CHAPTER
17

Trade Planning

In This Chapter

• Determine what to trade
• Planning your trade
• Money management for options traders
• Evaluating your trading results

Trade planning is an important discipline for successful trading. After all, trading is as much a mental game as anything. Having a playbook makes it so much easier. Figuring out what to trade and then keeping records will help you trade better and improve over time.

It’s not especially complicated, either. Most traders approach the market with an informal plan already. With just a little more work, you can set up a system to help plan and track trades. It really doesn’t take a lot of effort to use it, either. Some traders keep spreadsheets; some have notebooks. There’s no programming involved!

All you do is plan the trade, trade the plan, and evaluate what happened.

Pick Your Markets

The options industry covers a huge range of underlying assets. You can trade currencies, commodities, stocks, bonds, even market volatility. New types of contracts are invented all the time, with different features. The amount of creativity in the industry is just amazing.

But you can’t reasonably trade everything. The more you understand the fundamentals and dynamics in any one market, the more likely you are to have trading success. You’ll have better insight on market activity and be better able to place your trades appropriately.

If you have some knowledge of a particular market, start there. If you don’t, think about what interests you. Are you fascinated by exchange rates? A stock market junkie? Are you interested in specific companies or the overall economy? Are you stronger at calculus or at accounting? The more something interests you, the more likely you are to want to learn more about it. The research will be more interesting and more useful. That’s really important.

Pick Your Timeframe

Some of those who trade options are day traders. That is, they close out every one of their positions every night. They tend to make a large number of small trades, making performance on high volume of small returns rather than significant changes in any one position.

Swing traders tend to hold on to positions at least overnight and often for several days. Most options traders fall into this category.

Investors are those who hold positions for a very long time. Some investors use options as part of a risk-management or income strategy, but this is not their primary focus when they manage their portfolios.

A key step in planning your trading is to figure out what type of options trader you will be most of the time. If you are going to be a day trader, then you need to arrange your energies and planning around specific days and times. If you are a swing trader, you’ll need to figure out how you are going to monitor your positions. If you are an investor who does some option trading, then you have to determine when you will consider options and when you will not.

Set Your Goals

You have to know where you are going in order to see if you are actually getting there! Trading goals are important.

Sure, your goal is to make as much money as possible. But there’s more to an effective trading goal than making as much money as you can. Here’s a look at some of the considerations:

Are You Beginning or Advanced?

If options trading is your first foray into the financial markets, you should have simpler goals than if you have a lot of market experience but are relatively new to derivatives. The less experience you have, the simpler your goals and trading strategies should be.

The mechanics of researching a trade, placing the order, and then closing it out are complicated enough to trip up any trader. The less experience you have in the market, the more you need to pay attention to the niceties of procedure. Yes, it might be slower and less exciting than you had hoped, but you have to start somewhere.

As you build experience, your trade plans can become more complex.

Are You Speculating or Hedging?

Hedgers and speculators take very different approaches to the market. A speculator’s goal is set in terms of profits, while a hedger is looking to minimize losses. Understanding why you are trading will help you set better goals and write stronger trading plans.

Return Targets

A key goal is your expected return. Start by looking at your backtesting information. (Backtesting is covered in Chapter 19.) Are you swinging for the fences or looking for singles? Are you speculating in the hope of making large gains or generating steady income? Or hedging in order to minimize the losses on your account?

Understanding the return potential of your strategy will help you better manage your money.

The Probability of Ruin

Expected return tells you how much money you can expect to make from your trading. The probability of ruin tells you how much money you can lose. That’s really important if you want to stay in the game and manage the amount of risk you take. If you’re hedging, it’s critical to managing your risk.

Here’s the equation:

R is the probability of ruin. The lower the number, the less risk in your trading strategy.

A is the advantage you have on each trade. This is the difference between the percentage of winning trades you have out of the total number of trades you make. If your trades win 55 percent of the time and lose 45 percent of the time, then your advantage is 55 – 45 = 10.

C is the number of trades you make.

Let’s say you have an advantage of 10 percent and you have five open positions in your account. In that case, your probability of ruin is this:

In other words, if all of your trades can go to zero, you have a 36.7 percent change of losing all your money. To reduce that risk, improve your advantage or make more trades.

