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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10 Responses to Trade plan for the rookie

  1. Steve B 02/01/2011 at 10:29 AM #

    Great topic Mark,

    If I may offer some personal experience to this… you are absolutely correct, a new trader may not know how to “adjust” a position on the fly in order stay ahead of the game. This comes with a lot of education and even more experience. But one thing a brand new trader can do is set the target gain and the maximum loss they are willing to take on each trade and stick to that.

    For example, if we use the example trade in above, a max profit of $400 and a max loss of $1,600, decide that once the profit reachers $300, you will exit the trade and take your profits (or set up the appropriate stops so that you lock in profits). If you are down $150, you will exit the trade and cut your losses. Keep it simple at first. You don’t need experience to do that. Nothing blows up a trading account faster than letting a loser run, I speak from experience. And more often than not, if you try and squeeze that last few pennies of profit out of trade, it will turn against you.

  2. Mark D Wolfinger 02/01/2011 at 10:39 AM #

    Steve B,

    You just described an excellent trading plan for a first-time planner.

    I do want mention that the $300 and $150 numbers are not specific recommendations. I’m fairly sure you meant to use them as examples.

    I find $150 to be a bit conservative, but the point is to have a plan in place.

    Thanks

    • Steve B 02/01/2011 at 10:44 AM #

      Correct, just continuing the example from above. If $400 is a max profit, I personally want to keep at least a 2:1 profit ratio, but that is just my trading plan and rules. The $300 and $150 are just numeric example, not recommendation in the least bit.

  3. Mark D Wolfinger 02/01/2011 at 12:14 PM #

    2:1 reward ratios make a lot of sense for stock traders. I don’t believe they work nearly as well for option traders.

    As an example, if IV were to suddenly increase due to some expectation surrounding an important new event, any options position that is short vega would immediately be subject to a forced exit. That makes no sense to me when the underlying has not moved and the premise for the trade still holds true.

    I believe that much more aggressive ratios are applicable in the options world. In our example able, Personally, I’d be much more comfortable using $320 to $350 as my profit target and $600 to $800 as my maximum loss. I would have made at least one adjustment before that maximum loss target was reached, but I do not believe a premium seller can survive when planning to exit trades so quickly.

    • Steve B 02/03/2011 at 10:24 AM #

      I think for a trader (experienced or beginner), wouldn’t the ratio and risk acceptance depend heavily on account size? If a new trader starts out with a $5k trading account, which is a pretty decent sized starting account, he can’t be wrong too many times risking $800/trade. That is a pretty heavy % of his overall account to be risking on 1 trade, in my opinion and I don’t think that you are advocating new traders risking 15-20% of their account on each trade. That is trade suicide. 🙂

      On top of that, if the true max risk of the trade is $1,600, keeping with the example, wouldn’t that also greatly affect his buying power and ability to have more than 1 trade at a time?

      I totally understand where you are coming from especially as a seller of options and agree. But tying back to your previous blog on the trader who ignores all advice on risk… I would hate for a new trader with a $3-$5k starting account blow up his account in 3-5 trades because he was willing to accept $800 loss each time. So i was trying to keep the examples low in case someone just used a given number as hard fact and went out to apply it.

      • Mark D Wolfinger 02/03/2011 at 11:57 AM #

        Steve B,

        I would never suggest risking any specific amount on any trade. You said that your numbers ($300 and $150) were ‘numbers and not specific recommendations’ so please make the same assumptions about my numbers. As you know, I NEVER (NEVER) recommend a trade on this blog.

        I merely used one trade as an example. I would not expect someone with a VERY, SMALL trading account (and $5,000 qualifies as very small for an options trader, in my opinion) to trade a 20-point iron condor. Would you?

        The fact that I would risk $800 on such a trade has nothing to do with how much someone else would risk. If you prefer $150, then so be it.

        1) Yes, amount at risk depends on account size.

        2) No, it would not affect his buying power. If anyone with a $5,000 account were to make this trade, there would still be $3,400 of residual buying power. With that, he could make more trades. But, as I said, this is a very poor choice of trades for someone with a small account. Surely the 10-point iron condor could have been chosen instead.

        3) Your final paragraph is misguided. You use low numbers for risk management [unrealistic and suicidal numbers – in my opinion. Unrealistic because $150 losses will occur frequently – too frequently for the trader to have any chance to earn money.] But more than that you are tackling risk management backwards.

        Instead of finding a way to manage risk for that iron condor trade, you should accept the fact (as you obviously do) that this is a poor choice of trades for the small trader. The best method for managing risk is avoid initiating trades that are inappropriate for the trader and his/her account.

        Proper risk management is not primarily based on limiting the loss for a given trade. It’s avoiding the bad trade in the first place. Limiting losses comes second.

        Regards

        PS. Now that I’ve posted this, I recognize how important this topic is. I’ll be discussing this again.

  4. Robert D. 02/01/2011 at 11:10 PM #

    Mark,

    Thanks for emphasizing the importance of trading plans. Once you make yourself write a few of them, you find that they’re not so hard to put together. (It might seem that the hardest part of planning a trade is finding a good entry point, but that’s just the beginning!)

    Regarding your comment about not selling option premium when increasing volatility is expected, would you discourage selling call spreads during such times? My initial risk capital will be minimal, and I foresee trading no more than a few contracts at a time. So commissions will take a noticeable bite out of what will already be low-profit plays. It seems that if my profitable positions can expire, then I can avoid the closing round of commissions, and that could offset reduced spread value due to increasing IV.

    As always, thanks for your insights.

    • Mark D Wolfinger 02/02/2011 at 8:36 AM #

      Robert D,

      Your simple comment/question raises some VERY IMPORTANT points for traders.

