Jason Ng asked:


There are 2 kinds of option trading systems in general; Discretionary and Mechanical. A discretionary option trader follows no specific rules but chooses, enters and exits an option trade using all of his knowledge or gut feeling. A mechanical option trader is one who translates his knowledge of choosing stocks, entry and exit into objective rules. Such a system is commonly translated into a computer program in order to completely automate the option trading system. The advantage of mechanical option trading is obvious; the removal of human emotions in the trading process thereby reducing human errors.

I moved from discretionary to mechanical option trading years ago and only started becoming consistently successful in option trading after I developed my personal mechanical option trading system called the Star Trading System (http://www.mastersoequity.com).

So, what are the steps to be taken in order to develop your personal mechanical trading system for option trading? Here is a guideline…

1. Stock Selection

List down all the criteria you think must be true in order for a stock to qualify as an option trading candidate. Make sure all of these criteria are quantifiable. Example : a. Last close more than $10, b. Last price rising for the past 3 days c. PE must be positive. Finally, program a charting software with these criteria so that you can run a scan of all stocks that qualified within seconds daily. Technological advances have made possible to screen stocks within seconds. Traders used to have to spend hours going through each stock against a spread sheet in order to find trading candidates.

2. Option Selection Procedure

Now that you have chosen your stock, you need to determine which option qualifies for your option trading system. Your personal option trading system may be based on OTM options or ITM options or even based on bullish or bearish spreads.

3. Entry Procedure

Now that you have determined what stock to watch and which option to buy, it is time to determine under what conditions to make that move to buy on. It may be as simple as to enter upon market opening or as complex as to watch the underlying stock movement for a pre-determined period of time before it qualifies for entry. Whatever it is, it must compliment your personal option trading style.

4. Exit Procedure

Now that you have an open position, you need to determine what must be true for you to take profit or to stop loss. There are 2 classes of exit procedure that you must establish; Stop Loss and Profit Taking. Stop loss in option trading can be simply based on a % loss of the option position or based on a % loss on the underlying stock. Profit taking can be based on the stock’s target price or a % gain on the option position. After you have done that, you would want to see how your broker can help to automate that for you. Commonly, people break their own stop loss or profit taking points due to emotional involvement, that is why many brokers have features which allow fairly complex stop loss or profit taking strategies to be automated. If your broker does not support such automation and you are the type who cannot properly enforce your own stop loss or profit taking strategy, then it may be good to consider switching to a broker that does.

Now, give that option trading system a name and paper trade it for at least 6 months. Do not expect to get it right the first time. Developing a profitable option trading system takes time, knowledge and experience and is something which cannot be rushed. My Star Trading System (http://www.mastersoequity.com) took me years of work to arrive at a stage where even complete amateurs can follow easily and make a consistent profit from.

So, have fun translating your option trading philosophy into an option trading system and to watch it in action. I am sure it will be an extremely fulfilling experience whether or not the system turned out to be profitable.



Bobby

Barry Hurst asked:


There is a lot of money to be made from stocks and shares but the only hitch is nobody knows a sure fire way of a method. Let us now see some of the basics of stocks and shares. You can earn money in two ways by investing in stocks and shares. One is trading and the other is investing.

Buying and selling stocks, shares, futures and options over a short period of time is known as trading. If you buy shares, stocks, futures and options and retain them for a longer period of time then it is known as investing.

Besides the above, there is no get rich quick scheme which works. If such schemes work then almost everybody would be a millionaire. Money can be made by selling stocks and shares but it cannot be done quickly by buying and selling without reason. The patient, careful and intelligent investors definitely make big profits in the stock market when compared to the overeager and reckless speculator.

Stocks and shares should be bought when their prices are low and wait for the price to rise to earn a decent profit over a longer period of time.

A prudent investor should not worry about the downs and ups and look for the long-term cycles. If these simple principals are not followed, there is not going to be any profit for an investor.

Presuming it is going to fetch more money, never buy a stock or share when the price is going up, it is wrong. If the peak price is reached at the time of buying then the investor will be holding a stock or share of which its price will be slowly sliding down and you will ultimately end up with a loss.

There are certain golden rules to be followed when investing money in stocks. Never invest more than three percent of the total portfolio in one stock. Over time, a successful investor should make all efforts to protect the capital base.