An options position can expire worthless. Options are a zero-sum transaction, after all. For every winner, there is a loser. This makes options trading riskier than stock trading, because common stocks rarely lose all of their value.

If your probability of ruin is high and you tend to trade naked options, you need to pay particular attention to risk management.

Risk Limits

If you can lose all of your money on a trade, then it is a very bad idea to put all of it on one trade—no matter how good it seems at the time. The markets do many strange things. That’s one reason they are so darn fascinating. There is no such thing as a sure thing.

Let me repeat: there is no such thing as a sure thing.

There are a lot of trades that are really good, though—where the odds are in your favor. If you’re more likely than not to make a profit, then you want to take a particular trade. These trades might not be sure things, but they are close. And close makes all the difference to staying in the game for the long term.

The key is the ability to stay in the market. You have to keep some powder dry. If you bet 100 percent on a sure thing that turns out not to be, then you have 0 money to put in the next trade that looks good. By limiting how much money goes into each trade, you will be able to make the next good trade that comes along.

Time and Attention

We all have only so much time and so much energy, which limits the number of trades and amount of trading you can do. It’s not a glamorous consideration, but an important one.

Cash Management

The amount of cash you have on hand is a key consideration in your trading strategy. It determines how much open interest you can have at any one time, as well as how large those positions can be. Traders have many different systems for managing their money. Some are ad hoc or intuitive, but there are several with solid statistical research behind them. Some have been used by gamblers for centuries, and others are proprietary, developed by trading firms for internal use.

All cash management systems have the same purpose—to make it highly unlikely that you will ever run out of money to trade. This way, you will always have some money on hand to take advantage of the next great opportunity that comes your way. You have some cash available after a losing trade so you can make another trade to help recover the losses.

Of course, at some point, the account balance might become so small it is not practical to make a trade. If that happens to you, it is your sign to get out of options trading and try something else.

You won’t need to pull out your calculator every time you want to figure out your cash management. Some are so simple you can determine the amount to trade in your head. Most trading platforms include money management calculators that do the work for you—and they usually give you a choice from the styles listed below.

Fixed Fractional

The fixed fractional method is designed to limit each trade to a predetermined proportion of your total account value. The fractions are almost always between 2 percent and 10 percent of the total account value, with traders using a smaller fraction for riskier trades and a larger fraction for less risky trades. You might make that determination based on something intuitive or by tracking your own trading to see how risky and aggressive your style is.

Once you have that number, which we’ll call f, you use it in the following equation to find the number of contracts, N, to trade:

Trade risk is the amount of money you could lose on your trade. (You can limit it with stop-loss orders—and you probably should.) It should be treated as a positive number, hence the brackets for absolute value. Remember options trading is a zero-sum game—for every winner, there is a loser—and that most contracts expire worthless.

The number will almost definitely be a fraction, so you’ll have to round up or round down to determine your trade size.

Fixed Ratio

The fixed ratio money management system is popular among options and futures traders. It was developed by Ryan Jones, a trader and author who specializes in the options market. Under this system, you find the number of contracts N you should trade using this equation:

P is the accumulated profit to date, and Δ, delta, is the dollar amount of the minimum trade, usually 100 contracts. (It is not the same as the delta of the option.)

Using this equation, your first trade, with no accumulated profits, would be 1.5 contracts. This system focuses on profits rather than account value, which helps protect your initial capital so you can always stay in the game. As with the fixed fractional system, you will often need to round up or round down.

Gann

The Gann system was developed by William Gann, who developed an esoteric system for trading stocks. The money management system that goes along with it is a piece of cake: divide your money into 10 equal parts, and allocated one part per trade. That’s all there is to it.

The Gann money management system is an easy-to-use system for managing risk. There might be systems with more statistical rationale, but it works well enough that many traders use it.

Kelly Criterion

Unlike Gann, the Kelly Criterion has solid statistical research behind it. It was a side effect of work done at Bell Laboratories in the 1950s to manage signal-to-noise issues in long distance telephone communications. The researchers noticed their findings could be applied to gambling, and they went to Las Vegas to test it.

