Chapter 7: Kicking the Wheels of a New Strategy
2. Preventing profits from turning into losses
3. Letting profits run . . .
Shifting from Knowledge to Mastery
Strategy mastery doesn’t mean that every trade you place for a given strat- egy is profitable — it means that the appropriate conditions were in place when placing a particular trade, putting the odds in your favor for a prof- itable trade. Managing the position correctly is also another component that highlights discipline by exiting a trade if conditions change. It sounds pretty easy, but strategy mastery can take years to evolve. Your goal is to stay in the trading game long enough to achieve this mastery.
By focusing first on basic concepts and mechanics, you create a strong foun- dation that allows you to grasp advanced techniques more quickly. You implement new strategies via paper trading to avoid the most costly mis- takes. When you’re ready to take the new strategy live, you can further mini- mize the cost of mistakes by reducing your position size and remembering to take profits. This approach keeps you in the markets longer, allowing you to find and develop strategies that are best suited to your style.
Setting the right pace
There are a ton of great option strategies in this book, with some that proba- bly pique your interest more than others. Start out paper trading a couple of
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the more straightforward approaches, then transition to live trading with them. After that check out the strategy that has the most appeal to you, again by paper trading. There’s no guarantee that market conditions will be con- ducive to that strategy, so you may prolong your paper trading days until the market changes or you’re ready to explore a new strategy. But . . . it’s really important to keep this in mind. You want to focus on strategies that make sense to you and better suit your style. That’s how you’ll ultimately develop mastery.
Starting with a few strategies
Learning new strategies is hopefully something you enjoy. It’s amazing to find out about all the different ways you can make money in the markets. But not all strategies work in all market conditions. More importantly, they won’t all suit your style. If you’re new to option trading, stick with one or two basic strategies to develop a really good understanding of premium changes and mechanics.
There are a variety of strategies available to you that allow you to make money in the markets. Just like your preferred method of analysis, you’ll find you develop a preferred list of strategies that work for you.
Experienced option traders should identify current market conditions, then explore one, maybe two strategies that excel given those conditions. Start by paper trading and progress from there. If there’s a specific strategy that really intrigues or speaks to you, but conditions aren’t quite right, just paper trade it. In the long run, it’s better to focus on market approaches that make sense to you.
Adding strategies as market conditions change
I look at the markets as a lifelong pursuit because conditions are always changing. Although there’s a continuous cycle of bullish and bearish phases, the market is never exactly the same. It seems you already recognize this by purchasing the book in the first place.
When strategies that typically work well for you start weakening, take some time over the weekend to complete a comprehensive market assessment. You may detect early signs of a change in conditions.
Option trading allows you to implement strategies that can be profitable regardless of market conditions. A sampling includes:
Bullish, low volatility (basic long call, married puts)
Bullish, high volatility (covered calls, credit spreads — Chapter 11)
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Bearish, low volatility (basic long put, debit spreads — Chapter 11) Bearish, high volatility (collars, credit spreads — Chapter 11) Range-bound, low volatility (butterfly, condor — Chapter 16)
The combination of stock with options or options with options really provide you with great choices. That can be good and bad news because each approach requires some time to master. Be careful about checking out a strategy haphazardly, then discarding it because “it doesn’t work.”
Chances are you won’t be trading every strategy available. Most traders try different ones along the way, then master a smaller number of them. The experience gained allows them to maximize profits on their favored strategies (knowing when to hold them), while minimizing their losses (knowing when to fold them).
Deciding which option strategies to use is just like market analysis — there are a variety of ways to approach it, none of which represent the one ‘right’
way. The best approach for you is the one that intuitively makes the most sense so that when conditions change and things get tougher (and they will), you have the confidence to stick to your plan.
Achieving mastery through longevity
Experiencing different markets and exploring suitable strategies requires you to have longevity in the markets. Bull markets can run for years and volatility conditions can remain stable too. Expect to incur additional losses when mar- kets transition or when implementing a new strategy. Managing risk by using limited loss, unlimited gain strategies whenever possible sets a foundation for longevity.
Paper trading provides a technique to minimize learning curve losses. A second method is through proper position sizing. By starting out with smaller initial positions, potential losses are manageable. Adding rules that include profit-taking is the icing on the cake.
Successful trading does not happen overnight. Be prepared to spend time making low-cost mistakes, observing different market conditions, experienc- ing varying levels of emotion, and developing your trading skills.
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Determining appropriate trade sizes
There are different techniques available to identify proper trade sizes. Many are beyond the scope of this book simply due to space constraints. Two easily incorporated ones include the following:
Identifying a maximum dollar amount allocated per trade Identifying a maximum percentage amount allocated per trade I prefer the latter because it automatically changes as your account size changes.
Options represent a leveraged position (see Chapter 3) so you don’t need to allocate the same amount to option positions as you do for stocks. In fact, it’s probably not a good idea to do that at all. Using your stock allocation plan as a base, you can estimate an initial allocation amount by identifying an option position that controls the same amount of stock. This serves as a starting point that should be tested and reviewed.
Establish trade allocation amounts prior to analyzing a specific trade. You need to know in advance the maximum amount available for an individual trade so that you minimize your account risk.
When trying a new strategy (after paper trading), further reduce trade sizes so mistakes are more forgiving. If that means trading in one option contract sizes, so be it. Remember, you’re not out there to impress Wall Street with your trade sizes — you’re out there to make money in the markets.
As your skills develop, increase position sizes to those tested allocations.
