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Keeping a Trade Journal

See my site for a blog post and a series of articles about making trade plans and keeping a trade journal.

It is very easy for us to think about a trade: make the trade, wait a while and then take our profit or loss.

It is very beneficial for us as traders when we have a good record of the thoughts that went into our decision-making process as well as the results of the trade. When we return to read our journal entries, we are removed from the time and place of the trade and can analyze the results as if the trades were made by another trader. We can learn from our past decisions.

The objective is discovery

  • Was your reasoning sound? Or did you make a poor decision?
  • Recognizing that you made a bad choice, you should be able to understand what went wrong and how you can avoid a similar mistake in the future
  • Did you choose a strategy that was appropriate at the time, or did you take a shortcut and rely on using your bread-and-butter strategy without any real thought?

Was the trade profitable?

  • If yes, did the trade plan help you earn that profit?
  • Were you just lucky and earned a profit despite making errors?
  • Is there a lesson to glean? Is there something you want to be sure to repeat next time?

Was the trade a money loser?

  • Did you make a mistake? What was it? Did you ignore risk management?
  • Many times, the trade was unlucky. Was that true in this example? Be honest.

Trade plan example: Writing Covered Calls.

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Trading Plans: Profit vs. Loss

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I’ve stressed the benefits of writing a trade plan for each trade. This seems to be one of those things that is easier to ignore and many question the worth of such plans.

Before entering into any trade – especially a trade with limited profits, it’s important to know just how much can be earned so that it can be compared with the maximum possible loss. Without having an idea of the profit potential, there is no sensible method for deciding whether to make the trade. The thought process may resemble this:

Considering how much I can lose if things don’t work out well, and taking into consideration the probability of losing that much, is the potential profit (and the chances of earning that profit) worth taking the risk?

Let’s take a look at an example – one that I’ve used previously.

The trade: Buy (I know, most people prefer to use the term ‘sell’) a 20-point iron condor and collect a cash credit of $4.00. The underlying asset is a broad based index, such as SPX, NDX, or RUT.

Maximum theoretical gain: $4.00

Maximum theoretical loss: $16.00

We could look at the delta of the short options, or use a probability calculator to give us an idea of how likely it is that the position would finish safely out of the money. We could determine the probability that one of the options would become an ATM option (‘probability of touching’) during its lifetime. In other words, we have some idea of the statistical chances of success/failure.

To determine if you want to own this trade, you should not look at those $4 and $16 numbers, unless you know that you are going to hold this trade all the way through expiration. That would be a terrible idea and is a slap in the face to those of us who believe that risk management is essential to making money when trading.

For traders who do hold, these $4 and $16 numbers are real and the trader achieves one of these result in the vast majority of situations. A small percentage of the time the gain or loss is different, but that requires that the settlement price be within the borders of either the call or put spread. [When the short option is out of the money, then the profit is $4. When the long option is in the money, then the loss is $16. If neither of those situation obtains, then the final settlement price is between the strikes and the 20-point spread is worth anywhere between $0.01 and $19.99.]

Exercise risk management skills

For those of us who know we will neither allow the options to expire worthless nor allow the loss to reach the maximum, we must estimate a maximum profit or loss. Sure we all think of the chances of earning the whole $4, but the risk involved makes it a poor decision – for my comfort zone. I’ve often discouraged readers from seeking every last nickel from a trade.

The point of this post is to alert plan writers to the fact that the theoretical limits are not realistic and you are far better served to enter profit/loss targets that are realistic according to your own guidelines. I would probably use numbers such as $3.50 as the maximum gain and perhaps as high as $8 for the maximum loss. Note: that is a personal trading style, not a recommendation.

In reality, I never seek that maximum gain, while other go after seek every penny. There is no arguing with the fact that leaving money on the table is not the path of the expert trader. However, deciding how much profit is enough, and when the reward no longer justifies taking any risk, is something that comes with experience.

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