My strategy for 2015:
Create small, consistent wins through trading naked puts, covered calls and collars on CLF, TRN and GE which create a 1% monthly return and capture 60% or more of the available premium.
It sounds nice, but how do I put that into action? That’s the burning question I’ve mulled over for about the past month or so.
Of course, I should’ve thought about this prior to the New Year so I could implement it in January, but I’m still learning! So, how would you go about meeting your trading goal?
Here’s how I decided to break down my strategy to create small, consistent wins this year.
There is a method to the madness
After scouring the web and my books on building a solid trading plan I came up disappointingly empty.
Many books and sites say something along the lines of, “you really need a trading plan” or “you shouldn’t enter a trade without a plan”, however none of these sources really give you an idea on how to create a plan.
For example, over at Investopedia, a go to site of mine for learning about investing, you can find “10 Steps To Building A Winning Trading Plan.” Within this document, these ten steps consist of things like “keep excellent records”, “mental preparation” and “set goals”. While these are definitely ideas, there’s no real meat to the discussion.
Another article (here), again on Investopedia, provides detailed, multi-post info on building and testing a trading plan and I think it’s probably worth your read. But it still didn’t quite hit the mark for me.
However, after digging through these and otherresources I’ve come up with my own process on building a trading plan which is adaptable to anyone’s particular trading style.
A four step process to building a trading plan
As I dug through all the sites I slowly came to a realization. Each of these talking papers on trading plans really seemed to link back to a few, broader areas common to all trading plans. As we continue along in this process you’ll see I’ve broken this down into four different steps: Understanding the Underlying Security, Strategy, Techniques and Procedures.
Let’s jump right into understanding the underlying security.
Step One – understanding the underlying security
The first thought which struck me concerned understanding the underlying security you’re trading around. For me, this would be CLF, TRN or GE as my plan currently stands. There’s literally hundreds of pieces of information you could find on each security. What’s the minimum you need to know about the underlying?
Well, I broke it down into a few things. First and foremost you’ve got to know the symbol.
I know most of you are probably laughing and have the symbols on your watch list memorized or could list them backwards alphabetically, however we’re going to use it as to track which security we’re planning for.
Get to know the 52-week high/low
Beyond the symbol I think it’s also good to know the security’s 52-week high/low, various support/resistance levels and the earnings/dividend calendar. Let’s tackle each of these in turn.
The 52-week high/low can, for obvious reasons adjust every week, so why take a snapshot of it? I think it’s great for just this reason. It’s a snapshot in time of the security’s performance over the past 52-weeks. This metric helps you gauge where the security currently is in its roller coaster ride.
Is it on the low side? Maybe there’s potential for a big upward move. Is it hugging the high? Maybe it’s going to settle back down a bit. Regardless, it’s a single measure and shouldn’t be the end all in any analysis you do.
Let’s move on to support and resistance.
Support and resistance
I think support and resistance may be one of the most important characteristics to understand when examining a security’s chart. Just understanding this basic concept can enlighten you on so many traits of the security.
I won’t take the time here to explain what support and resistance are, but if you need a refresher head over to Investopedia and search for either term.
Understanding support and resistance provides you with two insights. First, they provide zones which are likely to be good for selecting strike prices for options. Let me give you an example.
Take a look at this CLF six month chart.
When you look at this chart you will see a support level of around $6. So, within the past six months CLF only closed below $6 during the past few days of trading. This tells me I’m likely to have success selling puts around $6 for CLF because historically the stock bounces back up off this price.
Is it a guarantee? Nope, but it’s another data point in your analysis.
With resistance, you flip this idea on its head and use it to sell calls. Again using CLF’s six month chart as an example, there are two resistance levels. One level exists around $7.5 and the other around $10. As CLF approaches these prices, gets denied and starts to fall away I could sell calls with strikes near either of these numbers and have confidence my trade will pan out.
The second interesting tidbit about support and resistance is how they tie into supply and demand for the individual stock. This is a concept I ran across back in November as I was digging around on the internet.
Let’s tackle support first. Refer back to the CLF six month chart and its support level of around $6. At this price buyers feel they’re getting a deal on the stock so demand for the stock increases, buyers purchase more of the stock and it “bounces” off the $6 zone. The $6 support zone represents the price point at which demand for CLF stock begins to exceed supply.
This creates upward pressure on the stock.
On the opposite side, the $7.5 and $10 resistance zones represent the points at which CLF or sellers of CLF stock are willing to supply more stock for sell. However, buyers see the stock as “expensive” at this level and supply begins to surpass demand.