When a wrong decision is made, accept it and cut down the loss immediately by five to fifteen percent rather than wait for more time thinking the situation will improve. Follow the performance of the stock and never deviate from the “stop loss point” to limit the loss in case the stock does not perform up to the expected standard.

Never set price targets. Stick on to one style of trading instead of following various trading methods. The performance of a stock or share is reflected in the volume and price it is traded. Never get influenced by the opinions expressed by individuals.

Take note of all the signals emanating from the market which is connected with the stock or share you are holding. Do not get swayed by variations in data during the trading day. Reliance on such swings will lead to wrong decisions. A trader who is stressed out will be making a lot of wrong decisions, so take time out periodically during the day.



Allen

John Forman asked:


Clearly, anyone who trades does so with the expectation of making profits. We take risks to gain rewards. The question each trader must answer, however, is what kind of return he or she expects to make? This is a very important consideration, as it speaks directly to what kind of trading will take place, what market or markets are best suited to the purpose, and the kinds of risks required.

Let s start with a very simple example. Suppose a trader would like to make 10% per year on a very consistent basis with little variance. There are any number of options available. If interest rates are sufficiently high, the trader could simply put the money in a fixed income instrument like a CD or a bond of some kind and take relatively little risk. Should interest rates not be sufficient, the trader could use one or more of any number of other markets (stocks, commodities, currencies, etc.) with varying risk profiles and structures to find one or more (perhaps in combination) which suits the need. The trader may not even have to make many actual transactions each year to accomplish the objective.

A trader looking for 100% returns each year would have a very different situation. This individual will not be looking at the cash fixed income market, but could do so via the leverage offered in the futures market. Similarly, other leverage based markets are more likely candidates than cash ones, perhaps including equities. The trader will almost certainly require greater market exposure to achieve the goal, and most likely will have to execute a larger number of transactions than in the previous scenario.

As you can see, your goal dictates the methods by which you achieve it. The end certainly dictates the means to a great degree.

There is one other consideration in this particular assessment, though, and it is one which harks back to the earlier discussion of willingness to lose. Trading systems have what are commonly referred to as drawdowns. A drawdown is the distance (measured in % or account/portfolio value terms) from an equity peak to the lowest point immediately following it. For example, say a trader’s portfolio rose from $10,000 to $15,000, fell to $12,000, then rose to $20,000. The drop from the $15,000 peak to the $12,000 trough would be considered a drawdown, in this case of $3000 or 20%.

Each trader must determine how large a drawdown (in this case generally thought of in percentage terms) he or she is willing to accept. It is very much a risk/reward decision. On one extreme are trading systems with very, very small drawdowns, but also with low returns (low risk – low reward). On the other extreme are the trading systems with large returns, but similarly large drawdowns (high risk – high reward). Of course, every trader’s dream is a system with high returns and small drawdowns. The reality of trading, however, is often less pleasantly somewhere in between.

The question might be asked what it matters if high returns in the objective. It is quite simple. The more the account value falls, the bigger the return required to make that loss back up. That means time. Large drawdowns tend to mean long periods between equity peaks. The combination of sharp drops in equity value and lengthy time spans making the money back can potentially be emotionally destabilizing, leading to the trader abandoning the system at exactly the wrong time. In short, the trader must be able to accept, without concern, the draw-downs expected to occur in the system being used.

It is also important to match one’s expectations up with one’s trading timeframe. It was noted earlier that in some cases more frequent trading can be required to achieve the risk/return profile sought. If the expectations and timeframe conflict, a resolution must be found, and it must be the questions from this expectations assesment which have to be reconsidered, since the time frames determined in the previous one are probably not very flexible (especially going from longer-term trading to shorter-term participation).



Kenneth

Jason Ng asked:


Have you ever heard of the terms Scalping, Swing Trading, Trend Trading and Momentum Trading? Wonder if you are any of them? Wondering what suits you? Here’s a quick definition.

The different forms of trading are actually better differentiated by time frame more than the techniques that are involved. Because of the difference in time frame, different techniques must be used in order to reap profits from the capital markets.

From the shortest holding period to the longest, we have Scalping, Momentum Trading, Swing Trading and lastly, Trend Trading.

