People, companies and ‘traders’ all need direction, clear idea of their goals and how to achieve them. I borrowed some “Planning and Strategy” habits from my Business Analysis profession and corporate CEOs and tried to implement those on my option trading practice. I used eight planning components to build an option trading plan. Hence, the heading: “Thinking like a CEO: Getting into my 8 step Option Trading mindset.”
If you don’t want to know about management terms that is ok, but know this at least, “trading is not about finding a brilliant trading strategy but, creating your trading process.”
This is not about management, but about trading, I will piggyback on managerial framework to carry my trading process. The only thing to understand about management and framework is: “Values (how do I behave?) to support Vision (what kind of trader I want to become, tomorrow?) and vision gives Mission (what should I focus on today, in general?). Mission is ‘purpose, focus, and goals’ and it needs a strategy (plan) to achieve these goals and goals (general) are made up of objectives (specific). To reach goals and objectives, specialized plans called tactics (now) are scheduled by organization (trader), that provides Resources, Infrastructure, and Processes for execution.
Components of my option Plan
This plan that you are studying is tailored for “environment” of risk tolerance, age, capital, trading experience, trading objectives and many other things that I intend to execute. I would also like to identify possible potential scenarios can threaten the achievement of my objectives. You can check out what you can pick from here and what you need to change here to make your own daily routine.
I have had built a trading style that matches my personally, thereafter I am building my lifestyle around consistently executing my plan. You have to find what type of trading style matches you personally. Right now, I am not a full-time day trader, I have a day job and I supplement my income with part time trading. What patterns of life would fit that trading style?
- Vision and Mission: My dream of becoming a successful trader. Mission is the objective, the goal
- Developing strategic mindset
- Identify targets, the watchlist of the Underlying I want to engage.
- Outline my quality control criteria. The justification for accepting or rejecting a trade idea from the watchlist.
- Identify tactics: the most appropriate option strategy that I will use.
- Setup tactical deployment, a.k.a. risk management
- Outlines my trade management plan: How I will manage my trade after the execution?
- Exit Plan
Every trader has a vision(dream), motivation or intensified desire to achieve some goal or be someone. And, every trader has a mission, this mission must include an objective(s) and a plan to achieve these objectives. Make sure your objectives are S.M.A.R.T. (Specific, Measurable, Achievable, Realistic, and Timely)
This plan is outlined exactly, the way I will accomplish each of my objective. In option trading plan I have defined tactical mindset, targets (potential trade candidates), quality controls (my accept or reject decision), the tactic (options strategy to use out of many) to achieve objectives.
My trade setup, that is tactical deployment method to mitigate potential risks. Then comes the post trade guidance, called trade management: it is course of action that follow after executing the trade.
Last step of this plan includes, the contingency plan for exiting trade prematurely.
Why? Because, trade did not go exactly as I have planned and I have to cut my loses, for that this exit plan is precise, and clear.
Defining a Plan: a series of steps to achieve an objective of my an(y) option trade.
Question: Why bother to plan options trading?
Short answer: an option trade plan is the only tool that keeps me being a disciplined a trader. It helps me to keep my fear and greed emotions at bay. An options trade plan is solid foundation for disciplined execution of trades.
More reasons to plan your options trading:
Having a plan fosters trading discipline. A plan also defines upper limit for the amount I am ready to lose, if things did not work out, in ‘Risk Management plan’. Planning process layout the minimum knowledge I must have to open an option trade.
1. Mission: The ‘purpose’ to trade options
I am a professional trader, trading options, stocks, commodities, bonds and Forex. My objective as traders is universal, that is “to make money, not to lose it!”. I have listed my three objectives as below:
- Income generation: Use Options to potentially generate income on stocks I own or want to own.
- Hedging: Options to minimize the risk on an existing stock position in my portfolio.
- Speculation: Options trading helps take a speculative market position using leverage. Surprisingly, I can even take a position that can profits if the market stays neutral.
Every trade plan I outline must supports these objectives.
The fact is, I am not going ‘win’ all trades, therefore, If, I am wrong about my trade, I want to get out of that trade with minimal loses and keep my capital to trade another better trade at some other time!
This is universal objective and guiding commandment for my option trading. I don’t need to write it down every time. It uses to take about 20 to 30 minutes in past when I was not using this plan. But now the planning process is understood, I hardly take more than 10 minutes to execute a trade.
