The One Thing Every Rookie Option Trader Needs

02/20/2014 7:00 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

If you want to graduate from being a rookie trader to an experienced one, you need to master this skill, says Mark Wolfinger of Options for Rookies.

I've posted about trade plans on MoneyShow.com in the past. However, it's an important topic and this time we'll 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 to 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, or 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/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, 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.

NEXT PAGE: Learning to Become a Skilled Plan Writer

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Why Bother?

The negative side of plan writing must be mentioned as well:

  1. It takes time
  2. It requires thought
  3. It's not as much fun as making trades that feel right at the time
  4. It takes discipline
  5. You may not want to adhere to the plan when the time comes

    The Rookie Plan Writer
    As a true beginner with no trading experience, making these plans is difficult. I understand completely. 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.

    By Mark Wolfinger of Options for Rookies

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