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Trade plan for the rookie

Trade Plans

I’ve posted about trade plans more than once. However, it’s an important topic and this time let’s discuss it from the perspective of a rookie trader.

It’s advantageous to write a trade plan for every trade and to keep that plan updated. As time passes or when the position changes (because of an adjustment) it’s time for another update. Why? The primary purpose is be certain that a trader understands why the trade was made. More importantly, the plan makes the trader think about situations when it’s no longer viable to hold the trade as it stands. The experienced trader will recognize the need for taking steps to reduce risk. The inexperienced trader may become frozen with fear or uncertainty. Having a trade plan that applies to the current situation offers one reasonable trading solution. The plan may be the decision to exit, reduce size, or make a specific trade to reduce risk. Having a solid trade idea in times of stress makes a huge difference to the confidence level required to pull the trigger on the trade suggested in the written plan.

Please recognize that it is not a winning strategy to enter into a trade just because it feels right – when you have no ‘real’ reason (other than your gut) for making the trade. [NOTE: If your gut has a good track record, then it’s right to pay attention to it.] If you are making a directional play, ask yourself whether you are truly bearish/bullish for a good reason. If it’s a non-directional play (such as an iron condor) does the reward justify taking the risk? If you have any reason to believe that a volatile market is approaching, then it is an inappropriate time for iron condors, writing covered calls, or other premium-selling strategies.

To decide if the risk vs. reward numbers for the trade are attractive, a trader must have both a profit target AND a maximum loss target (your own worst case scenario). Reminder: Just because a trade strategy comes with a built-in maximum loss, there is no reason to become lazy and allow the position to slowly reach that maximum. The plan must be realistic and based on having the discipline to take that loss – when the time comes.

Example:

Trade a 20-point iron condor by collecting $4.00 credit

The maximum gain is $400 and the maximum loss is $1,600. In reality, you would probably exit before $400 is earned. Thus, the profit potential is less than $400. It’s important to know (fairly closely) the real target.

I hope the maximum loss is less than $1,600. If it is, you must decide how long to carry this trade before exiting. By writing that number into your plan, you become aware of that number. For more experienced traders, the number may be flexible. If there is a good reason you can allow a slightly larger loss. However, the trap that must be avoided is deciding that the loss has become so large that you may as well gamble with the position. Long term success comes to traders who avoid the big losses.

As the trade progresses, you may want to make minor changes, but the experienced plan writer understands that it’s worthwhile to have a written plan – just in case action is needed when the market is volatile and you, as an inexperienced trader don’t know what to do. The answer is to do exactly as the plan describes. It may not be the best possible solution, but it is a well thought out plan, and is going to be a reasonable choice.

Why bother?

The negative side of plan writing must be mentioned:

  • It takes time
  • It requires thought
  • It’s not as much fun as making trades that feel right at the time
  • It takes discipline
  • You may not want to adhere to the plan when the time comes

The rookie plan writer

I understand completely. As a true beginner with no trading experience, making these plans is virtually impossible. How can you have any idea when it may become uncomfortable to own that specific position? How can you know how much profit to seek or at which level to limit losses?

The answer is: You cannot know. However, you can make a reasonable estimate. It takes trading experience to get a good feel. However, you can take a stab at it. Make a guess. Obviously when you are at this stage of your trading career, one of the things you are learning to do is to write a trade plan. Thus, it is clearly understood that the plan is not very valuable as a plan of action and that you may not trade as the plan directs.

Nevertheless, altering the plan to something better – assuming you have the time to do it – is a learning process in itself, and the next plan you write will be a better version. You not only learn to trade, but you also gain experience in writing plans. It won’t be long before those plans become valuable and truly assist in the decision-making process.

One good method for gaining experience is to write plans for trades in a paper-trading account. Think about it: It requires extra for each new trade, but the purpose of paper-trading is to learn something useful. If you not only gain trading experience, but also gather plan-making experience, it’s a double win. As always, there are no guarantees, but a successful plan writer has a better chance of succeeding when real money is at stake. And that’s the bottom line, isn’t it? Doing everything you can to recognize risk and avoid blowing up your account has to be a top priority. And that possibility is almost never given much thought by the overconfident rookie trader.

Keep the plan simple and only make it more detailed as you move ahead with your education. For your initial plan, include profit and loss targets. The next time try to estimate the stock price at which an adjustment may become necessary.