This caps the price at this level and forces it to start falling down again. I find this interesting because this concept goes beyond just looking at the stock’s chart and gets at the underlying psychology of those interested in CLF stock.
If the stock stays within this supply and demand range we can assume nothing fundamentally changed about the stock. However, let’s say CLF is trading around $6 today and announces they’ve created a new mining method which tremendously drops their cost to mine.
With this ground breaking development we’d expect CLF to blow through its resistance zones because their cost to do business, something fundamental about the company, changed. If this expectation turned into reality, we could be fairly certain the psychology of those who buy and sell CLF stock changed too and use this to our advantage when trading.
We’ve covered support and resistance; let’s move on to earnings and dividends.
Earnings and dividend dates
Earnings and dividends are special events which can affect how a stock is traded. Let’s start with earnings. Earnings announcements are events which increase the volatility of the stock because of the excitement of whether or not the company will meet expectations. As such, if you’re selling options across earnings you need to be aware of how the earnings announcement can affect the option you’ve sold.
Last year I was burnt a couple of times selling across an earnings announcement. I was tempted by the increased premium associated with these trades but I didn’t take into account how quickly the trade could go bad if the earnings announcement went against me…which they both did.
So, while I’m not advocating to not sell across earnings, I think it’s definitely something you need to track as part of your trading plan!
As for dividends, sellers of covered calls who wish to keep their shares probably already know when the ex-dividend dates are. If you don’t know what the ex-dividend date is, it’s the date on which you have to own the stock to get paid the dividend.
With sellers of premium, there is the potential your option could be exercised early if the buyer wants to collect the dividend. The details on this require a little math, but the bottom line is the remaining premium in the covered calls you sold needs to be greater than the dividend coming up for payout in order to avoid an early exercise.
Here’s a quick example. Let’s say you’re selling XYZ stock and it’s currently trading for $10 and you’ve sold a $9 call which is now in the money. You check and see you can buy it back for $1.25. Take the $1.25 and add it to the $9 strike price to arrive at $10.25.
The next step is to subtract the current trading price of the stock, $10, and you arrive at .25 cents. If the dividend of XYZ is greater than .25 cents, then you can guarantee you’ll be exercised on your shares. Why? Let’s say the dividend is .40 cents. If the buyer of your option exercises the option he’ll immediately make the .15 cents on the transaction.
This seems like a lot, but you can simplify by not selling when dividends are paying out. Your other option is to pay close attention if your option is in the money and roll it to save yourself the concern and math headache!
The bottom line is both an earnings and dividend calendar need to be in your trading journal so you can easily reference the information without constantly digging it up on the internet.
Step two – selecting trading strategies
Okay, so we’ve gotten the underlying’s basic info out of the way let’s tie this back into the bigger picture.
The strategy is the overarching idea of how you want to trade against the underlying security. Do you want to sell covered calls? Or are you buying options? Looking to trade credit spreads? That’s where this info goes.
Take care in selecting the types of trades you will use. I highly suggest only using trades you currently understand how to enter, exit and roll. Learning on the fly when real dollars are on the line is not fun!
Beyond laying out the type of trades you want to use you also need to layout some overarching concepts. Let’s talk risk.
Four methods to manage risk
What is your risk profile? How much risk are you willing to take on each trade?
There are a number of different ways to manage risk. Choosing a method or methods to manage risk is an individual preference and not really something anyone else can tell you to do. There are a variety of risk management procedures, all which are adaptable to individual trading styles.
Let’s take a look at a few different risk management methods.
The very first class I took on options trading at Learn-Stock-Options-Trading.com (LSOT) talked quite a bit about risk. This course suggested managing risk as a percentage of your total account. For example, if your account is $10,000 and you choose to risk 2% per trade, you’re willing to risk $200 with each trade.
I think this is a great way to manage risk when you’re buying options, however it’s a little difficult to look at risk in this manner when selling options. I prefer to look at risk in a slightly different manner when selling.
When I sell options I set an acceptable loss level if the underlying moves against my option position. For example, if I decide my risk level is a 30% loss when I sell an option for $1.00, that would me I’m only willing to buy back this option for $1.30. I can either set an order which is good until canceled to buy back my option if it climbs to $1.30, or I can just keep an eye on it and buy it back when it moves against me.
Either way, I’ve defined my risk tolerance and I can adjust it if I feel I want to become more aggressive or conservative.
A third way to manage risk is through managing your cash level, or buying power, in your account. Setting a cash amount as a reserve gives you the flexibility to adjust positions if they move against you. I currently maintain a $1,000 reserve in my buying power to give me the ability to close out positions which move against me.