Don’t set short term profit goals:
I cannot control ‘all’ trading opportunities in my watchlists. There are some days with more ‘high-probability’ trades opportunities. Other days there will be few or none. No good setup! I don’t trade! That is why, short term (daily or weekly) profit goal may not work well, as I might take on low-probability trade setups. These setups can potentially cause drawdowns. Instead focus monthly profit and loss, with patience for the best setups or problem of overtrading.
2. The Strategic Option Mindset: creating a mindset for trading
Some traders focus on the results, however the way I am trained while learning trading, I was taught to focus on perfection of process. You can focus on results if your win rate is very high, may be 80%. I know I will not be wining all my trades, so I cannot focus on results so I have to pay laser sharp focus on my trading process. I am a trader and I don’t execute bunch of trades then paid for, but my sole task is to get paid. I work hard and most demanding jobs in the world. I call trading a shark tank. (I don’t think trading a shark tank, it is just a metaphor to grab your attention. In fact, I think of me as a trader being a NASA astronaut, in charge of a rocket launch, I know, yet another metaphor, what a story teller I am!)
My process is a daily routine as well routine on each trade. Focusing on process keeps me focused on the things I can control like emotions, risk, better entries, cut my losses, find best markets and trades. Results, I cannot control, so I leave the as outcome of my process.
Trading, mathematically speaking is a zero-sum game, that mean money travel from one account to another. I want my account to receive more than it gives away! This is why the most important task is to ‘optimize’ myself for the day ahead; mentally, psychologically and motivationally. I am a practitioner of meditation and mindfulness for positive thought and energy. My day always starts with a 10-minute meditation session. My daily routine is well laid plan, you must make your own daily routine. Check Kirk Du Plessis of Option Alpha’s daily routine and Scott Phillips’s routine.
What is your strategy? How you specify your entry, stop and exits, your position sizing? How you manage your trades once executed and you are in? How you analyze the market(s) to spot best opportunities?
I have been trading options, only for 3 years now, there was lot of cognitive dissonance about some options trading terms, that obscured my understanding about options. I needed “some streamlined thinking process” and some “critical success factors to master”. I picked up some of important terms (shown under, in thinking icon) critical to success from Option Pricing Model. Some of the concepts I consider as ‘rule of the thumb’ in options trading are shown with rule of thumb’ icon. Both ‘mind set’ and ‘rule of concepts’ are subject to change in future, as I go along with the suggestions and critiques of veteran traders. Make sure you visit this page in future to check some updates. Following terms were most difficult for me to wrap my head around:
Implied Volatility Rank (IV Rank):
IV rank can be compared to P/E ratio for a stock. If above AFL stock is trading around $50 per share, that is absolutely meaningless, without additional information. Is there is any other way from price per share to figure out the relevance of Aflac Incorporated’s EPS (earnings per share)?
However, if I have another piece of information; “P/E ratio is 7.71”, then it tells me the earnings yield is 7.71%. Similarly, we can compare P/E ratio of comparable companies in Financial Services sector. (AFL is in life Insurance business) and general market.
Rule of thumb #1: IV rank provides context.
I took following real examples from yahoo to show option’s trading example. The stock I am citing in this example is:
Underlying stock: Aflac Incorporated (AFL), listed in NYSE and Nasdaq, on April 1, 2021 closing.
AFL’s Current stock price: $50 (actual $51.42, but nearest whole number is good for simplicity’s sake and to explain math)
Implied Volatility (IV): 22.8%Implied Volatility (IV) example trade: scenario low volatility ranking
Implied Volatility (IV) is 22.8% (for simplicity’s sake let’s make IV=20%), that is annually stock will fluctuate +$10 to -$10, that is $40 to $60
This means, 68% chances that price will stay between $40-60.
Option trade thinking:
That is, at the end of the year, if the price of AFL stock is above my $70 strike, then I can make money.
Should I purchase an AFL $70 strike call option that expires one year from today?
Now, million-dollar question, how much premium should I pay for AFL $70 strike call option contract?
AFL’s historically, moving maybe 22.7% per year on average. Can we expect AFL to move about same 20%?
I can see, that the $70 strike call option is probably not worth much. In (OPM) Option Pricing Model likelihood of price moving to $70 is only 16% that is, chances of profit are small.
I can see from IV of 20%, that probability price move above $60 is 16%. What is the probability of price moving from $50 to $70? An eyeball rough guess, is about 8%. This probability of moving is 2X the normal $10 move is apparently, even lower, than crossing $60 price level by next year.
