This article is written for beginning options traders and covers the most basic things that can go wrong in a simple call option swing trade.
By “most basic,” I mean that 9½ out 10 times if something goes wrong in a trade, it will be one of the things on this list. By “simple trade,” I mean we aren’t covering anything about advanced options trading strategies. We’re only discussing buying a call option, and selling the same call option in order to make a profit.
By “call option swing trade,” I mean the following:
Call Option—Simplified Definition
A contract that reserves a trader’s right to buy 100 shares of a stock at a set price, before a set future date.
Think of a call option as being a bit like a coupon: If apples are selling for $1.00 and you hold a “coupon” reserving your right to buy them at $0.99 or $1.02 (or, or, or — any price) for the next 5, 7, 14, or 60+ days, as the price of an apple increases, your call option (“coupon”) becomes more valuable.
If the price of apples falls below the price reserved by your “coupon,” your coupon may expire worthless, but you’ll often have had the chance to sell it before it loses all of its value.
A Note on Option Basics
- A trader who owns a call option contract does not own shares of the stock–he owns a contract that has reserved his or her ability to buy 100 shares at the pre-established price.
- In order to profit from the call option, the trader will not ever need to own shares of the stock, because the contract itself holds considerable value—assuming, of course, that the trade went as planned = stock go zoom.
“Swing Trade” — Simplified Definition
A trade that lasts from a couple of days to several months that attempts to profit on an anticipated price move.
Swing trading is different than day trading, as day traders typically do both the buying and the selling of a stock or option on the same day, whereas a swing trader will hold the stock or option for at least one overnight period.
Swing trading is different than investing as investors typically have confidence in the company issuing the shares of stock, whereas traders simply attempt to profit on short-term price movements and may or may not care for the longer-term potential of that company.
Therefore to summarize, the following is a list of what can go wrong in a short-term swing trade involving a call options contract.
5 Things That Can Go Wrong in a Call Option Swing Trade:
1. The upward movement in share price that you anticipated might not occur at all.
Options depend upon and get their value from shares of a stock, which are referred to as “the underlying” or the “underlying asset.”
When you buy a call option, you are basically saying (betting, predicting, assuming, postulating) that the value of the underlying stock (the stock that that call option gives you the right to buy) is going to increase in price.
Some of the many reasons you might have come to that conclusion could have included:
- Favorable news released
- Upcoming product launches
- Earnings reports (a touchy time to trade)
- News from another part of that industry that incidentally impacts another company
What can go wrong: The upward price movement you anticipated might simply not occur for whatever one of a million reasons. Your call option would therefore lose value.
2. The upward movement in share price that you anticipated might occur, but only after your call option expires.
Correctly predicting that an upward movement is going to occur in a stock is half of the battle.
The second and equally important half you have to get right is: When is the price increase going to occur? When is that predicted upward movement going to happen?
Will it be while you still hold the call option contract, or a few days or weeks after it (your “coupon”) expires?
Now, you don’t have to predict the exact day, date, or time that the upward price movement will occur, but it does have to be while you still own the call option.
- Example: You hear that Facebook is trademarking names for its upcoming transition into “Meta.” This makes you think that Facebook stock will increase in value and so you take out (buy) a call option contract expiring 14 days from today. Two weeks go by and the favorable price movement (up) hasn’t happened yet and so your call option expires useless [unless you sell it before its expiry date.] The following week, Facebook stock finally does go up. Well, you got the price action right, but the timing wrong.
- In this example, you may have been able to prevent the loss by taking out a call option with a later expiration date, but that would have cost you more money upfront. You could also “roll your options” forward but we’ll discuss that elsewhere.
3. The stock could lifelessly limp along doing basically nothing as your option loses more and more of its value.
One of the more damaging things that can occur to a call option is the stock could just limp along, lifelessly hovering around the same price range.
Day after day, the value of your call option decreases as its expiration date gets closer and closer. The formula behind this is called “theta,” and the money losing burn it causes is called “theta decay” or “time decay.”
To briefly and simply explain: The value of your call option comes from two things: INTRINSIC VALUE, and EXTRINSIC VALUE. Extrinsic value is the portion of your call’s value (or price) made up of time potential—the theoretical potential that it may become valuable at some point in its lifetime.
For example: If apples are $1.00 right now and I have a coupon that lets me buy them for $1.10 but it expires in three days, well, that’s a pretty useless coupon that no apple lover is going to buy from me. But, if I have a $1.10 coupon expiring two years from now, it has a built in extrinsic value reflecting the fact that the cost of apples is a lot more likely to reach above $1.10 at some point within the next two years.
4. The underlying stock may drop or ‘gap down,’ making your call option basically worthless.
You can usually, but not always, sell an option as it is losing value. Will you have lost money, yes, but losing 10-20% of what you paid may be better than losing 100% of what you paid.
And you usually can see the option slowly losing its value over time, and then decided whether you want to sell it and exit the trade.* But not always.
However, for a number of reasons, you may instead see that the option rapidly loses as much as 80-90% of its value after a crash, or after the stock “gaps down.”
In this case, you might find that not only have you lost 75-90% of the value of your call(s), but that no one is interested in buying it back from you any longer and thus it expires worthless.
[* Technically, you should make this decision of how you will respond to what occurs during the trade before you even enter the trade.]
5. You might get both the price increase and its timing right and be ‘making money,’ but then fail to sell the option and secure that money.
In short, you could get “greedy” or want more out of the trade than you’re likely to get.
This is tough decision that any trader needs to make on their own.
And it’s a decision that changes from trade to trade.
How much do you want out of the trade? And when should you sell?
What is your entry point? (When are you buying?)
What is your exit point? (When are you selling?)
I am personally of the mindset that:
- Some traders see loses and they sell,
- Some traders see gains and they sell,
- Neither is wrong, but if you do a bit of both you will end up only limiting your gains and securing your loses.
Are there times you should sell and exit the trade? For sure. Do you have to sell to profit at all? Yes.
But it’s the mental approach you take to the trade that is important.
It’s applying everything you do know to each trade and doing the best you can.
It’s relaxing, and learning and building your knowledge base and your confidence in increments.
It’s never investing more than you can afford to lose, and having fun learning and trading.
That said, options definitely can go from having a lot of value to having less or very little value fairly quickly. Usually not in seconds, but in hours or even minutes.
[The same can happen to stocks, however, because options have an expiration date, options are subject to more volatility, typically, than stocks are. The degree of this volatility is measurable by vega.]
So the timing of your sale of the call option is important.
You can try to gauge the state of the market overall, and go over what the trade has been like thus far to help decide whether to sell or hold. And the catalyst(s) behind that price increase you anticipated? I.e., The reason you ever bought into the trade in the first place and the due diligence you did? Whether right or wrong, what’s the current state of that? Is it—the news, the product, the new exec hires—still coming? Do you now think it’ll happen later? Has other news come out since?
These are all things you can keep tabs on and consider when in a trade that is “making money.”
Good luck!
