Tag Archives | trading plan

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.

786


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Risk Management: First Line of Defense. Part III

These trades are not always winners

As we were discussing before the time out,
stocks can fall and losses can accrue when you adopt covered call
writing as a strategy. (Stating the obvious to be certain no one misunderstands: All strategies can lose money)

If
the stock price decline is severe, two unpleasant things happen to your
position.  First, the option has become relatively inexpensive and affords
essentially zero additional downside protection.  If the stock price continues to
fall, you lose money at the same rate as any other stockholder.  The trader who believes in managing risk does not sit idly by and watch money disappear from the trading account.  Yes, there's always the chance that the stock reverses direction and money flows into the trading account.  But hoping for that to happen turns this option strategy into a gamble.

Assuming you don't want to gamble, select a stock price that represents your limit.  This is similar to a stop-loss order.  When the stock reaches your price, you already know that you will take some action.  This is one of those decisions that can be planned in advance. 

Knowing when to take action to hedge against additional losses is not an easy decision for the inexperienced trader – but it is necessary to learn that skill.  However, in the early learning stages of becoming a trader, the objective is to choose an appropriate trade that satisfies your needs to reduce risk to an acceptable level, and allow for a profit (going forward).  As you gain experience, you will learn which trades are best suited for your personal trading requirements. 

Good record keeping helps a trader to become better.  However, the concept of keeping a trade journal is a very lengthy discussion on it own.  It helps with risk management because it gives you an opportunity to see which previous ideas worked.  This series would never end if I included my thoughts on keeping a journal.

Now that you know when (in terms of stock price, not in terms of the calendar) you plan to take action to reduce risk, the next task is to consider some specific trade ideas that will accomplish two things.  First, risk must be reduced to an acceptable level going forward.  Second, the position must suit your comfort zone.  In other words, you must want to have that adjusted position in your portfolio.

When no suitable trade can be found, it's best to exit and take the loss.  Choosing which action to take as an adjustment is discussed later.


When to adjust

Knowing that your call premium protects you down to $23.50 (at
expiration) helps with the decision. 

NOTE:
Prior to expiration protection decreases (i.e. the break-even point is higher than $23.50.  Why?  Because that call option has
not yet reached a price of zero.  If you decide to take action to
reduce or eliminate risk, you must buy back the call sold earlier. The rationale for doing that is simple:  If you sell another call option to bring home more cash premium, you would still be short that original call.

Most brokers do not allow any traders to be short calls that are not covered by stock, but that's especially true for the inexperienced trader.  Although it only causes problems on occasion, it just' too risky to hold that short call with no protection.  Sudden good news can result in a price surge.  Being short a naked call is not prudent and a good risk manager knows not to do that very often (if at all).

When you buy back that call option, it will not be expensive, and it will feel as if it's a waste of money.  Nevertheless, if you decide to sell a different call option before expiration, you must repurchase that call.

Managing risk involves different techniques and different ways of thinking.  It's impossible to delve into specific risk management methods for each strategy.  My plan here is to make you aware of the need to do something, perhaps make a suggestion (such as buy back that call and sell another), but the emphasis of this discussion cannot be on specific remedies for every strategy.  Because I'm using covered call writing as an example, sample trades for that method will be included.


Assume that seeing the stock
touch 22.99 is the right time to reduce risk, then as that stock price
approaches, you have to be ready to do something.  When making the plan,
determine if 22.99 is a 'hard stop.'  if it is, then you will take
action and not bother to worry about changing that price.  If it's a
'soft' stop, then you must know – again in advance – just how much
leeway you are going to allow before taking action.  The best leeway is
probably zero.

As you
gain experience, gain confidence, and make money, DO NOT abandon these
guidelines that helped you get where you are.  It's okay to become a bit
flexible, but there's a big difference between being flexible and being
stubborn.  You cannot afford to adopt the loser's policy of refusing to
accept a loss.  The truth about trading and investing is that losing
money on some trades is inevitable.


The
Plan

Question:  How
far can this stock decline before you become
afraid of losing more than you can afford to lose?  Or to be less
dramatic, more than you are willing to lose?  In this example that price
is $22.99.