My decision to reject this trade idea: Consider this trade a lottery ticket!
This option contract costs $0.25 and probability of success is 8%. Can I go ahead and say, “this is less of trade and more a gamble?” Hallmark of a lottery ticket is cheap price and probability of winning, very low.
Now let’s see another example, but this time high volatility is crazy high! I took this example from underlying stock CDTX, on Friday April 1,2021 from Yahoo as below:
underlying stock: Cidara Therapeutics Inc. (CDTX) listed at Nasdaq GM
Price per share: $2.70
Option play: September 17, 2021 $7.50 call strike costing %0.35 with IV 190%
Industry: BiotechnologyImplied Volatility (IV) trade: scenario high volatility ranking
This stock is a small biotechnology company, moving as much as 180% per year. Therefore, market might expect the same type of volatility in the future. The expected range over the next year is $5.13 up or down.
That means there is a 68% chance the stock trades between -$2.43 ($0.0) and $7.83 before its expiration on September 17,2021. There is high probability that CDTX stock has potential to move In the money at expiration.
If the stock is expected to swing wildly in future than the premium value of puss and calls options, would be higher, because traders expect a higher chance of making money
Rule of thumb 2#: Relationship between implied volatility and an option’s price (other things being equal) is as under:
(1) When implied volatility or market expectations increase, then option’s premium price also increases.
(2) When implied volatility or market expectations decrease, then option’s price decreases.
Rule of thumb#3: When selling a PUT look at the delta value, which corresponds roughly with the OTM probability at expiration. For example, If you pick the strike at 15 Delta, then your probability of being OTM is 85%
3. Qualified Watchlist: Narrow down potential trade ideas (targets).
Sector Analysis for market assessment
Goal: Identify the best-performing underlying’s/stocks in outperforming or underperforming sectors.
I start with generic my watchlist and filter that though global financial situation, sector wise analysis, broad markets, specific sectors and VIX then drill down to stocks and underlying’s within a sector using chart, fundamental, macroeconomic and technical analysis.
I like to use this top-down analysis approach, starting with a quick look at the ‘broad market segments’ performance, then sequentially drill down to ‘sector analyses for granular level of the markets. I narrow down what are the current session’s high-performing and worst-performing sectors. There is sector-rotation approach too, used by some traders.
Step one, is find the hottest sectors in today’s markets, then step two: to find top and bottom ten to fifteen trade candidates to build or populate my watchlists. Did you notice I have multiple watchlists!
My generic watchlist of underlying assets, that are potential trade candidates for option trading positions. I will focus on eight asset classes, that is defined my Strategic Mindset.
Sector’s trading gain exposure to a specific area of the economy, for example the ‘oil sector’ and trader get a basket of related stocks, from the same index and industry. Trader can also go long or short on the sector as a whole without buying and selling companies’ individual shares.
Sector analysis examples from stockchart.com and barcharts.com. Bloomberg also has very clean sector-analysis page. The key to the ‘Sector Analysis’ is check on macro economy indicators and spot opportunities in a specific industry – opposed to a specific stock or index.
I have added Crypto currencies this year, after much debating. Previously, I did not touch Cryptos because trading community I follow, does not trade it, my background is economics and cryptos are created out of thin-air with no anchoring with any central bank or GDP. Lastly, cryptos are way too volatile for my appetite.
My trading platform does not allow me trade options on Cryptos (yet).
Baseline Assertion depends on analysis of the current situation to create a ‘Target Qualified watchlist’ which we narrow down to find potential trading ideas. These potential trading ideas guides are considered for Tactical selection to fit appropriate option strategy. Strategic Mindset way of market analysis is one the ‘Baseline Assertion’ to take, on underlying asset or the market from four categories:
Depending upon my baseline assumption of being bullish, bearish, volatile or neutral, I like to filter my watchlist for potential trade ideas based on market action, volatility, earnings, and income-based pre planned strategies.
4. QA- Quality Control
Market-analysis results in my market-view and ‘Qualified Watchlist’ that facilitate most of trading decisions like:
- To analyze potential option trade positions
- Appropriate bias for the current market.
- Baseline assertions from market-view
- Qualifying potential trade ideas before finalizing them.
