How to Swing Trade Options

Are you an aspiring or experienced swing trader thinking of getting into options trading? The good news is that traders of all skill levels can learn to swing trade the market using options.

Swing trading strategies use momentum indicators like the Relative Strength Index (RSI) to inform them when market movements are overdone, either on the upside or downside, and are ripe for a correction in the opposite direction.  

Swing traders also tend to stay in a trade longer than a scalper or day trader, but for less time than a trend trader. Since purchased option positions have limited downside risk, this can make them safer positions to run overnight as part of a swing trading strategy.

How Does Swing Trading Options Work?

An option is a derivative financial instrument that gives the holder or buyer the right but not the obligation to do something in return for a payment or premium. In financial markets, options also have a strike or exercise price that determines at what level the holder can buy or sell the underlying financial asset. Options also have an expiration date beyond which the option ceases to exist.

Option traders use a variety of options strategies that involve buying and/or selling one or more options to take either directional or market neutral views on the underlying asset market.

They also typically use graphs called option payout or payoff profiles to get a visual sense of what the option strategy will pay off on its expiration date for a range of underlying market values, such as the one shown below.

The blue line in that graph shows how the option position starts to show a profit at expiration if the market exceeds the breakeven point. What is not shown, however, is that the position can also show a profit prior to expiration if you are able to sell the option for more than you purchased it for, which is generally the objective when swing trading using purchased options.  

Fortunately, for a directional trading strategy like swing trading, you can easily learn how to trade options to implement your market view. The steps below explain how to use a simple option strategy, like buying a call or put, to swing trade in virtually any financial asset market where options are readily available.

How to Swing Trade Options

Step 1: Select an Asset

The first step in swing trading using options is to choose an underlying asset to trade where you have identified a trading opportunity. Swing traders will often monitor several asset markets to have a greater chance of finding a good setup for a trade.

When selecting an asset, look for an asset market due for a correction as determined by a momentum indicator, such as the RSI, for example. This particular indicator is a bounded oscillator that suggests that a market is overbought when its value is above 70 or oversold when its value is below 30.

Look to sell a market at RSI values over 70 and buy it at values below 30. If you want even more reliable swing trading signals from the RSI, you can wait until you see something called price-RSI divergence occur, which means the price makes a further extreme in a move, such as hitting a new high, but the RSI fails to do that. That is an even better swing trading signal that the market is due for an imminent correction.

Step 2: Choose a Direction

Once you’ve identified a market and used your preferred form of market analysis, whether technical and/or fundamental, to find a trading opportunity with a good risk/reward ratio of 2 or more to 1, for example, then you might feel comfortable taking a directional market view on the underlying asset using call and/or put options.

For example, if you think the market is going to rise, you would use a call option to go long the underlying market you wish to trade with limited downside risk and unlimited upside potential.

Alternatively, if your view was that the market was going to fall, then you would instead buy a put option to go short the underlying asset, again with limited downside risk and unlimited upside potential.

The option payoff profiles below shown at expiration for long call and put positions shows how your losses are limited to the premium paid if your directional view turns out to be incorrect. Also, potential profits on an option position are unlimited and start to accrue past the breakeven point where the gains on the position exceed the premium paid.

Step 3: Pick a Strike Price

The strike price of an option helps determine its price. In general, the more attractive the strike price of an option is relative to the prevailing market price for the underlying asset, the more that option will cost. Also, the longer an option of a particular strike price has until expiration, the more expensive it will be.

When strike prices are better than the prevailing market, they are said to be “in the money” or ITM. An option with an ITM strike price also has “intrinsic value,” which is equal to the difference between the prevailing market price (for the option’s delivery date) and the strike price.

When an option’s strike price is right at the prevailing market, it is “at the money” or ATM, and when at a level worse that the prevailing market, it is “out of the money,” or OTM. Both ATM and OTM options have no intrinsic value.

Most swing traders are looking to profit from relatively short term directional moves in a market, so they will probably choose a somewhat OTM option that they expect will go ITM fairly quickly so they can sell it back.

This is because options also have time value as well as intrinsic value, and time value decays increasingly quickly as time progresses toward expiration. This encourages a swing trader to want to sell back any option they buy at the first opportunity when a respectable profit presents itself.

Step 4: Decide on an Expiration Date

Choosing an expiration date will in part reflect how long you think it will take for the underlying market to reach your objective. You will generally want to choose a shorter-term option if you think the move will be fast or a longer-term option if you think it will take a while.

Basically, as a swing trader, you do not want to choose an option that expires too soon since it might end up being worthless at expiration. On the other hand, you may not want to buy an option with an expiration date too far in the future because of the relative high cost.

Many swing traders will choose roughly one month options or options on the near futures contract, as long as it is more than 1 month away, since that will usually give them enough time for their view to pan out before expiration.

Step 5: Time Your Entry

Trade entry timing is typically done using technical analysis. Since swing traders trade both with trends and with corrections to those trends, they first need to identify the prevailing trend, if any, in the asset they are looking at.

When trading with the trend, swing traders will look for a corrective pullback to establish a position in the direction of the trend. Once the pullback seems to be losing momentum, as signaled by an RSI level in overbought or oversold territory ideally showing divergence with respect to the price, they would sense the time is right to step into the market.

Step 6: Execute Your Trade

Once the time to trade has arrived, it’s time to execute according to your trading plan. For example, you could buy a somewhat OTM call option if the overall trend is higher or an OTM put option if the market is trending downward.

It’s also important to remember that how you trade is just as important as where you trade, so make sure you pick the right broker as your trading partner. Transaction costs, including dealing spreads and fees, can really add up over time if you trade frequently as a swing trader.

Don't have a brokerage account? You can check out some of Benzinga's top options brokers below.

Step 7: Manage the Position

Once you’ve executed a trade and have a position, you run the risk of loss, although since you purchased an option, your risk will be limited to the premium you paid for it. You will also need to watch the underlying market and manage the option trade appropriately.

If you purchase an OTM option, you can aim to sell it when the underlying market reaches the strike price so that it becomes ATM. This will also result in the option picking up extra premium as its time value increases.

Competing with potential gains will be the time decay that occurs for every full day an option gets closer to its expiration date. This means that you’ll want to sell back the option position at the earliest available opportunity to avoid having a trade based on a view that was directionally sound lose money due to excessive time decay.

If the market still looks like your trade will pan out eventually, but the short term move you were hoping to capitalize on failed to materialize, you might consider giving it more time to come to fruition.

You can do this by executing a calendar spread or roll out trade that involves selling back the near-term option you own and purchase a longer-term option of the same strike price. This prevents you from taking losses due to the sharply increasing time decay on near the money options as their expiration approaches.

Mastering Your Swing Trading Options Strategy

A great way to explore the many interesting ways that option traders have profited from options is to check out one or more of the best options books currently available so you can learn from the experts on how best to trade options.

Then, find a reputable broker so you can start implementing your new swing trading strategy.

Want to learn more? Check out Benzinga's guide to the best swing trade stocks, best options trading strategies, the best day trading brokers and best options brokers.

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