A Strategic View of Options for Swing Trading
The success of a swing-trading program relies on following the rules: identifying the setup after an uptrend or downtrend and acting quickly to take advantage of the short-term price swing. But many stock-related considerations should be kept in mind as well, including:
- Selection of stocks based on value. No matter what potential profits you might earn using options for swing trading and other strategies, it remains a sensible approach to limit your trading activity to high-value stocks. Using the relatively logical and simple theory of value investing, you may limit your options trading to stocks that also offer long-term growth and profits for well-managed companies.
- A stock's price volatility. Options traders face a dilemma when considering strategies like swing trading.
Smart Investor TipNo matter what options strategies you employ, limiting your activity to high-quality companies is simply smart investing. Those stocks will be more predictable, less volatile, and better for all types of option trading.
- Price history (recent) and potential. The definition of various volatility levels is invariably based on past price performance. But the potential price history can be further clarified by checking the size of the stock's recent trading range. Stocks with relatively narrow trading ranges of 10 points or less are excellent candidates for swing trading in the $40 to $80 price range. These stocks display historical volatility of 12.5 percent to 25 percent. If this range has been consistent, it is reasonable to extrapolate the same volatility levels into the future. This may oversimplify the task, however. In an ever changing market, yesterday's sedate stock may be tomorrow's most volatile, and vice versa. But investors and traders have to rely on trends and trust them. Without the trend, you would have no basis for selecting one stock over another for swing-trading purposes.
- The price-to-earnings (P/E) ratio of the stock. The P/E ratio tells you how much the market anticipates future price appreciation. So a P/E multiple of 20 represents a price per share 20 times higher than last year's earnings per share. The P/E can be used to limit the range of stocks you consider for swing trading. An exceptionally high P/E often indicates that the market has driven the stock's price too high, that enthusiasm is higher than justified. An exceptionally low P/E ratio is a symptom of a lack of interest in the stock. The P/E ratio may foreshadow future volatility as well. High-P/E stocks will tend to overreact to marketwide price movements and be highly volatile. Low-P/E stocks will tend to underreact, making them poor candidates for swing trading. With this in mind, limiting a stock portfolio to those with P/E ratio between 10 and 20, for example, will help avoid companies with overpriced stocks as well as those lacking the moderate price volatility swing traders desire. The range of 10 to 20 for P/E ratio is subjective, but if you check typical P/E ranges, you will find that this range represents the midrange of stocks. Historically, a P/E of 15 has been considered the "norm" for the market's P/E ratio, and the stocks in the S&P 500 have often ranged between 15 and 20, but in more volatile markets, such as the year 2002, the P/E range for the S&P 500 rose as high as 45.The history of the S&P 500 collective P/E over several years is summarized in Figure below.
Smart Investor TipPicking a range of P/E in which to consider stocks is a matter of personal preference. The multiples between 10 and 20 are reasonable, but some investors will prefer P/E ranges far higher.
[caption id="attachment_12601" align="aligncenter" width="550"] S&P 500 P/E Ratio.[/caption]
This period ends with the last quarter of 2006, when the P/E was below 20 for the S&P 500. During 2008, the P/E inched up to about 25, reflecting a combination of lower earnings reports coupled with lower stock price ranges. The historic norm remained at the long-established level of 15. This indicates that even with the disastrous 2008 stock market history, the historical P/E reflected a degree of optimism about the market's future. The difference between a 15 (historical average) and 25 (end of 2008) P/E is substantial.
Smart Investor TipFor a good overview of financial and economic indicators as part of your portfolio analysis, check . Indicators such as P/E as well as broader indications classified as "bullish" or "bearish" help you to gauge the current market mood.
- Fundamental and technical tests of the company and stock. Any stock you pick for options trading as part of a swing-trading strategy should also pass a few basic fundamental and technical tests. You may develop your own short list of essential tests. On the fundamental side, these should include tests of working capital, the trend in debt versus equity capitalization, revenue, and net return. On the technical side, you will want to test price history and volatility, expressed in terms of the volatility percentage and breadth of the trading range for stocks at various price levels.