Clarification: When speaking of risk in this context, I almost always refer to the risk of mounting losses. However, when a position has been working well and profits have been accumulating, there is always the risk of losing those profits. That’s a true risk. One of the factors to consider is reducing trade size, exiting the trade, or adjusting to lock in some profits. Risk refers to any position that doesn’t feel right. If profits could easily vanish, that’s just as much of a risk as the chance that losses can suddenly increase. In either situation, it is your money at risk, and a good trade plan insures that the chances of losing that money are minimized.

That’s the rationale behind getting a lot of practice before entering the game with real money.

Paper trade. Open a practice account with your broker (or at an online site) and make some trades. Manage those trades. As you see more and more different situations (please take notes in a trade journal), you will begin to see things with your own eyes. I can tell you what to look for, but seeing for yourself is far better as a learning experience.

It’s all too easy for the rookie trader to assume that plans are too complicated or that they are for the more experienced trader. However, if you expect to become one of those experienced traders, becoming concerned with risk and writing trade plans go a long way toward keeping you in the game long enough to gather that experience.

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Trade Plans

Mark,

Thanks for another thought provoking column.

Would you be willing to
share the template of your trading plan? What factors you deem
important, trigger points, why or if you modify the plan, etc. Nearly
everything I read talks about preparing a trading plan, but nobody gives
an example or explains how to build one.

I always start out by sizing my trade, establishing my maximum
downside limit and expected profitability, then I look at the Greeks,
but I'm sure that I'm blind to factors or processes that will help me
execute better trades. I mostly trade covered calls, with some spreads
and iron condors added from time to time.

Thanks,

Gordon

***

Hello Gordon,

I appreciate the kind words, but it's readers such as yourself who provide the fodder with excellent questions.  Thus, I thank you.

One reason you don't see a lot of plans is because too few traders use them and they are very personal.   Besides, what suits one trader is not likely to suit others.

My trade plans are different from those of most traders.  While I initiate positions as iron condors, I always manage them as two separate trades.  I look at the call and put spreads as separate positions – from the point of view of exiting at a profit, and adjusting  for risk.  I almost never have an opportunity to exit both sides of an iron condor simultaneously.

One of the valuable inputs for a plan is:

If something unforeseen happens, which trade am I likely to make? If I list one or two, I can make a trade in a hurry.

For covered calls, the choices are few.  You can exit or you can roll the call.  Or you can sell extra calls (this is a risky choice and I would never choose it).

For iron condors, there are many alternatives, and having a specific plan in place is helpful. 

I don't mean a plan that includes this statement:

'I will cover this call spread and sell this call spread for these prices.'

But I do mean one that reads like this:

'I'll exit 50% or 100% or ?% of this trade when the underlying reaches this price area by this date.  After I do that, I see three good choices: a) do nothing; b) sell a new call spread (list possibilities) if the trade meets my requirements for new trades; c) use this opportunity to buy, or at least bid for, some cheap put spreads – so that I don't get hurt if the market reverses.'

Some traders may prefer to exit the iron condor and open a new one.  This choice is not for me (don't want to move to a more dangerous put position), but it is a viable alternative.


I don't use a template. 

When I own insurance (I don't own any at the moment), I feel less urgency to exit a touchy situation. However, I must make an important statement:  Just because you own insurance and just because potential losses disappear when the market moves far enough, that does not mean that the spread being protected can be ignored.

Repeat: Owning insurance is no reason to ignore risk.  It may appear that your position is well insured and 'safe,' but most of the time if you examine the risk graphs by shifting the date to expiration week, you will notice that the protective nature of the insurance has disappeared [The reasons why this is true is a whole separate discussion]. 

Thus, please treat risky positions as risky positions.  Do not depend on insurance to save you from a large loss.

1) Like you, I have a target profit – with an estimated target date to exit.  When that profit is available, I re-examine the position to see if I still want to exit, or perhaps go for another incremental profit.  I am referring to an extra profit that can be earned in a day or two.  I am not referring to changing a 20 cent bid to only 15 cents.

2) I also have an underlying price at which I expect to make an adjustment.  Obviously, the date that the price is hit makes a big difference in my adjustment choices.  For example, I cannot expect to move the position to another in the same expiration month when time to expiry is short.  That is one good reason for updating the trade plan as time passes.

When expiration is nigh, and I am still holding a trade, if an adjustment is needed, I simply exit.  That's personal because I avoid front-month positions.  I don't just roll to a new position.  I exit.  that's the end of the trade and of the trade plan.