- Analyzing all potential Trade ideas through Probability, assess the potential risk, reward, and pricing scenarios of a trade before deciding to take a trade
Quality control is a “elimination Process of qualified watchlist” that will result in justification for fila trade candidates. Why I decided to trade or reject an underlying asset.
5. TACTICAL DEPLOYMENT: my action plan
After my ‘Qualified Watchlist’ is narrowed down with ‘Quality control’ parameters, I end up having final list of trade candidates. Here, I Identify ‘my action plan’ from the ‘Options Strategies Toolbox’. It is doing, detailed and step by step part telling me ‘How’. You have to build your own detailed decision-making process tree.
Picking up a most appropriate option strategy is rather a “process of elimination” than selection process. Tactics Tool box, helps me to shortlist most appropriate option strategy from my 20 strategies to deploy for desired position that I am planning to opening.
Many option traders deploy more than 30 strategies, but I am contended with the 20 options strategies in my tool box. How many ‘options strategies’ you have mastered and use in your options trading?
Example of tactical tool box with 5 strategies:
|Objective||Baseline assertion||(Tactics) Strategy||Description|
|Income generation||Neutral to bullish||Covered Call||Sell a call against an existing stock position|
|Income generation||Neutral to bullish||Cash-Secured Equity Put||Sell a put, secured by cash set aside in case of assignment|
|Hedging||Neutral to bearish||Protective Put||Buy a put on an existing stock position|
|Either direction||Straddle||Buy a call and a put at the same strike|
|Speculation||Either direction||Debit Spread||Buy and sell a call at the same time, or buy and sell a put at the same time|
Build your toolbox of strategies like shown in this table
6. Tactical Employment: RISK MANAGEMENT PLAN
My Pre-Trade Planning, KPIs, Performance and answer to an important question, “What I’m getting into with this particular trade?” Tactical deployment is the set up for our option position. It outlines tactical what we are getting into, when we enter a trade. I think of tactical deployment as performance monitoring of trade parameters, the good, the bad and the ugly. My trade can fall into any of these parameters. Profit and Loss decisions are sole responsibility of Individual traders’ as defined parameters in the trade plan based on his or her:
(1) Risk tolerance of trader
(2) Investment goals
Risk management is integrated into the option trading plan, as risk parameters are defined below:
- I know exactly when to get out
- how much is my maximum acceptable loss is for the trade
- How I will exit or adjust the trade position to save profits or limit losses.
Defining these parameters beforehand will prevent me from getting into mental-landmines (emotions such as greed, fear, attachment to a trade etc.) to take bad decision making.
7. Trade Management plan
In the following illustration, I am using ‘The Rocket Ship Launch’ analogy to compare to each of my trade launch scenarios. I am using ten steps ‘count-down’ in my every trade. Step 0 is kind of semi-permanent, I update annually, as my situation changes. Once the trade is executed: trade management kicks in.
Meteorite threats to success of my trade, are occurrences that can negatively affect our position during the life cycle of the trade. An example of a threat to our success: We were bullish and then implied volatility increased unexpectedly due to a negative economic report.
Contingency planning is simply having a basic game plan if our trade is not going per design: do we roll up, roll down or get out? Our Eject Criteria are our ―no questions asked, I will just get out of this trade.
In my ‘Vertical Bull Put Spread’ from Option Strategy Toolbox; exit criteria includes rule: “Exit this Vertical spread in any of following condition occurs first”:
- Exit with profit of 50% (of width of spread) maximum gain is achieved.
- Exit with lose of 100% (of width of spread) maximum gain.
- Exit with 21 DTE, or roll into next month.
8. Exit Plan
The Exit Plan is how we are going to get out of a trade. We never get into a fight unless we know exactly how we intend to exit. Factors for planning an exit include: a sound reason for exit, layout our closing trade set up, whether we are exiting prior to expiration or taking it all the way to expiration.
It is important to know exactly how you are going to exit a trade before the volatility of the markets get the better of you.
Passive Exit when:
1. my initial stop-loss is hit
2. When my target-profit is hit
3. When trade parameters no longer valid
Active Exit when:
4. My trailing-stop is hit
5. When trade parameters no longer valid
6. Volatility based Exit approach using (ATR)
7.Roll into next contract
That’s my plan and mindset for trading option. Have you noticed; this is nothing but a logical sequence to steps trade options?
You can take this idea make your own plan that suits your needs, how find best candidates, verify them, what suitable strategy to use, then how will you enter and exit. Don’t trade without plan.