With quick market fluctuations in the stock market, emotions can run high, and it can be easy to make impulsive decisions that can harm you financially. It is important to create your own detailed plan on how to conduct your option trading in order to protect yourself and your investments.
Professional stock analysts use two different types of analysis: fundamental and technical analysis. Technical analysis uses historical pricing and market trends. Decisions are based more on the data rather than emotion and impulse. It is necessary to have more than 1 investment plan in order to adjust to market trends such as a bear or bull market.
#1 Create an Objective
The first step is to create an objective which states the purpose and focus of this plan. It specifies the market condition you are trading in whether bull or bear. It also includes a time frame.
Let’s say that I am interested in learning how to trade options using vertical spreads. There are four different types of simple verticals:
- debit (long or bull) call spreads
- credit (short or bear) call spreads
- debit (long or bear) put spreads
- credit (short or bull) call spreads
Credit (short) vertical call spreads and debit (long) call spreads are both bearish because they make money when the stock price trades lower, and debit (long) call vertical spreads and credit (short) call spreads are bullish trading strategies because they make money when the stock price trades higher.
You could make an investment plan for simply a bullish market or a bearish market. It will be easier to create a separate investment plan for each type of spread when you first start trading as a detailed framework in order to limit the amount of mistakes.
In this example, we will say we are bullish and focusing on long call spreads only.
I am naming this investment plan: Long Call Vertical Spreads.
Here is my objective: Learn how to effectively trade short term rallies in an intermediate-term uptrend using long call vertical spreads through the use of general technical analysis.
#2 Watch List Criteria – What to Buy
Your watch list criteria describes what to trade. It contains your buying criteria, describes the trend, and includes financial ratios. When trading verticals, you want to trade options with high liquidity meaning it has a tight bid-ask spread, decent volume, and open interest. These components make it easier to enter or exit a trade.
Investment plans should be catered to your own tastes.
Here is an example of some criteria that I use on my watch list for bull verticals:
- Weekly option expirations preferred over monthly
- Charts demonstrate bullish trends
- Diversify = include multiple sectors
- Liquidity = Tight bid/ask spread
- High volume and open interest
- American companies
- Beta no greater than 1.5
#3 Entry Signals – When to Buy
Entry signals identify when to buy or sell (to open) your option contracts. It is important to stick to a written plan and refrain from letting emotions cloud your investment decisions before entering a trade.
Here are some entry signals I use when buying call verticals:
- No upcoming earnings
- Historical stock price is showing bullish trends
- Volatility rank is lower than 50
- Expiration date is 30-60 days
- Debit should be ~$0.50 per $1 width of strikes
- Bid/Ask spread is $0.20 or less for each option strike
#4 Money Management – Risk/Reward
This part of your investment plan sets rules that help you determine how much of your portfolio to put at risk. It will include how many contracts to buy, specific rules for trades, and overall portfolio allocation rules. It can be easy to see the dollar signs and feel tempted to risk more than you are willing to lose, therefore, this will provide guidance to help you stick to your plan.
Let’s say that you have $10,000 in your account and are using the entire balance to for trading. Many experts advise never risking more than 1% into a single trade. 1% of $10,000 is $100. This means that you would not complete any option trades that would cost more than $100 to enter or with a max potential loss greater than $100.
#5 Exit Rules – When to Close Your Trade
Now it is necessary to know when to close a trade or how to adjust your stop orders which will be your exit rules. Personally, I like to close all of my option trades before expiration due to the risk of the option potentially being exercised at expiration which could cause a larger dip in my investment account than I had planned.
Here are some exit rules that I use for closing my debit vertical calls:
- Sell to close my vertical call when I achieve 50% or more profit
- Sell to close my losing vertical call contracts before expiration
- Close all contracts 3-4 days BEFORE expiration at the latest
Lastly, it is important to create a general routine of tasks that you will complete daily, weekly, and quarterly in order to track your progress and financial account. This can be as simple or specific as you like it be and is the same for me with all trades.
An example of my Daily routines include:
- Check open positions daily for potential exit signs
- Monitor my watch list daily for potential entry signs
- Update my trading journal as needed
- Update my watch lists and alerts as needed
An example of my Weekly routines include:
- Search for new potential option trades through market research and financial news
- Spend at least 1 hour enhancing my knowledge of option specific strategies and use of the ThinkorSwim Platform
A Quarterly routine I complete is:
- Review my option trading journal including all winners and losers and find ways to optimize my trading.
Now Create Your Investment Plan
Having an investment plan is the key to your success with option trading. Mistakes can easily be made without sticking to a specific plan. Creating your own investment plan can help you avoid the misery of losing additional money that could have been avoided.
Investment plan should be individual to the person regardless of strategy and adjusted to what works for you. These can be created by yourself, with a mentor, or a financial expert to help meet your needs. Remember to include your objective, watch list, entry signals, money management, exit rules, and routines.
For beginners, you can try using a platform like ThinkorSwim using paper money first for a few cycles of option trading until you get more familiar with the platform and option trading in general. ThinkorSwim is a platform created by TD Ameritrade which also has great information videos and education for getting started. Then create your investment plan and put it into action.