If I chose to become more aggressive, I would reduce this level to free up additional cash for selling or buying options. On the other side of the coin, I could maintain more cash in reserve to maintain a more conservative posture.
A last way to manage risk is to reduce/increase the number of lots you trade. This is an easy way to manage your exposure to moves against you in the market. If you’ve bought 10 lots for $1.00/ea. you have $1,000 at risk. However, if you choose to only buy 2-3 lots for the same amount then you’re only risking $200-$300.
This method of risk management is similar to setting a particular percentage of your account as a max risk per trade, but it’s just a different way of approaching it.
Combining any number of these methods is probably a good move. On a recent covered call trade I made against my CLF position I chose to employ two of these methods. I set a 30% max loss for the position and then I also chose to only sell a single contract instead of two to reduce my cash requirements if the position moves against me.
Managing risk is one of the most important concepts for an options trader to understand and the most important part of the trading plan. Without a good risk management plan, you’re likely to quickly blow up your account. Risk management allows you to take a loss but still have longevity within the market.
With a good understanding of risk management, let’s move on to talking about why we’re all trading options…profit!
Setting a profit target
Trading options is all about making a profit. If you’re not out to make a profit while trading then I’m not sure what you’re doing. However, instead of just “rolling the dice” and hoping for the best there’s a smart way to go about making a profit.
“Let your winners run.” It’s a saying I’ve seen mentioned on many a trading site. The question is how long do you let your winners run? Is there a point beyond when collecting profit is just greed and exposing you to unnecessary risk?
These questions can only be answered by you. But like risk management, you can set profit targets and adjust them as you become more comfortable trading.
Let’s take a look at my 2015 trading plan again:
Create small, consistent wins through trading naked puts, covered calls and collars on CLF, TRN and GE which create a 1% monthly return and capture 60% or more of the available premium.
Within this plan there are two different profit targets set. The first is captured as a “1% monthly return”. This sets a profit level I not only aim to hit with each trade, but as a total return on my account. Beyond giving me a target, it helps me discriminate between which option to buy/sell.
Let’s say GE is currently trading for $25 and I want to sell a naked put against it. If my target is a 1% monthly return, and I intend to sell only a single contract which covers 100 shares, then I need to find a strike price which nets me $25 after commission.
The second profit target within my 2015 plan is “capture 60% or more of the available premium”. This profit target allows me to set orders to automatically buy back options I’ve sold to capture the profit I’ve made on the trade.
With a recent CLF trade I sold a March 7 call for $.33. If I want to collect 60% of the premium within this trade, then I need to close the trade once it reaches around $13 minus commission. I’ve set up an automatic order so once CLF reaches this predetermined target, then I’m automatically out of my trade.
Could I let the trade continue to run and collect additional premium? Sure, however I would leave myself open to risk I’ve deemed unnecessary since the trade could still move against me and force me into a loss.
We’ve talked about choosing your trade, various risk management techniques and how to look at various ways to set a profit target. Now we move a step away from the concept of your trade towards the techniques you’ll use to choose to meet the intent of the strategy.
Step three – techniques to match concept to reality
A solid strategy for your trade plan is great. However, you need to be able to translate that concept into reality. How are you going to actually meet your risk management and profit target goals? What will you look at or read to get you there?
There are a TON of trading techniques and indicators you can use to help you meet your goals. You could probably spend a year just learning about the variety of techniques available to you to help interpret the movement of the underlying security you’re trading around.
From Bollinger Bands to Stochastics to the Ultimate Oscillator, there are many techniques you can apply to chart reading. The question isn’t should you use some of these technical indicators, but which ones?
Many of these like the Ultimate Oscillator or the Fast/Slow Stochastic are momentum indicators using previous closing prices or various highs and lows in an attempt to help you understand if the underlying security is going to continue to move up or down.
Others, like Bollinger Bands, work off the volatility of the underlying and attempt to give you a range of movement to predict future moves.
These and many more types of technical indicators are out there for you to examine, experiment with and put to use. My go to resource for understanding the basics on technical indicators is Investopedia. I haven’t found a great book just yet which acts like an encyclopedia for technical indicators. If you know of a book which gives you a little bit of history on the indicator and how to use it, please leave a comment below!
The goal is to select as few indicators as you need to execute your trade. Too many indicators and you’ll go crazy trying to figure out all the nuances and attempting to determine if you should enter or exit a position.
In the trading plans I’ve built, I’ve identified 3-5 indicators which give me the signals I’m looking for in a timely manner. Any more and I think you might start confusing yourself.
Now we’re at the point where we have our strategy and our techniques we plan to use to employ this strategy. The next step is writing out the detailed procedures to tie it all together and help us understand when to push the “buy/sell” button.