In gambling, the odds are against you. The casino is most likely to win, not you. In options trading, the odds are even: for every winner, there is a loser, and the likelihood of being one or the other is randomly distributed. If you have a system that gives you an advantage, so much the better for your trading. All of this means a system that works well for gambling is likely to be even better for options trading.

You need three numbers in order to find the Kelly Criterion:

• The percentage of your trades that are expected to win, known as W
• The average return from a winning trade and loss from a losing trade
• The ratio of the gain from a winning trade to the loss of a losing trade, known as R.

Put these into an equation, like so:

Then, use the Kelly % to determine what percentage of your account you should allocate to any one trade. The Kelly Criterion equation is often known as “edge minus odds” in trading shorthand.

The Kelly Criterion leads to open interest that is concentrated in a few contracts. This maximizes profits but also causes trading accounts to wither quickly when trades go bad. Many traders use half the Kelly percentage in order to prevent rapid reduction in the account.

Martingale

Martingale is another money management system developed for gambling. It was designed for games with even odds, such as a fair roulette wheel. And guess what? Options trading done randomly—with no underlying research system—also has even odds.

Start with a set amount per trade. It should not be all of your capital, and maybe you’ll want to use one of the money management systems to determine the size of that initial trade. If the trade succeeds, start over with a new trade of the same size. If it fails, place double the amount on the next trade. If it wins, start over; if it loses, double the amount again for the next trade.

In gambling, this is known as doubling down—the trade that wins will recover your losses on the earlier trades. If you have an infinite amount of money, it will always work. The problem is no one has an infinite amount of money. This is a significant flaw in the martingale system. If you choose to use it, start with a low percentage of capital for your initial trade.

Value at Risk

Value at risk is a measure of how much money you can lose at a given level of confidence, and it can be used to determine trade size. In fact, this is the risk-management system used by most institutional traders. The program might look at historic returns, variance and covariance, or use a Monte Carlo simulation to calculate risk.

Cost of Carry

The cost of carry of an option trade is the amount of money it costs to finance it. Options trades are inherently leveraged. When you write options, you can earn interest on the premium received—how much depends on the terms of your account and the current market rate of interest, of course. When you buy options, you give up interest on the premium paid, at the margin rate charged by your broker.

Cost of carry is higher when the market rate of interest is higher. When that happens, you give up more interest to place a trade and earn more interest on the premium in your account. This changes the return on your position, which is one reason why interest rates are included in the Black-Scholes formula and other options valuation systems.

Plan Your Trade …

With all this information, it’s time to sit down and plan your trade. At first, it will seem almost like an artificial process, but after a while, it will be almost second nature. You won’t be able to place a trade without some sort of plan.

You should write down your trade plan, whether in a computer spreadsheet or a bound notebook. It does not have to be fancy, but it has to be done.

By the way, a lot of traders write down their trade ideas and hunches, even if they do not commit money to them. That way, they can go back to see if their ideas were good and whether they should trade them in the future.

How Much Money?

Start by noting the size of the position. What will you be buying or selling? How much margin do you need to commit? (Margin, of course, is the amount of money you are borrowing in your account to establish and maintain your position.) Then, using your money management system, determine how large this trade will be.

Setting down the reason for the trade is the most important part of the trade plan. Knowing why you are trading will help you fight off the emotional complications that can interfere with successful trading. It will help you recognize when things are going right—and when they are going wrong—so you can better manage the trade from start to finish.

For How Long?

Are you holding your trade for a day, a week, or until expiration? Will you roll it over at expiration or move on to something else?

Some options traders are day traders. Some are placing long-term hedges. And some do both. Set the target timeframe for your position up front.

… and Trade Your Plan

The trade plan is an active document! You don’t write it for the heck of it, but rather to guide your trading. Put it to work.

Order Execution

Your trade plan includes an entry point and an exit point. Paying attention to the market and using limit orders might improve the cost of your position.

A limit order tells the broker to buy or sell a security at a specific price or better. This would be a lower price on a buy order or a higher price on a sell order.

Let’s say you are looking to write a call option but want to receive at least $4 for it. You would enter an order to “sell limit 4” using the order entry form on your broker’s screen. This is a common type of order. You’ll probably see a field reading “order type”; that’s where you enter “limit.”