NOTE:
When writing covered calls it's usually easiest to choose a stock price
as the trigger for taking action to reduce risk.  But there are other
strategies, and other means are often used to make the decision.  Some
of these triggers:

Position delta.  Are you too long or too short for comfort?

Position gamma? Is the delta changing too
quickly?

Dollars lost? 
It's best to set a maximum loss per trade.

Something different?  Perhaps technical
analysis.  Perhaps you changed your market view on the underlying stock.  Any rationale you for adjusting that you believe is worthwhile – is worthwhile.


Please understand that this is an example, and I
am not recommending a specific price. There is no correct price
because each trader has his/her individual risk tolerance and stock
market outlook.  But let's assume that price for you is $22.99 per
share. 

You now have
the answer to the second of the two questions posed earlier.  You will
'take action' when
the stock price reaches, or approaches $22.99 per share.  Above that
price
you are willing to hold the position.

It's necessary to answer the other question: 
What action will you take?

to
be continued…

694



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Risk Management. The First Line of Defense. Introduction IV

Parts one, twothree



One of my main
theses is that risk management is the key to long-term success as a
trader.  As such it's a skill that's best developed as early in your trading career as possible.

But that presents a conflict.  If you are brand new to options, you are spending time learning various strategies and trying to understand at least one of them well enough to make trades.  If you accept my premise about the importance of risk management, then becoming familiar with a given strategy is not enough.  Now there's the additional concern of learning to manage risk.

This doesn't have to
be a problem because there is no urgency, especially when you are making trades in a practice, or paper-trading, account.  You must have a good working knowledge of how to trade your strategy before you can get involved with making other trades to 'fix' a troubled position.  When you feel comfortable using your strategy, that's the time to pay attention to discovering what to do when your plan for the trade is not working as hoped.

When you are ready to monitor and adjust a position gone awry, as with any skill, you cannot expect
to be proficient at the start.  The major advantage of trading without real money on the line is that you can experiment with a variety of risk-reducing adjustments.

This may sound overwhelming, and if you feel that way, it's reasonable to exit trades as your only risk management approach – but only as you gain experience and look for alternatives.  the most important aspect of managing trade risk is recognizing that 'doing nothing' is not going to work over the longer-term.

As a new trader, or
as an
experienced trader who is expanding his/her understanding of trading,
please recognize that trading is similar to many other professions.  Practice improves your skill set;  it makes you a better
decision maker.  By making practice trades, you encounter far more decision-making opportunities than when you trade a real account.  In a practice account, you can trade more positions – as long as you are not overwhelmed and devote sufficient time to manage them properly -and that translates into more education, more experience, and greater confidence in your ability to make a good decision under pressure.  Practice is extremely worthwhile.

If you cannot earn
money with a practice account, then there is no reason to believe you
can do any better with real world trading.  Michael Jordan and Tiger
Woods were not born as stars.  They worked long, hard hours and
practiced. A lot.  No one is expecting you to be the top trader, but if
you want to earn a living, it takes work.  You don't just open and
account, enter some trades and collect the cash.

Thus, if I have
encouraged you to learn about risk management, it's okay to get some
good experience with a paper-trading account.  When a trader comes to
believe that proper risk management is vital for long-term success, then
he/she accepts the notion that there is more to learn than merely buying and selling some options.


Not everyone believes in paper trading.  The primary reason is that it's not real and that no emotions are involved in the decision-making process.  In addition, there's a temptation to make it a game.

I cannot disagree more.  First, the successful trader must learn to control emotions, and if you can make emotionless decisions when it's practice money you may be on your way to doing the same with real money.  If you want to be a
winning trader, you must take paper trading seriously.  You must
concentrate on figuring out how to make good decisions, and not just try something weird on
a whim (you an do that in addition to making serious trades).

Paper-trading will be the focus of a future post.

Not everyone has the talent
to become a champion or an expert.  But in the world of trading, you
must be significantly better than average to survive.  I cannot verify
the accuracy of the statement, but I have heard, and find it easy to
believe, that most people who attempt to become traders never
make any money.  If that's true, you must learn, understand, and
practice to be certain you are way above average.

