Five Tips to Help Your Option Trading in 2009

12/29/2008 10:54 am EST

Focus: OPTIONS

Price Headley

Founder and Chief Analyst, BigTrends.com

2008 was a historically tough year for mutual funds, hedge funds, and the "buy and hold" blue chip crowd. But every year can be a good year for the shorter-term trader who actively manages his account.

How can you increase your trading results in 2009? Here are a few ideas and concepts that will increase your bottom line:

1) Review Your Past Trades for Patterns

Keep your previous trades in a spreadsheet with a running sequential balance. Run examinations on the data that will show you patterns of success and failure. What types of options worked best (ITM, ATM, OTM, for example)? What holding period worked best? How far out should you go with your option expiration month? What indicators/system worked best? Would a different option strategy have worked better on the trades? Would a different option choice (different strike, different expiration month) have increased the bottom line? Are you comfortable with the risk/reward ratio of the results, drawdowns, etc? Other considerations that you will want to look at are the average percentage gain and loss of winning and losing trades (are you taking too much or not enough risk for your risk tolerance and capital level), and also the number of trades per month (too much or not enough, especially when commissions are taken into account).

2) The "Profit Ratio" Is the Most Important Metric on any Trading System

Many people think the win/loss percentage is the most important factor in analyzing a system. In fact, it is the combination of the win/loss percentage and the average winner versus average loser that gives the true reading. The formula that we prefer to use is the win/loss percentage times the average winning trade/average losing trade. A general rule of thumb is that it should be 1.50 or higher. The average size of the winning trade divided by the average size of the losing trade is the other key component. As a matter of fact, a 90% winning trade scenario can actually be worse than a 40% winning trade scenario where the average winner is far bigger than the average loser

3) Look to Sell Option Premium and Time Decay as Well as Buying it

Most option traders just buy and sell calls and puts. In doing so, you are 100% long premium, but also inherently face time decay and implied volatility risk. To balance this out, your option trading portfolio should be diversified by having some premium selling strategies in there, such as credit spreads, covered calls/collars, butterflies, etc. You should also be looking at limiting risk on your option trades by incorporating strategies where you sell another strike (debit and credit spreads), sell another month (calendar spreads), and/or sell volatility (long-term calendar spreads, ratio spreads).

4) Determine what Type of Market a Security/Index Is in and Look for Systems and Indicators That Work Well in Different Types of Markets

The key here is to determine whether we in a trending market, a trading range market, a flat market, a whipsaw market, or a parabolic explosive market. The same applies with individual stocks or ETFs. Different technical indicators and systems will work much better in different types of markets. To determine what type of market/trend an index or stock is in, you can evaluate whether it is hanging in the top or bottom half of the acceleration bands for a length of time. You can also step back to look at a longer time horizon chart than you use for your short-term trading, or look to things like: the volatility/range of the shares; is it hugging moving averages or moving far away from them; is volume increasing or decreasing; is percent R making moves above and below 20/80, or is it oscillating around 50? There are also specific technical indicators that may show the strength of a trend, such as ADX.

5. Always Have a Trading Plan That Includes Targets and Time Frames (and Stop-out Points)

Have a specific target for the shares over a specific time period and be disciplined with cutting losing trades. So, if you have a bullish signal on XYZ stock, you will want to determine what price you think the shares will reach over what specific time frame. For example, you may determine the shares will reach five points upside over the next two calendar weeks. Once you have a target, and the ability and knowledge to do a wide variety of option strategies, you can tailor your trades to any expectation and make money from any kind of market or chart. For example, you can say whenever an option trade reaches 100% profit, you will take out half the contracts, leaving a "free trade" with the other half. You also can have specific levels and closes that, if violated, will force you to exit a trade. For example, if XYZ shares have a percent R close above 50 for two consecutive trading days, exit the position. Quite often the best trades are the ones that go your way quickly, while the ones that lag or stagnate become the "hope" trades where you are wishing for it to come back your way. Cut those losers short and move on to the next opportunity with a clear mind.

By Price Headley, founder and chief analyst, BigTrends.com

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