5 Tips for Short-Term Trading

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 yield triple-digit returns for the shrewd speculator. To raise the odds of a winning short-term trade, take heed of these simple tips.

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 21-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 a few years to uncover any long-term technical foes that could hamper your forecast for the stock.

A thorough technical analysis along these lines might include a check of major trendlines, round numbers, previous highs/lows, double lows, half-highs, and more. Pay especially careful attention to any levels that have served as resistance before, and are currently hovering 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.

Schaeffer's Volatility Index (SVI) is a helpful tool for gauging option prices. This indicator measures the level of implied volatility priced into current near-term option premiums, and then compares that number to similar readings from the past year. When the SVI's percentile rank is above 50%, it suggests short-term options are relatively expensive, from a volatility standpoint. Conversely, readings below 50% indicate options are fairly priced.

4.) Select your option carefully. When your trading time frame is measured in hours and days (instead of weeks and months), it's particularly important to calibrate your option selection very carefully. 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. Otherwise, a front-month strike is probably the next best thing.

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 might meet your needs, and at a lower upfront cost.

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 that 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 good-til-canceled orders with your broker, or you can simply use these numbers as guidelines to go by 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.

 

What You Need to Know About Volatility

Implied volatility (IV) refers to the expected movement of a security's price over a given time frame.  IV is a crucial concept for options traders to understand, since it's one of many factors that influence an option's price. Higher IV results in higher option premiums, while low IV often translates into more affordable option prices.

Stock-specific events, such as management changes or earnings reports, can have a big impact on IV. If investors are expecting the stock to make a major move in one direction or the other as a result of these known events, those expectations will push IV (and, by extension, option prices) higher. In the aftermath of the event, IV tends to decline rapidly as the market's reaction to the news is priced directly into the equity.

When IV spirals lower after an event, it's referred to as a "volatility crush," since options prices can drop so dramatically in such a short time frame. To ensure success in options trading -- and avoid the crush -- it's crucial to avoid buying extraneous volatility.

Before buying an option, it's possible to determine whether IV is relatively inflated by comparing it to the stock's historical volatility (HV). For example, a trader considering an option with one month of shelf life would review the contract's IV level against the stock's one-month HV. If IV is considerably higher than HV, it means expectations for future volatility are getting frothy. This type of situation is far from ideal for options buyers. When premiums are inflated, the upfront cost and total risk are that much steeper, and the stock must then stage an even greater move to surpass breakeven.

Whenever possible, premium buyers should be on the lookout for scenarios where IV appears to be underestimating the stock's ability to break out, as suggested by historical volatility.

Putting it into action with Schaeffer’s
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You see, Bernie Schaeffer launched this company in 1981 because he loves trading options, and he’s been making money ever since. He and his team are regularly quoted in The Wall Street Journal, The New York Times, BusinessWeek, Investor's Business Daily, and USA Today.

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Using the knowledge they have gained during their 30+ years of options trading experience, they spend hours poring over charts and numbers, analyzing trends and information, to identify trades that have the potential to bring in those big gains in a little amount of time.

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