687



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Short Course in Risk Management: Introduction

In my opinion, there is only one hard and fast rule about managing risk:  You must get it right.  Most beginners accept the fact that it's important to trade very small size and/or use paper trading accounts to gain experience. Few jump into trading with large trades.  There's no denying that sizing trades is the most efficient and easiest method of managing risk.  But that's where risk management ends for beginners.

When a rookie gains confidence because of his/her ability to earn money, it's natural for that trader to want to increase position size.  And making a gradual change is justified. 

However, it's not a string of profitable trades that should be the determining factor.  The best approach is to demonstrate the ability to profit by making good decisions before considering the possibility of increasing size.  This does not mean three consecutive winners. 

It means several months of success – both in dollars earned and in terms of holding positions that do not involve more risk than you should be taking.  It may be difficult for the rookie to tell the difference between good luck and good trade management, but it's necessary to make that distinction.


If I'm making money, isn't that all there is?

Risk management is never considered from the same perspective as profits. Most traders who are able to earn profits – especially when they earn profits as soon as they begin trading – make the unwarranted assumption that they are talented traders.  They don't consider that the market may have behaved perfectly for their chosen strategy.

It's very important to understand the difference between trades that are well-managed and those that luckily end well.  This is a subtlety lost on too many.  The 'obvious' but inaccurate conclusion is often: 'If I made a profit then it was a good trade and I must have handled it well.'

To understand the risk of any given position (or portfolio), it's essential to know

  • How much can be lost, if the worst case scenario occurs
  • How much can be lost today, under unusual market conditions
  • What you have to gain by holding the position; i.e., potential profits
  • The probability of earning a profit from the position as it exists now
  • How theta (the passage of time) affects the position
  • The effect of a large change in implied volatility (vega risk)


To manage risk successfully, you must know

  • What is your first line of defense?
  • When will you take that defensive action?
  •     At some specific number of delta away from neutral?
        When your short option reaches a certain delta?
        When your position loses a specific sum?
        When you get nervous?
        When the risk graph tells you something specific
            Lose $X if the market moves another 2 or 3%?
            Lose X$X if one week passes or if IV drops by 10%?

  • What is your general plan when trouble looms?
  • Will you exit the entire trade?
  • Will you buy back a portion of the losing side?
  • Will you trade shares of the underlying asset to get delta neutral?
  • Will you buy extra options?  Which strike price?
  • Will you roll the position to farther OTM strikes?
  • If rolling, to which month do you plan to roll?  Same?  Next?
  • Do you plan to adjust in stages, or all at once?

As a rookie, you cannot be expected to have the knowledge or experience to prepare a plan with all this information.  But, you can pick a small number of items. 

I'd suggest that you know your first line of defense.  To me that means whether you plan to get out of the whole trade or plan to find a suitable adjustment.

The other important topic is when you will implement that line of defense.

That's a good start.  When you find it's time to make a position adjustment, the decisions you make may help you find another couple of items to add to your trading plan.

Over time, you will develop a sense of what you want to know in advance.  The better the plan, the better you can manage risk.

It's not essential to know these items in advance, but if you do, you will be in much better shape.  You can make decisions, when necessary, even when conditions are stressful.  Having a well thought out plan makes a big difference, especially when you lack the experience or discipline to make good decisions under pressure.  If you have never been short a bunch of puts in a rapidly falling market (with exploding implied volatility), then you cannot know how you will react.  It's far better to have a plan in place and then act on that plan when necessary.

As you gain more experience over the years, as you gain more confidence in your ability to react well under pressure, then these plans will be easier to compile.  If you prefer to make decisions on the fly, and are confident you can do that well (without emotions getting in the way), you can continue making trade plans with rough guidelines rather than specific trade ideas.

But don't give up making those trade plans.  It's good risk management to prepare for contingencies.

to be continued

675


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The Importance of Having a Trading Plan

Mark,

In my last post I explained how I am in my second month of trading
spreads. I also explained that for this month I entered the call side
first and entered the put side last Friday. As you continue to point out,
the key to being successful in these spreads is how you adjust (or NOT
adjust) not just whether you make or lose money.

