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Alternatives to Shorting Stock at Swing Tops
by Michael Thomsett

Swing traders have a dilemma: Getting in with long positions at the bottom is easy, but shorting stock at the top is much more problematical. This article proposes a low-risk alternative to going short.

Swing trading is a popular and widely understood trading technique. Based on a three- to five-day short-term trend, you expect to see stock prices turn and reverse in a predictable movement. This occurs as a correction to market over-reaction to news, or simply as a hand-off between buyers and sellers.

The original method for swing trading involves buying shares at the bottom in anticipation of a short-term uptrend. Then when an uptrend does occur, those shares are sold and profits are taken. At the same time, swing traders short stock at the top, anticipating a downtrend. When that occurs, the short position is closed and the profit is taken.

This basic plan is great on paper. But for large numbers of traders, shorting stock represents an unacceptable risk. As a consequence, many play only one side of the swing, buying at the bottom. Then when the price tops out, they close the long position and wait on the sidelines, planning to again enter the trade at the swing bottom.

A low-risk alternative

Rather than buying shares of stock, you can use options for swing trading. This reduces your risk and enables you to play the downtrend without going short. The most basic strategy involves buying calls at the bottom and selling to close at the top, and buying puts at the top and then selling them at the bottom. The advantages to this approach:

1. Risks are lower than selling short. When you short stock, you face a significant risk. The stock could rise, meaning you have to cover the margin shortfall while still paying interest to your broker. With long puts, you can never lose more than the cost of the put, which averages five percent or less of the cost of the 100 shares the put controls.

2. Risks are also lower than owning stock. When you buy 100 shares of stock, you face the market risk of price decline. As a swing trader, buying the stock is done in expectation of a price rise; but what if the price falls? Using calls in place of those 100 shares, your maximum risk is the cost of the call, which like the put, is only a fraction of the stock price.

3. Using options allows you to diversify and swing trade using many stocks instead of only one or two. Because calls and puts are cheap compared to buying or selling stock, you can spread capital among many different stocks. Assuming you limit your swing trades to single options (each one controlling 100 shares of stock) and also assuming the average price is five percent of the price to buy 100 shares, you could swing trade 20 different stocks for the same price as buying and selling only 100 shares of a single stock. Or you can double up or triple up when the swing looks more promising than average, buying as many options as you wish. For example, buying three options duplicates the price movement of 300 shares.

4. This is one of the only options strategies that work best using options that are going to expire in less than one month. The majority of options strategies are based on a balancing act between cost and time. Most traders want the most time possible so that profits have a chance to develop; they also want to pay the smallest premium possible. As a result, most long strategies require two to three months at a minimum. With swing trading, well-timed entry needs only three to five days to develop. So options expiring in less than one month are ideal. Swing traders do not rely on long-term holding periods. However, in this last month of the option’s lifetime, there is little or no time value remaining, so options are also quite cheap.

A range of strategic possibilities

Using long calls at the bottom of the swing and long puts at the top is the most basic of strategies. For those interested in a little more risk, the long call at the bottom can be replaced with a short put; as prices rise, the short put’s value declines and can be bought to close at a profit. At the top, a short call serves the same purpose. That call can be naked or covered; when it is covered (meaning you own 100 shares of the underlying stock) the risk is quite small.

The range of possible option-based swing trading strategies is even broader. You can use a variety of spreads to minimize risk and cost while exposing your position to advantage when stock prices move in the direction you expect. For this purpose, an advanced approach requires not only a view to the swing trend, but also an awareness of implied volatility. When volatility is high, spreads are opened in expectation of an adjustment; then when volatility returns to more normal levels, the spreads are closed at a profit.

One of the most intriguing possibilities is the use of options to create synthetic stock positions. Opening a long call and a short put at the same strike and expiration creates synthetic long stock. The overall position duplicates movement in the stock, but the position costs little or nothing (it may even yield a net credit). Opening a short call and a long put with the same strike and expiration sets up synthetic short stock. Setting up synthetic stock positions in place of buying stock, and even in place of simply buying or selling options, is a low-cost or no-cost method for swing trading with minimum risk.

Beyond these strategies, you can also weight option positions, using more calls than puts, more longs than shorts, set up straddles, vary expiration in a calendar or diagonal spread, or use more contracts on one side of the trade than on the other. Options are flexible instruments. They have significant risks in some configurations, so great care is always essential. You need to be proficient in options rules and risks before opening up and swing trading strategies based on options. But once you know what you are doing, the possibilities are only limited by your imagination.

About the Author

Michael C. Thomsett is author of Getting Started in Options, Trading with Candlesticks and numerous other books on technical analysis, stock trading and options.

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