Step four – building procedures to tell you when to push the button
Great, I’ve decided I want to sell covered calls against my shares of CLF and I plan on using a mix of Bollinger bands, moving averages and some of the momentum indicators…now what? How do I make this work?
The goal with your procedures is to identify those conditions, in detail, which meet your optimal trading conditions and write them down. This removes much of the emotion involved in the trade. It’s quite possible during this segment of building your trading plan, you’ll discover you have too many or too few indicators and you need to adjust.
Creating detailed procedures for executing your trade puts all the thinking up front and allows you to execute when your conditions are met.
Let’s walk through this as if we’re working through a trade. Some other traders like to begin with exit conditions, and I can’t argue against it, but for logical progression let’s start at the beginning with entry conditions.
So, you’ve got your strategy in mind and your technical indicators, now you need to pull up a chart and examine them all together. When do the mix of the indicators you plan to use meet your optimal conditions to implement the trade your strategy calls for?
Do all your indicators need to be pointing in the same direction or only a few? Are you going to wait for the indicators to reverse? There are a lot of possibilities which you need to think through and I can’t possibly cover them all, but let me give you a sample of what your entry conditions may look like.
Going back to selling covered calls against CLF, here’s one possibility for entry conditions:
CLF hits upper Bollinger Band and starts to pull away; Ultimate Oscillator signals overbought; Momentum is steady or decreasing; Rate of Change is steady/decreasing; Slow Stoch %K crosses below %D.
This example covers five different indicators and their conditions which should be met. I don’t include which strike to buy at because my profit target sets this for me. See how it’s all starting to come together?
Setting your exit conditions is similar. You want to again look at your indicators along with the underlying security and see when it makes sense for you to exit your position. If you’ve hit your profit target you should be exiting your trade, however you also need to set conditions to exit if your trade starts to move against you.
Circling back to our CLF example, let’s take a look at some possible exit conditions:
Capture 60% of premium after commission; CLF hits/nears lower Bollinger Band; Ultimate Oscillator shows oversold or near; Momentum is increasing or steady; Rate of Change is steady or increasing; Slow Stoch %K crosses above %D.
Exit conditions are very similar in makeup to entry conditions, however they clarify when your indicators tell you it’s time to exit the trade or the trade is beginning to move against you.
Unfortunately, sometimes you just aren’t quick enough. Maybe your boss just finished up talking your ear off about his latest pet project he’s decided to “grace” you with, and when you finally break away you see your stock has gapped against you and blown clear through your exit conditions.
What now? Panic is starting to set in, emotion is getting the best of you, however it’s a good thing you set up your roll conditions!
The key to setting roll conditions is to link them to your risk management. If the two aren’t connected then you’re not connecting your strategy to your actions. Before writing your roll conditions, take a quick second and refresh yourself on what your risk management is for this particular trading plan.
Once you’ve got that stored in your brain you can start back to work. Roll conditions can be as simple as a single statement saying your risk management measure was met. For example, it may look like this:
Buy back option @ 30% over premium sold (including commissions).
You don’t necessarily need indicators to tell you when to roll your trade. Your exit conditions are probably already met at this point, however some of your indicators may be a bit ambiguous. Maybe two out of three are showing the underlying is going to keep moving against you, but the other says “maybe not”.
At some point though you just need to cut off the trade and start anew. This is what your roll conditions should tell you in as much or little detail as you need.
Push the button! It’s time to execute!
Now it’s time to push the button, awesome! I know it’s a lot to take on, but building a trading plan is definitely worth your time and effort. Put the work in up front so you’re not scrambling when it’s time to make a decision.
Many of the poor decisions I made last year and at the beginning of this year were because I didn’t have a plan in place. I made trades either based on my intuition or paid little or no attention to what the technical indicators were telling me.
Overall, this led to a fickle trading style and inconsistent results. With a trading plan you can easily identify what works, what doesn’t and adjust as necessary. Hopefully you don’t need 15 indicators to tell you your stock is going to increase, four may be enough.
Even if your trades go against you, a trading plan gives you the opportunity to break down your trades, find the broken part, tweak it and maneuver yourself back into profitable trades.
Regardless, with a plan in place you’re putting all the thinking up front and now it’s time to execute!
Congratulations! You’ve made it through my longest post yet at just over 4,200 words. As a way to thank you for putting in the time, I’ve put together a little gift for you to help build your trading plan.
Click the link below and you’ll be able to download a fillable trading plan PDF along with a set of instructions which will walk you through the process I’ve laid out here.
Enjoy and happy trading!