At this point, I could
exit my call side (these are May index options) for about a 60% of
max profit. If I exited my put side I would probably lose most of that
profit, and have a slight gain from the whole transaction. the delta on
my puts are about .06 so I am not at risk at this point.

How would
you normally handle this situation? There are many "options" I see, but
most likely are:

1. Close all positions, take a small gain

2. Close the Calls for a 60% of maximum profit and either

a) sell a new call
spread to try and bring in more premium; or

b) do not sell a new call
spread and wait and watch the put spread

3. Do Nothing

Scott

***

I've previously explained my personal methods.  They suit me but may not suit you.

1) The point of adjusting is to prevent loss and to give yourself an increased chance to earn profits going forward


2) When you opened this trade, did you have a plan?  Did you have some idea of WHEN you hoped to exit or HOW MUCH you hoped to earn?

Having such a plan makes these decisions so much easier.  The fact that you lack a plan is why you are asking questions now.

The plan is not the absolute final word.  You can be flexible.

Would your plan call for exiting now at a small profit?  If not, why are you considering doing that?  Are you afraid?  Are you outside your comfort zone?  Do you fear a rally – is that why you want to repurchase the calls?  You cannot expect to be able to continue trading when you don't know he answers to these questions.


3) I always exit my 'winning side' regardless of whether the 'losing side' is in serious trouble.  The problem is when to exit and how much to pay.  I trade my iron condors, collecting about $3 credit.  I close almost any spread at $0.15, and will bid as much as $0.25, depending on circumstances.  That's my plan.  Decide what your plan is.

I don't care about 60%. That's not enough information.  For example, if you sold @ 10 cents, would you pay 4 cents to cover?  You'd lose money after commissions. 

How much would it cost to cover?  That's the key issue.  Are you willing to take the risk of remaining short this call spread at its current price?  If yes, then do nothing.  If you are a bit concerned, then consider covering a few of your short call spreads.  Enough to move you back withing your comfort zone.

If you are covering because you are bullish – that's okay, if you want to trade with a market bias.  There is nothing wrong with doing that.  It's your money.  But be certain that's what you want to do.  There is no shame is risk avoidance.

Selling another call spread is a legitimate way to play this.  But I dislike that idea.  I prefer to establish a plan and not increase risk at any time.  Selling a new call spread brings the position back near delta neutral and that is desirable for many traders. 

I prefer to be satisfied with my target profit – if I can get it – and not be greedy.  To me, selling new call spreads just sets up the possibility of a huge whipsaw.  You are too new to do this.   One major decision you must make:  how much extra cash must you take in to make this trade worth the added risk?  You are too inexperienced to have a good idea.  I recommend saving this idea until you have proven that you can manage risk well enough to take the chance of increasing it.  That does not mean six months.  Take your time.

Keep in mind:  Some extra cash from call spreads provides very little protection if those put spreads get into trouble.  That's why I don't like selling replacement spreads.  Too little to gain, too much chance of losing.

When I cover a call spread, I almost never sell other call spreads as a replacement.

4) If you have no plan write one right now.  Look at your position as it exists right now and make some decisions:

  • When do you hope to be able to exit?
  • How much would you like to pay when that time comes?
  • How flexible do you want to be in the above goals?
  • How much are you willing to pay to exit the call (put) spread?  How much is cheap enough?
  • Does time remaining prior to expiration affect that low price you are willing to pay?
  • When do you plan to take a good look at risk?
  • How high must the delta of your short option be before you plan to adjust; or
  • How much money must you be losing before planning to adjust; or
  • How much time must pass before you would consider exiting the whole thing at a small profit?
  • Anything else that occurs to you

The trading plan offers guidance in making a difficult decision under stress.  If you already have a plan in place, you can execute that plan. 

As a beginner, the more guidance you can provide for yourself – in advance – the easier it becomes.  A good exercise is to look at that plan daily and decide if it's still good, or whether you should revise it.  The point is for you to THINK about your positions frequently and make a plan often.  It is NOT to change the plan.

The plan gives you more confidence because you have already thought about what's important.

It truly helps manage risk.  It makes decision-making easier.

668


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