with compressed Bollinger Bands, you may be able to pinpoint opportunities where volatility is on the verge of exploding.

    And, as always, be aware of upcoming corporate events. Product launches, earnings reports, and other planned events all have the ability to prompt a major move in the shares.

    2.) Check the charts for key support and resistance levels.

    When you're targeting major gains in a minor time period, it makes sense to be aware of any and all levels of technical significance that could impact your trade. Even though you're focused on the short term, go ahead and dial back the charts to uncover any long-term technical foes that could exert an immediate impact on the share price.

    A thorough technical analysis along these lines might include a check of: major trendlines and moving averages; round numbers; previous highs and lows; double lows and half-highs; Fibonacci retracements of previous directional moves; and "round-number returns" (i.e., gains and losses of 10%, 20%, and so forth) from recent highs and lows, as well as the stock's year-to-date breakeven. Pay especially careful attention to any of these levels that are located in between the stock's current price and your projected target.

    3.) Make sure there aren't major volatility expectations priced in already.

    No matter how abbreviated your trading time frame might be, it's an essential rule of money management that you should avoid overpaying for options. The price you pay to play is a key determining factor in your risk/reward profile, and it also determines how much leverage you stand to gain.

    Implied volatility reflects the market's expectations for the underlying stock during an option's lifespan, and it's one of the key variables that impacts option premiums. So, if most traders expect Apple shares to make a big move on the charts during the next month, AAPL's front-month option prices will rise accordingly. This is why options with an expiration date timed to coincide with a planned event -- such as an earnings report, or the release of an updated iPhone model -- are often costlier than their "anytime" counterparts.

    But as the market's reaction to these types of known events is priced directly into the shares, rather than the options, implied volatility will collapse. And if the directional move in the stock doesn't live up to expectations -- even if it's heading in the right direction -- options can actually lose value.

    4.) Select your option carefully.

    When your trading time frame is measured in hours and days (instead of weeks and months), it's important to calibrate your option selection very deliberately. Your two primary considerations are time and strike price. For short-term trading, it makes sense to buy as little time premium as you require for the expected stock move to play out. If weekly options are available, those might be the optimal choice -- and during standard options expiration week, front-month options can easily serve the same purpose.

    As you choose your strike price, consider your appetite for risk. An in-the-money option may cost more, but also has a relatively higher probability of retaining some intrinsic value at expiration. However, if you feel confident in your prediction for a sizable swing in the share price -- and you're not deterred by the prospect of a potential 100% loss -- an at-the-money or out-of-the-money option typically carries a lower upfront cost, which maximizes leverage on the trade.

    5.) Determine your exit plan in advance.

    Capturing a short-term stock move requires you to be nimble. Unfortunately, if you fail to create a concrete exit plan in advance, you may find yourself paralyzed by quick gains (or losses) in your options trade. How long should you ride out the gains on a winner? Do you want to close out a loser immediately, or wait to see if the stock pares its decline?

    Of course, the answers to these questions will vary from one trader to the next. But regardless of how healthy your risk appetite might be, determine your target profit and stop-loss levels before you enter the trade. You may wish to enter corresponding orders with your broker, or you can simply use these numbers as guidelines after the trade is executed. Once your option starts gaining or losing value, it's too easy -- and too risky -- to start making emotional decisions based on greed or fear.


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