- 1997: Volume 6, No. 1 Common Sense Trading Principles

Trading principles are best described as "easier said than done." At first, it seems ironic that these basic principles are difficult for most traders to apply, but it's not so strange when you realize many people think they can outsmart the market. In the end, those who are undisciplined in their trading habits wind up with bruised egos and depleted accounts. By contrast, traders who manage their accounts in accordance with these principles can watch their accounts grow over time.

Manage Your Losses

Take your loss when it reaches a predetermined amount. This is the cardinal rule of all trading. It's the trait shared by all traders that survive. Refusing to act and waiting for the market to bail you out is the prime reason traders go out of business. A trader should never "white-knuckle it" and give a manageable loss an opportunity to turn into a large or catastrophic loss. Don't let your market opinions or emotions paralyze you. Violating this rule guarantees that, sooner or later, you'll cripple your account beyond the point of ever being able to recover. Specifically, I believe in buying back any naked short option that has doubled in price. I may replace it (adjust my position) by selling other options, however, the critical action I take is to close any naked short option that's doubled in price. I also believe in selling a long option that's withered down to half the price I originally paid. These are "trigger points" I'm comfortable with. You may prefer different parameters but it's important you use something specific. Another way of saying this is "Manage your losses and your profits will take care of themselves."

A Trading Plan

Follow a trading plan that addresses what you'll do if the market advances, declines, or drifts sideways. The market will do what it wants to do, and you have no control whatsoever over it. What you can control, however, is how you respond to the market. Your plan should have rules for initiating, adjusting and closing positions.

Get Out Fast!

Don't be penny-wise and pound-foolish. When it's time to close or adjust a losing position, use market orders and not limit orders. You run the risk of not getting filled on limit orders if the market continues against you and your losses will be greater than your plan allows.

Classify Your Trades

Classify your trades between directional trades and non-directional, volatility trades. Directional trades either go your way or don't. Don't try to adjust them. Simply close them if they reach your trigger point for taking losses. Non-directional, or neutral trades, on the other hand, should be adjusted if the market moves and the position becomes unbalanced.

Learn To Spread

Learn the characteristics of different types of option spreads. Spreads are the building blocks for your trading plan and you must use them in creative ways to capitalize upon the ever-changing landscape of the market. For example, if you want to take advantage of high option implied volatility in a particular market, you have four basic spreads to choose from: a short straddle, a short strangle ("neutral option position" or "NOP"), a ratio spread, or a 1x1 credit spread. The profit potential, maximum loss, probability of profit or loss, and likelihood of adjustment are different for each (especially since you can choose between nearby or farther out expiration months). Your selection should depend on your account size and personal tolerance for risk.

Repect the Market

Resist the temptation of guessing when a market is going to move. Traders frequently lose money anticipating when a market will move. They research the fundamentals, study charts, read the news, and develop an opinion of what the market should do. They then place a trade in accordance with their expectations. Even if they correctly guess direction, their timing may be off. So why not use the "Forrest Gump" approach and wait for confirmation of a rally or decline before committing your money to directional trades? For some, it's ego and a matter of wanting to say "I called the market." For others, it's not wanting to run the risk of "buying the top" or "selling the bottom." There's always the fear that once the move has begun, the options will be too expensive. Whatever the reason, I believe it pays to "let the market tell you" where it's going before taking a position. This is a simple, yet extraordinarily powerful principle to apply. It'll save you from lots of losses on your directional trades.

No Second Guessing!

Don't "second-guess" your trading decisions. Analyze the prospects and risks of your current positions, and don't waste time figuring out what you've already done. Adjustments you previously made are "water over the dam." If you take your focus off the present and future and spend your time recreating how you arrived at your current position, you're misdirecting your energy and can easily miss new opportunities.

Review Your Positions

Don't stay married to your positions. I remind myself that "Every day is a new day." I review my positions each morning, and ask myself if these are positions I'd want to initiate right now. If not, I either adjust them or close them. In other words, I assess their profit potential and risk. Whether they have performed well up to this point is irrelevant.

Be Consistent

Understand your trading inclinations. Do you like to "go with the trend" or are you more comfortable "picking turning points"? Do you take profits quickly and delay dealing with losses, or are you slow to take profits and quick to take losses? Perhaps you have no consistent approach. Study yourself and know how you feel about these things. This is the first step to knowing how easy or hard it's going to be to implement your trading plan. And following a plan is necessary, otherwise you'll be reacting emotionally- and this is a recipe for eventual failure.