3) I may, and often do, open a new position – but that trade has its own, brand new, trade plan.  In other words, rolling to a new position and combining the trade plans and profit/lost numbers together – is not something I believe is a good idea.  Each trade stands on its own.

4) Although I have a portfolio consisting of several different iron condors (maybe three for each of three different expiration dates), I manage each 'risky' situation on its own.  Sure, I can look at the risk of the overall portfolio and choose not to adjust a specific trade, but I have discovered that this is a losing proposition (for me).  I manage each trade on it's own.

5) If I exit a trade that was insured, I make an immediate decision:  hold that insurance for other trades, or exit the insurance, recovering part of the cost (or sometimes, exiting at a profit).

6) My written plan cannot contain all of this.  However, I can make trades based on experience, even without every detail being written.  The trade plan serves two primary purposes.  It allows the less experienced trader to plan ahead and not face a panic of an 'I don't know what to do' scenario.  When the situation arises, the plan may no longer represent the number one choice that you would make given more time to work on the trade, but it gives you a GOOD trade under stressful situations – and that has real value.

The other reason for a plan is to provide a record of trades and thoughts.  As you review them later, you may be able to see a error in your planning.  Good.  That's a mistake you can avoid making in the future.  Or perhaps some situation will occur a few times and you can see if you handled it well or poorly.  That's educational and information to be used later.

As a new options trader, use the plan to help speed up the learning process, not as a 'written in stone' trade that must be executed if such and such occurs.

7) Right now, I use size as my primary risk management tool. Then I have 'points OTM' guide that is flexible.  When a short spread reaches that point, I make an adjustment.

8) My adjustment strategy varies with market conditions, and whether I own insurance.  When IV is high, I prefer to roll to a position with the same expiry – assuming there's enough time remaining – at a higher strike.  I prefer to increase size – usually in a buy two and sell 3 ratio.  But I only increase size when overall risk allows for it.  More size is often a very poor adjustment choice. 

9) I tend to cover 10 to 20% of the short spreads at one time when making my first adjustment.  I do NOT 'roll' into a new trade.  I'm always looking for new trades, and add them when appropriate – not just because I exited a risky position at a loss.

10) If a position is too risky – because the market moved a bit too far or because I got stubborn, then I exit the whole position.  I truly don't feel that I must make a new trade to recover the loss or that I must roll to give myself a chance to recover the loss.  The next trade I make – whenever that turns out to be – will, by definition, be an attempt to recover all, or part of that loss..

11) A plan written with 90 days to expiration is no longer valid when only 30 days remain, so rewriting plans weekly or bi-weekly makes sense to me.

12) I don't believe that your plans prohibit you from finding better trades.  There is only so much you can do with a covered call.  Once you pick the stock, the biggest part of the task is finished.  Choosing the option is probably not a methodology you can set in stone.  Whether IV is high or low may influence the expiration date.  Your gut feel for the market, even if you claim not to have a bias, may influence the strike price.  Thus, sticking to one unshakable CC strategy probably does not work for most people.  I recommend consistency, but common sense and comfort zone boundaries must count for something when planning a new trade or adjusting an existing position.

13) Gordon, from your description it seems to me that you are covering the important points with your plan.  For me, the plan's purpose is to provide an idea in case of an emergency market move. It's designed to prevent a panic decision.  It's not so much used to make the daily decision on whether to hold today or exit.  Once your trade is near that 'take the profit or hold' point, you must manage the position to satisfy the risk/greed ratio.

14) However, here's something you can add to your plan:  "Why am I making this trade?  What will convince me that I made a mistake and that the underlying is not going to behave as expected?  Dare I still hold onto a covered call (or iron condor) and the downside risk?  Is this price decline likely to be temporary, or must I abandon this trade now?"  The answers may be the result of technical analysis, a re-evaluation of your stock selection process etc. But this re-evaluation becomes part of the plan.

15) I don't look at the plan as a big money-maker.  I look at it as good method for being certain that a trader understands the specific trade and what he/she hopes to accomplish (some traders slap on a position with no idea of what they expect to happen). 

Plans help.  They are not essential, but they offer guidance and help solve the anti-greed problem.  You may even discover (too late for this trade) a good reason why a choosing a different strike price for the initial trade would have been better for your specific situation.  I am not saying:  Strike should have been lower because the stock declined.  No.  I'm referring to a real, logical reason: Something you could have seen, but missed.

Use plans to provide guidance.  Don't allow writing the plan to drive you nuts.

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