There are an unlimited number of ways to skin a cat and trading is no different. Despite your strategy, risk tolerance or trading capital, having a plan is one of the most important components of achieving success in these treacherous markets. However, perhaps the most important characteristic of a profitable trader is the ability to adapt to ever-changing market conditions. Knowing this, it seems logical to assume that a trading plan should be established but just as rules are meant to be broken, trading plans should be flexible to accommodate altering environments and new events.
The premise of a trading plan is similar in nature to a business plan. It is a relatively detailed outline of the structure of the trade and the contingency plan, or plans, should the market go against the trader’s original speculation. Once again, trading plans are not set in stone; behaving as if they are could lead to financial peril.
There are two primary components of a trading plan: price prediction and risk management. Price prediction is simply the method used to signal the direction and timing of trade execution. This may involve fundamental or technical analysis, or both. Risk management specifies when to cut losses, when and how to adjust a position, or better yet when to take profits.
Price Speculation (Hopefully Prediction)
The only way to make profitable trades is to buy low and sell high. This is true whether you are trading options, futures, or baseball cards. Although it is a simple concept in theory, in practice, it is much harder than one may think. In order to successfully buy something at a low price and sell it at a higher price the trader must first be accurate in his speculation. Determining an opinion on where the market prices could or should go is only half the battle. Once you have done your homework in fundamental analysis, as well as technical (or a combination of both), you must be able to construct a trade that will be profitable if you are correct and hopefully relatively painless if you are wrong.
Timing is Everything
In trading, timing is everything. I constantly remind my clients and prospects that there is a big difference between being right in the direction of the market and actually making money. I have witnessed traders be absolutely correct in their speculation of price movement but miss getting into the trade due to unfilled limit orders, or being too early causing him to run out of money or patience before the price move. The determination of timing can be based on technical oscillators, psychological barometers, supply and demand or anything else that provides clues to price direction and timing. I am a firm believer that there aren’t right or wrong trading tools. Trading indicators can be compared to guns; guns don’t kill people, people kill people. In trading, oscillators or charting tools don’t siphon trading accounts; unfortunately traders sometimes do it to themselves.
While it isn’t important which indicator you use to time entry and exit, it is important how comfortable and confident you are in using it. This is especially true in reference to computer generated oscillators such as the MACD and Slow Stochastics. In the long run, it seems that blindly taking all buy and sell signals triggered by such indicators would yield similar results. Avoiding panic liquidation, properly placing stop orders, or exiting option trades gone bad are the aspects that can determine the line between profit and loss. In other words, good instincts and experience are likely more valuable than any technical indicator or supply and demand graph that you will run across.
Once you have determined your speculative tool of choice and determined your conclusion on the direction or lack of, it is time to construct a strategy that will benefit if your assessments are accurate and mitigate risk if you are wrong. This may include the use of options, futures or a combination of both as the trading vehicle. The method that you choose should be based on your risk tolerance, personality and risk capital.
Options, Futures or Both
Speculators have an unlimited number of "options" when it comes to trading vehicles. The strategy that works for one trader may not work for the next. The key is to find an approach that will provide you with a manageable risk profile while still leaving the potential for a profit that you will be satisfied with. We all know that with risk comes reward, but only a fine balance between the two will allow the trader the probability of a reward rather than the dream of one. Accepting reckless amounts of risk may pay off for a lucky few but for the masses the results will be dismal.
Depending on the characteristics and personality of the trader, an S&P bull may purchase a futures contract, purchase a call option, sell a put option, or even use a combination of long and short options and or futures to construct a trade with various risk and reward prospects. Likewise, a crude oil bear may opt for a limited risk option spread such as an iron butterfly or may be willing to accept large amounts of risk and volatility by choosing to short a futures contract. I couldn’t possibly touch on each of the possibilities in within the realm of this article but you should be aware of the alternatives available to you and which fits your personal trading profile before ever putting money on the line.
The "meat" of a proper trading plan is risk management. This is concerned with establishing thresholds of loss that you are capable and willing to accept. In the case of futures traders this may simply mean picking a stop loss price and placing the order, as well as determining a profit objective and placing a limit order accordingly. Once again, trading plans are for guidance and shouldn’t be followed blindly. Don’t be the trader that misses taking a healthy profit because the price came within ticks of the limit order but held out for the extra $20. Also, even if your trading plan doesn’t involve a trailing stop don’t be a fool. Markets don’t go up or down forever, if you have a large open profit tighten your stop or place protective options or option spreads and walk away.
Managing Risk is an Art not a Science
Depending on your trading experience, your trading plan may involve selling call option premium against a correctly speculated long futures contract as a form of risk management. Likewise, in-line with this strategy you may want to use the proceeds of the recently sold call option to purchase a put and protect your risk of an adverse price movement. Believe it or not, there are an unlimited number of ways to adjust the risk and reward of a futures position and a trading plan couldn’t possibly cover all market scenarios but writing down a few potential ideas may keep you from freezing in the heat of the moment.
Risk and Reward: Give Yourself a Chance!
When deciding how much risk you are willing to take and setting your profit objectives, you must be realistic. Beginning traders are often surprised to hear that many of the best traders struggle to keep their win/loss average above 50%. With these odds in mind, it doesn’t make sense to consistantly risk more on a trade than you hope to make should you be right. For instance, if your average risk is $500 you should have an average profit target of at least $500. Anything other than this puts the odds greatly in favor of your competition.
