The guidelines and the strategies that I introduced in several articles about option spread trading are only half of what you need to be a successful options spread trader.
In addition to the technical and analytical knowledge, you need patience and discipline to execute the strategies. One way to make sure you follow all the steps is to create a trading plan.
A legendary trader, Richard Dennis, founded a school of trading known as the “Turtle Traders.” Dennis’ method advocated a strictly technical form of trading, with trend following regarded as the key element to success.
After years of successful trading, Dennis recruited and trained complete novices in his methodology. He instructed them that it almost did not matter how you entered a trade, but that what was important was how you rode the trade from your entry point.
While I believe that statement is a little extreme, there is some truth in it. I experienced this effect multiple times in my own career when I advised others on how to trade options.
I was completely shocked when I found that giving someone advice about what to buy and when was only half of the battle. If I did not monitor their trades for them, they would find ways to miss the best profit opportunity.
In one instance, I recommended bearish spreads on a few industrial metals using stocks as proxies. The copper market fell as I had predicted, and the stocks followed along. However, the people that I was advising were unsure of when to hold for more profit, when to sell immediately, or when to cut losses short.
While automatic stops can be helpful, some trades have too much volatility. In such cases, option prices bounce up and down too much to set a 10% or 20% stop that will automatically sell our position. These trades need close monitoring and a plan with specific instructions for closing out our position when the technical conditions are met.
Fortunately, spread trading can minimize the downside of our trade and reduce the need to constantly watch each transaction. However, our profits are based just as much on how we enter a trade as how we exit it.
Before I enter a trade, I create a trading plan. My plan includes the following:
- Sector: small-cap, large-cap, tech, financials, consumer staples, commodities, metals, etc.
- Sector major trend: bullish, bearish, non-trending/neutral
- Underlying security: the stock, index, commodity, or instrument the option is based on.
- Option(s) traded: calls and puts with strike prices and expiration with one to four options.
- Strategies applied: one or more of the option strategies explained in previous articles.
- Expected trade duration: date I expect to close the trade, or expiration.
Maximum Loss Allowed
Based on account position and personal limits for losses, I recommend that you limit your loss on any one trade to no more than 5% of your trading capital. That means that for every $10,000 in your account, you want to limit your trading loss to no more than $500.
It is even better if you can risk the recommended 2% or less on any one trade. Larry Hite clarified this recommendation in Jack Schwager’s Market Wizards, which was published in 1989. Hite originally stated that a trader should risk only 1% on any trade.
While that would be an ideal situation, it would also be hard to manage for new traders just starting out. The top end for trading is 5%. I hate to admit it, but when I started trading at the age of 12 (through my father’s broker), I risked it all.
I continued this foolish level of risky trading until I gained a significant portfolio. You should try to keep your risk to under 2%. However, when you first start, you might have to risk a higher percentage until you develop enough of an account to reach the recommended risk level. I will discuss more about risk management in future articles.
Triggers for Quick Close: What events would change my anticipated profit scenario into a high-probability loss scenario? This relates to a trend change, a reversal, a financial shock such as when Lehman Brothers went under, etc. If one of these triggers pops up, I close my trade immediately, irrespective of the loss or profit.
Potential Upside: Maximum potential profit, or unlimited upside.
Potential Downside: This will usually be limited and defined by the option spread strategies on which I choose to focus. Occasionally, I engage in selling call or put options that could open me to unlimited losses.
Probability of Profit This comes from using options calculators and running some scenarios through databases of probabilities for various markets and stocks.
Options calculator: http://www.optionsprofitcalculator.com/
Theoretical pricing options calculators: http://www.volatilitytrading.net/optioncalculator.htm
These calculators will help us identify our risk levels, potential profit and general probability for profit with a specific options trade.
This is an average expectation for success that tells me whether I am expecting a miracle, if the potential for profit is 3% or less. On the other side, the potential might be over 60%. While this is not a definite source of profitable trades, it is a good indicator of how the trade may go.
I generally avoid day-trading. I trade when the odds are stacked in my favor. There are always good trades available in almost all markets where there is enough volume.
Developing a trading plan is the key to removing emotions from your trading. Knowing why I am in a trade, what my probabilities are, and why I would bounce out of the trade makes riding the trade a bit like following a working GPS to a destination.
A trading plan is not nearly as definite in guiding us to profit, but it dramatically increases our chances of managing our trade to the desired profitable end, or at least minimizing potential losses.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.