5 Ways to Make More Money in Options

11/25/2011 7:00 am EST

Focus: OPTIONS

Moby Waller

Editor, Wyatt Research

With 2011 winding down, a review of some key functional areas can help the trader diagnose what is working and what isn’t and make adjustments for a more consistent and profitable year ahead.  

The year 2011 has been a grinding, volatile one for stocks. The major market indices have made little in the way of net gains for the year (and in fact, some are down). For many mutual funds, hedge funds, and the "buy and hold" blue chip crowd, it's been another tough year. But every year can be a good year for the shorter-term trader who actively manages his account and utilizes the leverage of options.

So how can you improve your trading results in 2012? Here are a few general ideas and concepts that will increase your bottom line.

Review 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. Think about these types of questions when analyzing the data:

  • What types of options worked best (in the money (ITM), at the money (ATM), or out of the money (OTM), for example)?

  • What holding period worked best?

  • How far out should you go with your option expiration month/week?

  • 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/loss of winning/losing trades (i.e. are you taking too much or not enough risk for your risk tolerance and capital level), and also the number of trades per month (i.e. too much or not enough, especially when commissions are taken into account).

Know Your "Profit Ratio"

Many people think the win/loss percentage is the most important factor for analyzing a system. In fact it is the combination of the win/loss percentage and the average winner vs. average loser that usually gives the most accurate reading, in my view.

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 in analyzing a profit ratio that we like to use is that it should be 1.50 or higher.

You can achieve a strong profit ratio with a winning trade percentage of 50%, 60%, or 70% (or as a matter of fact, any win percentage). The average size of the winning trade divided by the average size of the losing trade is the other key component.

For example, there can be a 90% “winning” trade scenario that is actually worse as far as actual profits when compared to a 40% winning trade scenario (where the average winner is far bigger than the average loser).

NEXT: Look to Buy (and Sell) Option Premium

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Look to Sell (and Buy) Option Premium and Time Decay

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 debit/credit spreads, calendar/diagonal spreads, covered calls/collars, butterflies/condors, etc.

See related: How to Sell Options for Income

You should 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/diagonal spreads), and/or sell volatility (long-term calendar spreads, ratio spreads).

Look for Systems, Indicators That Work in Different Market Conditions

The key here is to determine whether we are in a trending market, a trading range market, a flat market, a whipsaw market, or a parabolic explosive market. Same applies with individual stocks and 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 look at things like:

  • Is it hanging in the top or bottom half of the acceleration bands for a length of time?

  • Step back to look at a longer time horizon chart than you use for your short-term trading

  • The volatility/range of the shares

  • Is it hugging moving averages or moving far away from them?

  • Is volume increasing/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.

See related: The Pure Technician’s Indicator: ADX

Always Have a Trading Plan Including Targets and Time Frames

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. 

Or, if the maximum potential value of a multi-legged option trade (like a spread) is 80%, you can have a rule (written or unwritten) that you take out half or all of the position when it reaches half of the maximum profits (in this example, 40%). (A similar rule can be applied to exiting losing trades.) Or else have somewhat of a profit-taking trailing stop.

You also can have specific indicators 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!

Just some food for thought. Here's to increasing your trading profits in 2012 and beyond! 

By Moby Waller of BigTrends.com

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