This will improve profits because option trading costs are often higher than stock trading costs from a percentage standpoint. If you’ve properly prepared and continue to manage your risk, increasing position sizes shouldn’t be a problem. In fact, it should improve results because you’ll realize economies of scale with trading costs.
Emphasizing profit-taking
Throughout this book there’s an emphasis on managing risk. In this chapter though there’s an additional emphasis — that’s on profit-taking. It’s not enough to simply have a high number of profitable trades. Your profits must include the following:
Exceed trading costs
Exceed conservative investment approaches Exceed your losses
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This doesn’t just happen out of the blue, you have to have a plan that includes reviewing strategy and trade results to put the best profit-taking rules in place. Such rules should minimize the number of profitable trades that turn into losses and allow profits to run. Developing these skills means you’re evolving as a trader.
There are a lot of different price points that can invoke an emotional response while in a trade. Be sure to identify exit points for a loss as well as exit points for profits.
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Chapter 8
Mapping Out Your Plan of Attack
In This Chapter
Identifying business costs Minimizing learning curve costs Understanding order execution
Trading is a business and developing as a trader means evolving as a busi- ness manager. Understanding the costs associated with the business helps you budget accordingly. Initially certain costs will be higher and others will be lower. You’ll likely be paying more for education and your learning curve (a.k.a. losses) when you start out. As your trading evolves, those costs will go down while subscriptions to analysis platforms and data services will go up.
Always keep in mind that losses are part of operating expenses. Minimizing them by managing risk is your goal — not eliminating them. This is done by determining proper trade allocation amounts and maximum loss per trade.
Effectively executing trades is another step toward minimizing losses. I cover all these topics in this chapter.
Managing Your Costs
There are a variety of costs to consider with your trading — some are higher when you first start and many continue throughout your career. You need to think of trading as a business and manage these expenses so you can mini- mize them as your business matures. The expense categories included in the following list will all continue throughout your trading career, but some will begin higher than others:
Education:Education expenses include materials, courses, and learning curve costs for new markets and strategies. These costs will decrease as time progresses, but will remain on-going as stay current with market conditions (books, periodicals) and continue to develop new strategies.
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One of the largest education costs is your learning curve. These decline as you figure out how to:
• Trade under best conditions for the strategy
• Use options with the appropriate liquidity
• Develop paper-trading skills
• Allocate the appropriate amount to the trade
• Effectively enter orders for the best exit
• Take profits
Analysis costs: As your skills progress and your trading generates regu- lar profits, you may add analytical tools to your business costs. Talking to fellow traders that use such tools and finding out which ones you may be able to take for a spin using free trials are good places to start. Such costs represent one of the few that may increase over time. Be sure to only subscribe to a limited number of services so you can make the most out of them.
Trading costs: You have to not only have to account for commission but also for slippage. Slippageis the cost associated with the market spread — the difference between the bid and the ask. A good exercise is to calculate commission and slippage percentages for different size option positions (i.e. 1, 5, 10 contracts) established at different price points (i.e. $1, $5, $10).
Taxes are another consideration, so you need to identify what types of trading will be completed in different accounts. In addition, when estab- lishing certain option positions, you may trigger a tax event in the underlying. Be sure to contact your accountant about option trading tax considerations. The bottom line for these cumulative costs is that in the long-term, they must outpace a buy and hold approach.
If you borrow from your broker via trading on margin, you need to add monthly margin interest charges to your trading costs as well. Short option positions have margin requirements that can get complicated.
The main consideration for this margin is whether the option is covered or naked. If you decide to move forward with strategies requiring margin, be sure to contact your broker so you fully understand all of the calculations and account requirements. Then add these costs to your expenses.
Losses are another trading cost that should be considered part of doing busi- ness. They will likely be higher at first, but reduced with time and experience.
Following these trading plan guidelines should help keep these initial costs to a minimum:
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Determining the trading allocations:As part of an overall trading plan you should identify both your total trading assets and your maximum allocations for different assets and strategies. Stock and ETF trading will require larger allocations than option positions. You may even want to break this down further to include a maximum allocation amount for new strategies based on paper trading results.
Calculating trade size: You must also determine guidelines for maxi- mum position size prior to entering any trade. Once these are set, identi- fying the maximum number of contracts you can allocate to a position is pretty straightforward. Divide the option price by an allocation amount below your maximum and you’re all set. Don’t anticipate using the max allocation.
Identifying maximum acceptable loss on trades:Your maximum accept- able loss can be defined as a dollar value or a percentage. I prefer the latter because a fixed dollar amount can be significant with smaller trades or if your trading assets decrease. Periodically perform an analy- sis on your trade results to determine if your losses remain at reason- able and sustainable levels.
Focusing on entry and exit rules:Option entries are often driven by trending and volatility conditions, but may also be time oriented with positions created prior to specific scheduled event. Option exists can also be time driven (post-event or pre-expiration) or may be triggered by movement in the underlying security. Regardless, these methods must be focused on supporting your risk management and maximum allow- able loss.
Exiting with technical indicators typically does not provide you with a price for use with risk calculations. A maximum loss price should also be identified.
Optimizing Order Execution
Successfully trading options means gaining proficiency with order execution.
A variety of factors come into the mix here including:
Understanding order placement rules unique to options Knowing how different order types work
Learning how to use combination orders for multi-leg positions Gaining skill while using the underlying to identify option exits Recognizing your broker’s role in execution quality
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