6 Do’s in Options Trading - dummies

By Joe Duarte

Skillfully applying your trading plan as a seasoned pro requires practice, patience, and experience. It’s a journey that, ideally, you must welcome, hone, and implement as part of your life. Following are several Do’s for you to apply in your trading strategy.

Do focus on managing risk

Managing risk is the name of the game and your number one priority. The less money that you can manage to lose, the better off you will be. In fact, when people ask you about your trading and what you do, tell them you’re a risk manager. Become one with it. How’s that for nuance? It could make you popular at dinner parties too — or not.

By just exploring option strategies, you are actively addressing other financial risks in your life. These include inflation risk, income risk, and even market risk associated with buy-and-hold investing. The study of options trading — because it is all about risk management, attention to detail, and planning your exit before you make a decision to trade in real time is likely to subconsciously rewire the way your brain look at the markets, and ­perhaps life.

When your trading is built on risk management, you train yourself to

  • Thoroughly understand the risks and rewards associated with the ­markets you trade.

  • Learn and test strategies before putting money on the line.

  • Create a plan that identifies trade sizes entry and exit approaches and maximum loss allowed.

  • Identify how the plan will be implemented to honor your risk ­parameters.

  • Understand how to establish positions and manage a trade, including communication with your broker regarding any margin requirements for complex options strategies.

  • Have a plan for taking profits.

  • Ask yourself, “What if I’m wrong?”

Other, more general risk considerations include diversifying sectors and strategies traded. You may properly allocate trade sizes, but if you enter five trending trades using the same strategy on stocks in the same sector, well then, you’ve kind of gone against that trade-sizing rule. That’s the nuance. By extending these guidelines on a portfolio basis, you’re acting more as an effective risk manager.

Do trade with discipline

Trading with discipline means following your rules on each and every trade. Not some of the time, or most of the time, but every time. Will you have a perfect record on the discipline front? Probably not . . . But don’t worry. It takes time. If you lack discipline early on, and you’re fortunate enough to remain in the trading game, you may be in more trouble than you realize. The fact is, your luck will eventually run out. It’s best to work at it so that your discipline will continually improve. Otherwise, it’s just a matter of time before your luck will run out, and so will your money.

Unfortunately, those experiencing initial success may delay an appreciation and commitment to disciplined trading. Early success can give you a false feeling of being right, which is not what trading is about.

Characteristics of trading with discipline on each trade include the following:

  • Allocating a reasonable amount of money to a trade

  • Identifying a maximum risk for the trade

  • Identifying entry and exit signals

  • Executing an order when your plan requires it

Those are the checklist items, but trading with discipline goes beyond this. Doing your homework, reviewing your trades, assessing your plan . . . The bottom line is that the process involves learning what you have to do to trade successfully, mapping out how you’ll do it, and then putting it into practice.

Do have a plan

Many Wall Street sayings have been around for a while simply because they remain true, year after year. Other adages do as well, including one that fits perfectly here: “When you fail to plan, you plan to fail.”

Creating a base plan should definitely be considered a process rather than a one-time event. Think draft and start by writing an outline. Completing it with an easily edited word-processing document or spreadsheet may be great, but if you feel you’re at the computer too much, a plain old piece of paper and pen is fine. The old-fashioned approach allows you to jot notes along the way without procrastinating because your computer is off. The bottom line is to create something and put it in writing.

When working on your first trading plan, set a timeframe for completion and revisit it about three months later. This gives you a chance to kick the wheels, identifying what seems to be working and not working. It also highlights what elements may be missing. Anticipate a second review about six months later and then get on a regular schedule that makes sense.

In addition to primary risk-management elements, start incorporating items such as general rules (for example, buying low implied volatility (IV) options and selling high IV options when feasible) and the steps you’ll be taking to accomplish this (such as reviewing historical and implied volatility charts and checking IV levels with an options calculator).

Identifying other aspects of your trading job helps too (such as analyzing market conditions for long-term investments separately from short-term trading). And again, identify how you’ll be accomplishing this (for example, monthly Saturday analysis for investments, weekly Sunday analysis for trades).

Because both the markets and your personal situation change over time, expect your trading plan to change as well. Better yet, plan on it.

Do be patient

Because so much emphasis is placed on managing risk and creating a plan, you may feel a lot of pressure to create the “right” plan. Try to understand that there’s almost always more at stake when there is no plan as opposed to a plan that needs some work.

Part of the trading plan process includes making adjustments to your rules. That’s definitely something you do outside of market hours. Making ­adjustments as the result of assessing strategy performance works toward improving your overall trading plan. It may mean increasing trade allocations or your stop-loss percentages or trading fewer strategies at one time.

Your plan may be too aggressive or too conservative, but at least it serves as a base for making adjustments. Will your second draft be better? Probably, but changing market conditions could impact the effectiveness of your adjustments. It’s okay; at some point you will have traded under a variety of conditions and will have learned techniques to capitalize on them. It’s called experience, and it takes time.

Patience is not just for trading plans. Sometimes the best thing a trader can do is nothing . . . waiting for the trade or waiting to take profits are useful skills that can have a big impact on trading profitability.

Do take responsibility for your results

It’s all on you. Never, ever, ever shift any responsibility for your trading results on anyone or anything but you. Why put your success in someone else’s hands? It makes it too elusive.

In your trading career, different situations or problems will certainly arise that impact trade profitability. If there’s a problem with executions, consider how you’re placing the orders and discuss it with your broker. If problems persist, remedy it by shifting a portion of your assets to another broker and measure those results.

When you don’t have sufficient time for your standard analysis due to work constraints, personal commitments, or whatever, shift to strategies that you do have time to do the right way. If there is still insufficient time, stepping away from trading is your only responsible choice. Don’t worry. The markets will still be there chugging away when you’re able to get to them. And when you do, you will have preserved some assets for trading.

By always acknowledging the fact that you are responsible for your own results, you seek out solutions faster and take control. You don’t have to wait for someone else to take action or for some event to occur. Accepting responsibility early in the game helps you assert much greater command over your learning curve and accelerates successful trading.

Do love the game

Successful traders love what they do. They love reading about trading, learning new strategies, and hearing the adventures of other traders. You learn and improve by participating in as many aspects of your craft as possible. Believe it.

Primary drivers for successful traders include really enjoying the challenge of understanding the markets, applying the right approach, and being disciplined. For them, it’s not about getting even or making money. That’s partially because you have to love something that requires such intense work — not necessarily long hours, but certainly focused ones. Simply making money, as a singular driver, will eventually lead to large losses for most traders.