Analyze Risk

Recognize the very high risk you take if you hold short options close to expiration. A move in the underlying can have a dramatic, unfavorable affect on your position. A rally can cause short calls to explode in price while a drop can cause short puts to escalate quickly. Worst of all, you can't adjust to manage risk. Only well-capitalized accounts that keep these positions small in relation to account size should attempt to capture the accelerated time decay on options close to expiration. These positions are strictly a short-term bet on where the underlying will go by expiration, so don't rely on an option pricing model for theoretical values or probability of profit.

Watch for Emotional Markets

Watch for times when markets become emotional. You can take advantage of these periods if you "ride the emotional roller coaster" and manage your risk at the same time. As the move is occurring, "jump on board" by buying close-to-expiration calls as the market rallies or buying close-to-expiration puts as the market falls. Don't fight the market by trying to pick a turning point, especially in a fast-moving, emotional market. Simply respond to what the market is doing. You may buy overvalued options and the market may slow down or reverse direction, but your long options can easily double or triple if the move continues. The losses you will sustain doing this (if you follow the rule of selling any long options that decline by half) can be more than offset by the large profits on your successful purchases. This is especially true if you buy calls in upward trending markets that have a negative volatility skew (i.e. S&P 500) or if you buy puts in downward trending markets that have a positive skew (i.e. grain markets). A negative volatility skew simply means out-of-the-money calls are cheaper than out-of-the-money puts. A positive skew means out-of-the-money puts are cheaper that out-of-the-money calls.

Seek Liquid Markets

Be careful selling options in illiquid markets because price moves in the underlying can be dramatic and calls will become extremely overpriced in a rally while puts will become overpriced in a sell-off. Covering your short options in either of those cases will be very costly, so you're better off executing an equivalent strategy. This means buying the underlying futures and buying a put if you're short a call, or selling the underlying and buying a call if you're short a put. This option purchase is a good substitute for a stop on the underlying futures because there's no way the floor traders can hurt you by "stop hunting" (an unfortunate reality in thin, illiquid markets).

Diversify

Keep your exposure in any one market small relative to your entire account. Think of each trade as a hand of cards in the game of blackjack. It's obvious that if you bet too much on any one hand relative to your bankroll, you could get into trouble. Apply this same thinking to your trading. Even if you identify a trade that has a probability of profit of 85%, don't jeopardize your account by putting it on in large size. The laws of probability play out only in the long run so you must initiate a series of independent trades each having a probability of profit of 85% to ensure you'll achieve the 85% success rate. This means you should diversify among different markets and should scale into independent positions over time. Adjusting positions that become unbalanced will help achieve profits, but don't underestimate the power of entering small, high probability positions over time in a diversified mix of markets.

Trade Small, React Fast

Respect the size of the underlying contracts you trade by trading small and by reacting quickly. Hesitating to close or adjust positions when a trigger point has been reached (under-reacting) is far more dangerous than mechanically acting when your rules call for action. When I was trading in Chicago, a favorite expression among traders was "The S&P market takes no prisoners." It reflected how the market from time to time would rally or drop far beyond everyone's wildest expectations. It would take your breath away to see how far and how fast the market would move-and how much money would be made or lost. At current levels in mid November, 1996, one S&P futures contract is worth about $375,000. A similar saying was "Size kills."

Know Your Market

Become familiar with the characteristics of each market you trade. For example, it's important to know that the currency markets have a tendency to trend for long periods while the meats and the S&P 500 can be choppy in their price behavior. Study the volatility charts of each market so you'll know if current volatility is relatively high or low from a historical perspective and you can also see if volatility is trending higher or lower. Charts of implied volatility, when superimposed on historical price charts, can show patterns that may have merit when planning trades. Learn the volatility skew of different markets because it's important to know if the out-of-the-money calls are more expensive than the puts, or vice versa. Last but not least, learn whether volatility rises as price rises or as price declines in each of your markets. This is known as the "elasticity of volatility factor." In other words, each market has it's own personality with respect to how option implied volatility moves as the market moves, and this is very valuable to know because it may affect how you should adjust your positions.

Trading is as tough to master as the game of golf. It takes application of proper techniques and constant practice to become consistent. Most golfers develop bad habits and make the same mistakes over and over. Practice applying all of these trading principles so you won't be a trader who repeats his mistakes.

Paul Forchione is a Vice President and broker for Opportunities In Options in Oxnard, California. Paul is a CTA who began trading in the early 1980s as a market maker on the CBOE and as a floor trader in Treasury Bond options on the CBOT. He also has traded S&P 500 futures and options from an upstairs environment. Paul can be reached at 1-800-926-0926 ext 105.