“Sell limit 4” means the broker will write your calls as soon as the option price hits $4. Your order will be filled as long as the price is $4 or higher. If the price falls to $3.99, the broker will stop selling calls for you.

If you have a long call position with a price target of $4, you could enter the sell limit $4 order even if the current price were only $2. The order would stay in the broker’s system, and then be executed automatically as soon as the $4 limit is hit.

Sticking to Your Limits

If you have set a target for your trade, and the trade hits it, get out. This is especially true on the down side. If a trade is moving against you, you need to get out. The miracle is not going to happen.

Many traders use stop orders to ensure they do not linger too long in a position that is moving away from them.

A stop order, also known as a stop-loss order, tells the broker to buy or sell as soon as a price is reached in the market. Traders often use these to close out a position automatically when it moves against them. For example, maybe you have a short position on 45 July puts with a premium of $2.35, which was a deep out-of-the money position when you wrote it. You want to limit your risk, so you also enter a stop order to close out the position if the premium were to rise to $5. You tell the broker to buy 45 July puts with a stop of $5: “buy stop 5.” You enter that order, and it stays in the system until you cancel it or until the price hits $5.

The difference between a stop order and a limit order is the stop order will be executed as soon as the price hits $5.00 or more, even if it keeps rising. The limit order will be executed as long as the price is $5.00 or less. Stop orders generally provide more protection for risk management of a current position, while limit orders are good for enforcing entry and exit points when establishing new positions.

There’s another type of order, known as a stop-limit order, that combines features of the two order types. It tells the broker to execute the order at a specific price or better, but only after it reaches a specific price—but you don’t want to chase it. So you could enter “buy 6 limit 7,” which would have you buy the option as soon as it hits $6, and you’d keep buying until it hit $7. You’d buy at $5, which would be cheap, but not at $7.50, which might be too expensive.

Stop, limit, and stop-limit orders can help you manage risk and force buy and sell points to improve your trading. They work even if you are away from your trading desk—and even if your emotions are creating the temptation to violate your trade parameters.

Keep a Trade Diary

A trade diary might be part of the trading plan, or it might be kept separately. It is simply a record of the trades placed along with a note about what worked and what did not.

This information is crucial to your long-term trading success.

• Keeping a record holds you accountable, which will help you manage the emotions of trading
• Reviewing your trading diary will help you improve your trading over time by revealing areas of weakness
• The information about risk and reward is a key part of many cash management systems

Managing Your Profits

Part of your overall trading plan includes figuring out what to do with the profits you make from trading. Will you trade it the same way, trade it more aggressively, or pull it out to put into a long-term investment?

Most traders do a combination, but understanding how it works can help you with your trade planning.

Compounding Returns with the Same Strategy

If you keep your profits in your trading account, and use them to trade the same way, you’ll keep earning a return on your return. That’s great. Compound interest is one of the most powerful forces in finance. It lets your money grow without changing the risk profile of the account.

This is an especially important practice if you are starting with a small account and hope to build it up over time.

Pyramiding

Not to be confused with pyramid scheme, which is a type of fraud, pyramiding is the process of taking your profits and placing them in riskier trades than are used in the core of the account. You trade the principal value of the account in the usual manner, and then commit the profits to trades with greater potential return—and greater risk.

If the market is moving in the direction of your trades, this will increase the total account value rapidly. If the trades turn against you, then you’re left with the core account value.

Traders who favor pyramiding have enough money in their core account to execute their desired trades. They are able to risk their profits but stay in the market with the core of the account. Hence, this is a more advanced strategy.

For stock traders, pyramiding involves leverage. Options trades are inherently leveraged, so there is no change in the order structure to use pyramiding.

Taking Money Off the Table

As trading profits build, it’s an excellent idea to move some money into a less risky investment. This doesn’t necessarily help your trading, but it does help the rest of your life.

And that’s good, because it will help you manage the emotion of your trades.

If you speculate in options, then the options account is probably the riskiest part of your portfolio. You can reduce your portfolio risk by diversifying into other assets. As your profits build, pull some money out and place it into government bonds, real estate, or even bank CDs. Sure, the returns will be much lower, but the risk will be much lower, too.