Option Sellers Face Optimal Win/Loss Ratios but That Doesn’t Guarantee Success
This concept is especially important for option sellers. While option sellers often have much better win/loss ratios than futures traders they are facing limited profit potential and possibly (depending on the type of premium collection) unlimited rewards. In this game, winning far more trades than you lose is only the beginning. An option seller must be savvy enough to prevent the small percentage of losing trades from wiping out months of profit and part, or all, of the original trading capital. My intention isn’t to deter you from selling options, in fact this is the strategy that I prefer and recommend to clients. However, those that partake in this practice must be ready and willing to face the consequences during draw-downs.
It isn’t feasible to place stop loss orders on most options or option spreads due to the nature of the bid/ask spread and the seemingly high probability of being stopped out prematurely. However, short options should be monitored closely and keeping a "mental" stop in mind is important. I typically advise traders to use a double out rule. This means for every naked short option within your spread or individually sold you should strongly consider buying it back at a loss if its value doubles from your entry point. In essence, if you sell a mini-sized Dow option for 50 points or $250 ($5 x 50) and following your entry the option doubles in value (appreciates to 100 points or $500) it may be fair to say that you were wrong. At this point, a trader should strongly consider liquidating the position and moving to the next opportunity. Failure to do so may convert a moderate loss into something much more.
The double out rule should be part of the overall trading plan but this doesn’t mean that it is an exact science; trading is an art and should be treated as such. Imagine if you are short a put option in a declining market and have reached your double out point on the position but the market is approaching significant support. If you strongly believe that the futures price will hold support, exiting your position in panic and at top dollar due to potentially high implied volatility, doesn’t make sense. However, on the flip side; if you find yourself counting on hope rather than rational logic you have let it go too far. Sometimes the line is difficult to see until it has already been crossed. It is times like this that make or break a trader. The ability to properly manage these scenarios come from instinct and experience and cannot be attained from reading a book or attending a seminar.
The 10% Rule in Trading
Many trading courses and literature claim that a trader shouldn’t risk more than 10% of their trading account on any one trade. This seems to be relatively sound advice but may or may not be feasible for everyone. A risk averse trader may not be psychologically equiped to handle such a loss and this can easily lead to irrational trading behavior.
Most beginners underestimate the value of psychology. Once the balance is broken it is hard to regain logic and can lead to large losses. For example, a trader that opens an account with $10,000 and immediately loses $1,000 on the first trade may dedicate subsequent trades to recovering losses on the original. In other words, they are often tempted enter a market prematurely and aggressively to make up for lost ground. This would be an example of a trader that simply isn’t capable of taking such a large loss without detrimentally impacting the original trading plan.
An additional drawback of the 10% rule is the fact that during volatile market conditions, whether trading options or futures and depending on the risk capital available, it may not be possible to construct a trade with reasonable odds of success without surpassing the appropriate percentage. In this case, the market is often best untouched but as humans we are naturally drawn to that of which we shouldn’t.
Leave Multiple Contract Trading to the Pros and Well Capitalized
One of the most destructive things that I have witnessed traders do is execute multiple contracts in a moderately funded account. Inexperienced traders are under the assumption that trading several contracts at a time will maximize their "return" but what they are actually doing is maximizing risk and minimizing the probability of a successful trade. Despite the emotions involved, trading isn’t about feeding your ego it is about making money…right?
Stop the Loss!
Futures traders may look to manage risk of loss through the use of stop loss orders. A stop order instructs the broker to exit an outstanding futures position if market prices move adversely enough to reach the named price. However, keep in mind that a stop order can also be used to enter a market. Such a stop order is often placed above areas of significant technical resistance or below support in an attempt to capitalize on a potential price break-out.
In order for stop orders to be effective, they must be properly placed. Anything less will result in either too much risk or premature liquidation of a trade that may eventually go in favor of the position. This too is an art and not a science. Where stop orders should and shouldn’t be placed isn’t a black and white decision. There are many areas of gray involving market conditions and characteristics as well as the personality, account funding and risk tolerance of the trader.
If you are a beginning trader this may be a good argument in favor of using a full service broker. However, you must realize that even a well experienced broker or advisor can’t see into the future and is subject to the same frustrations as you may be. Nonetheless, in theory she may be a little more savvy and that could have a positive impact on performance in spite of the slightly higher commission rate.
Be warned, stop orders aren’t a guarantee of risk. Because a stop order becomes a market order once the stated price is reached there may be slippage and in rare cases, lots of it. An experienced broker may also be able to help you avoid placing stop orders by constructing option spreads as an alternative in risk aversion. For example, a short option or futures position may be hedged by a one by two ratio right if the volatility and premium allows.
The ability to place a stop order or limit the risk of a futures trade through options and option spreads should eliminate some of the stress and emotion involved in trading. Rather than losing sleep over a trade gone bad, those with stop orders or protective option positions (insurance) can relax knowing that he has done his homework and has mitigated his risk.
It is Your Money
We don’t all wear the same shoe size or have the same hobbies so why should we all use the same trading strategy and risk management techniques? The truth is that we shouldn’t. My perception of what constitutes reasonable timing of entry and how much money or emotion to risk on a particular trade is likely far different than yours. Trading is an ambiguous game; there isn’t a right or wrong answer to most aspects of speculation. For example, the same trading "ingredients" may work for one person but not for another due to differences in experience, education, risk capital and emotional constraint.
Only you will be able to determine what works for you and discovering what that is requires patience, discipline and an open mind. The most important feedback on your progress will be your account statements. This isn’t to say that you should hang up your trading jacket if you experience a drawdown or even a complete account blow up, but it is important that you are realistic. Some people tend to only remember the good trades and others only remember the bad. Each of these distorted perceptions of reality can have an adverse affect on your trading. Successful traders remember the good trades and the bad trades, but most importantly learn from all of them.
***There is substantial risk in trading options and futures. It is not suitable for everyone.