6 Steps to Profitable Options Trading
03/03/2011 5:00 am EST
Look over the shoulder of a professional options trader as he outlines the six steps he uses to identify and execute trades, citing three recent winners as examples.
One of the best ways to learn to trade is to examine real trades executed with real dollars. What led to the decision? How was the trade managed? What led to the decision to exit? I have shared, on occasion, some of my own trades, either ones taken in the class with my option apprentices, or on my own without them.
The Friday before to the President's Day holiday, I made three similar trades, and now that they have been exited, I can share them. By the way, these MoneyShow.com articles are not meant to be trade advisories, for their sole purpose is strictly for education.
In order to present myself clearly, I will utilize my six trading steps:
Step 1: Fundamental Analysis
I always start with fundamental analysis (FA), which deals with the question, "What to buy or short sell?" Prior to the long weekend, I chose to trade the exchange traded funds (ETFs) that have huge liquidity. By using ETFs, I do not need to spend too much time looking at the next earnings release dates, stock split dates, or dividend payouts. Hence, all the time gained by not doing these fundamental detours can be utilized for technical analysis and for grasping the bigger economic picture.
Step 2: Technical Analysis
Technical analysis (TA) is concerned with answering the question "When is the right time to enter a trade?" Besides timing, TA helps us to determine in which direction the underlying should be traded. In my case, I selected a bearish stance. There were several reasons for it.
First of all, my belief that the US stock market, in general, was ripe for a correction, was based on the fact that virtually every single daily bar of the Spyder Trust (SPY) for the month of February was a green one. There was not even a single down day; the last one being Jan 30, which was totally recouped just a couple trading sessions later.
Secondly, there was a ton of divergence on various technical indicators that I checked. For instance, as the price action was creating the higher highs and higher lows, I noticed that indicators were giving readings of lower highs. (By the way, technical indicators should be placed on the charts when the market is trending to see if they confirm the trend. Going into the long weekend, they were not confirming it, but were diverging.)
Thirdly, I noticed that the major leaders, such as Apple, Inc. (AAPL), were already lagging behind the market. All these points combined led me to the conclusion that the market was ready for a pullback.
Step 3: Implied Volatility
Due to the fact that the market was in a strong uptrend, neither the implied volatility (IV) or the VIX was very high. In an ideal situation, it would be a dream come true to sell juicy premium, and although that was not the case, I did sell anyway because of the long weekend and my strong bearish bias.
Step 4: Proper Position Sizing
Position sizing should always be relative to the trader’s account size and will not be discussed herein. However, not one of these three positions was greater than ten contracts. Moreover, every one of them was first entered by a “foot soldier,” and only after the foot soldier had been killed/filled were the rest of the troops sent in for the executions.
Step 5: Entry and Active Monitoring
The specifics of these three bear call trades are listed below in Figure 1. They were all entered during the last hour of trading on that Friday.
As you all know, the market was closed that Monday due to the President’s Day holiday, and by the time it opened the following Tuesday, the market traded lower. I actively monitored performance while waiting for my orders to buy back my obligation for a nickel or less to get executed. After all, it was only my short leg that I had to be concerned about.
Step 6: Exit and Learn from It
The very same day, Tuesday, the PowerShares QQQ Trust (QQQQ) short leg was repurchased for a nickel per contract. On Wednesday, the market traded lower and the other two trades were exited in the same way. Once the trades were exited, the profit/loss (P/L) needed to be recalculated because the trades did not achieve their maximum profit. But that is not all of what needs to go into the P/L calculation. To calculate the true profit, the commissions also need to be included. In my case, there were three commissions paid, one dollar per contract.
The worst rate of return (ROR) was actually on QQQQ, yet that was the most obvious trade for me, because AAPL (which represents 20% of it) was trading lower even on Friday. The short leg was exited on Tuesday. Personally, for me, the sweet spot for ROR is 25%. Verification of these trades is provided in Figure 3 below.
At the time of writing this article, the leaders appear to be bottoming out and getting ready for a bounce. Again, I am referring to the mighty AAPL, which has created a green bar on the market's red day. This should be interpreted as a "Proceed with caution" sign, for the market tends to do what is most unexpected. In the end, please always buy back your obligation without any regrets.
By Josip Causic, instructor, Online Trading Academy