      1) I understand the need – and the advisability – of trading just a small number of contracts. However, one of the problems with doing that is it will cause you to to something that you just KNOW is not in your best interests. You will reject making an adjustment because the commission cost is too high. Or you will refuse to exit early, trying to collect the last 10 cents on a trade just because commissions are too high.

      The only viable solution is to change brokers. And it can be temporary. Open an options trading account with a broker who charges very low rates. Once you have gained some skills and experience, have more money etc – and are ready to trade more options at one time, then is the time to move back to your preferred broker – if you still prefer them.

      One of the lessons I learned long ago is to NEVER refuse to make a necessary trade – just to avoid commissions. You don’t have to agree with my conclusion because this is my opinion, based on my experiences, and not a fact. Please be careful when deciding to ‘do nothing’ due to costs of trading.

      One other caution: DO NOT increase position size in this situation. That’s not the answer.

      2) If you believe the market is heading higher, I assume you avoid taking short positions. So, if you think volatility is very likely to increase, why would you get short vega?

      Having said that, I want to emphasize that most traders cannot (although they truly believe they can, predict market direction. It’s then natural for such traders to assume they can predict implied volatility direction. If you have a track record that says you have prognostication abilities, then do not sell vega when you believe IV will increase. However, if you recognize the truth – and that is you don’t really know what is happening next in the marketplace, then don’t let high or low IV hinder you from making trades.

      Just use common sense. If you fear that IV will increase; if you believe there’s a good chance that it will increase then all you have to do is trade with less negative vega. Perhaps add a calendar spread to your portfolio (not ATM). That’s another way of saying that you can turn all or part of your iron condor (or credit spread) into a double diagonal (or diagonal). The purpose would be to own a portfolio that is near vega neutral rather than being short vega.

      That vega neutral is not a cure-all because the calendar or diagonal can easily perform poorly in the market. But is does reduce vega risk and does outperform iron condors – at least part of the time. This is not a recommendation to alter strategies. Just a way to reduce vega risk.

      The bottom line reply is that if you truly expect the market to do something, don’t make a bet against that specific something.

      3) Yes, not paying those commissions increases profit potential. No doubt about that. However, holding a position with very little to gain exposes you to risk of loss when the reward to risk ratio is at a terrible point. Nor exiting is a difficult decision under those circumstances. But I understand. I’ve been there when commissions were MUCH higher ($6 to $10 per CONTRACT) than they are today.

  5. Mike C. 02/02/2011 at 4:36 PM #

    Hi Mark,
    Thanks for another richly informative post!

    Can I bounce a quick trading thesis off you?

    In my paper account, I’ve had really tremendous results over a short testing time frame selling spreads with just a couple of days to expiration, on underlyings with big news driving IVs up.
    (Sold a straddle on AAPL the day between the Jobs announcement and earnings, for example. It was naked, but breakevens were above the all-time high and below the 50DMA. Covered when the puts were at 90% profit and the calls near 0 time value.)

    My theory is that the safety gained by limiting the trade to one day offsets the risk of selling premium in a wild market.

    (The example above was a naked position; I’ve since realized hedged positions make more sense. This morning I bought the 25/28/31 weekly butterfly on SLV, $2.23 credit, 2 days to expire and rather strong technical support and resistance inside the wings.)

    So I’m hoping for insight from your market experience. Is this a strategy that’s going to blow up often? Intuition tells me (I haven’t found a way to backtest this yet) that when these go wrong, they’re going to usually go wrong very quickly and be max losses. Extra-high volatility is extra-high for a reason. But not holding overnight eliminates risk of surprise gaps, and when the premium is so rich, your winners can more easily outweigh your losers, no?

    I’ve gathered from your writing that this won’t suit your trading style – and I can understand liking the steady accumulation of theta decay. For me, though, these were very satisfying trades- waiting, waiting, waiting for the right setup, applying it, and seeing the payoff quickly.

    To stick to the topic of the post, too; this lends itself to a straightforward closing plan. Close at either a % of max profit (say 50%) or at the end of the day, whichever comes first.

    I just hope you can tell me whether I’m trading more dangerously than I think I am.

    Thanks!
    Mike

    • Mark D Wolfinger 02/02/2011 at 7:05 PM #

      Mike,

      Thanks

      Let’s begin with the end. If you size these trades properly for the size of your account – and that means both respecting the potential loss, and not being too greedy (a string of winners can do that do you) then no, you are not trading too dangerously. I do suspect that risk is greater than you currently estimate it to be, but no trade is too risky when trade size is chosen carefully.

      I can understand why this has been so successful. The probabilities of success are on your side. These are one of those situations in which losses occur infrequently. The problem is that when you lose, there’s no good estimate of just how much that would be.

      You appear to be doing this intelligently by picking your spots, not jumping on every opportunity, and being aware of just how far OTM feels right – due to charting or how much option premium you collect.

      The negative of these trades is that when is a short moves far ITM, there’s nothing to do. No place to roll, no offsetting options to trade. It’s just a loss. I don’t like these plays for myself. But my guess is that speculators love buying these options and that the prices received are high enough that you can be a consistent winner. You must expect to lose part of the time, so the obvious warning is to avoid getting blown away.

      Regarding the one day trade: Because you are selling premium into news, you already know that the market will be ‘wild.’ So there is no special advantage to exiting the same day (but it is still a wise move).

      If you sell spreads, limiting losses, then you cannot blow up the account. You can take a hit – and your job is to keep those occasional hits to levels that do not hurt.

      I endorse this idea for you because it suits your trading style and you seem to be aware of the risks. I understand how tempting it is to play the Weeklys, especially on high implied volatility. Just be careful out there.

      Sometimes the same play can be made with longer term options. After all, if IV collapses, so do those options. And gamma is not as bad.