Scalping is a term used for a method where trades are opened and closed within a very short time scale, perhaps anything from a second or two to a few minutes. This is a day trading method where Scalpers make several, perhaps hundreds of trades a day, accruing small profits intraday for an overall daily return.

Momentum trading is another day trading method where the trader sees an acceleration in a stock’s price, earnings, or revenues and takes a long or short position in the stock with the hope that its momentum will continue in either an upwards or downwards direction. Once momentum slows down or falls, the trade is exited. The holding period is commonly from a few hours up to a whole day.

Swing Trading is a style of trading that attempts to capture gains in a stock within one to four days. This is mainly used by private, at home traders. The individual trader is able to exploit the short-term stock movements without the competition of major traders. Swing traders use technical analysis to look for stocks with short-term price momentum. These traders aren’t interested in the fundamental or intrinsic value of stocks but rather in their price trends and patterns.

Trend Trading is a trading strategy where traders commonly hold their positions for up to a month. It is a trading strategy that attempts to capture gains through the analysis of an asset’s momentum in a particular direction. The trend trader enters into a long position when a stock is trending upward (successively higher highs). Conversely, a short position is taken when the stock is in a down trend (successively lower highs).

All in all, Swing Trading and Trend Trading seems like the way to go for most private traders who has a day job or who cannot afford to day trade the market.

I too am a Swing Trader and have enjoyed tremendous success for the past few years using what I call the Star Trading System. Read about it here at http://www.mastersoequity.com



Allen

John Forman asked:


Options provide great position management and risk control potential when using them to trade the market directionally. This goes beyond the simple fact that a long position in a call or put option has an absolute maximum risk equal to the cost of the option (plus commissions, of course). That, in and of itself, is a very useful thing. What this article discusses, however, are a couple of handy little things one can do while holding an option position to maximize the return and keep the risk well constrained.

Roll Up/Down

Most traders are familiar with the concept of a trailing stop whereby one moves their protective exit as the market moves in favor of the trade. This is used to lock in profits. The same thing can be accomplished when one is trading options rather than the underlying. This is done by rolling one’s position up or down strike prices depending on whether the trade is a long using calls or short employing put options.

Here’s a recent example from the author’s own trading.

A long position in Seagate Technology (STX) was initiated when the stock was trading at around 21.50 using the March 22.50 call options. They were purchased for $0.80. The market rallied over the next few weeks, eventually moving up above $24. At that point, a roll-up was executed by selling the March 22.50 calls at $2.60 and purchasing the March 25 calls at $1.40. This action served two purposes. The first is that it took $1.20 off the table, reducing the portfolio exposure and freeing up cash for use elsewhere. It also locked in a profit of $0.40 ($2.60 sales price minus the $0.80 purchase price for the 22.50 calls minus the $1.40 purchase price for the new 25 calls). At the same time, it had no effect on the remaining upside potential for the trade. The two strikes would probably profit about the same from any further appreciation in the price of STX shares.

If the portfolio exposure was deemed acceptable at $2.60, an alternate course of action would have been to sell the March 22.50 calls and not take any money out, but rather roll it all in to the March 25 calls. For example, if the position was 10 options, selling the 22.50s would net $2600. That cash could have been used to purchase 18 of the 25 calls ($2600/$140 = 18.57). By doing so, one actually increases the upside potential for the trade substantially. Of course, the full position is at risk, meaning one could theoretically lose the whole $2600 invested, which is more than could have been lost when the trade was first initiated.

Roll Forward

One of the issues with options is the limited duration they provide for holding trades. If one is an intermediate to longer-term trader, this can be an important hurdle. That said, however, in a manner similar to the roll up/down, if one wants to extend the holding period of a position it can be done by rolling forward the expiration month.

Continuing with the STX example, we can look at rolling forward. That would be accomplished by going from the March contract to the June one. As of this writing, the March 25s are trading at $2.40 and the June 25s are at $3.60. There’s the rub, though. Because of the longer time to expiration, the June contract is priced significantly higher. That is why a roll forward is often best accomplished with a roll up/down.

Consider the earlier roll-up in STX from the 22.50 call to the 25 call. If we were still in the former, and wanted to both roll forward and up, we could jump to the June 25 call. The current price on the 22.50 option is $4.10. With the June 25 at $3.60, we could accomplish both the roll up and roll forward and take $0.50 off the table. That is not quite as much as we accomplished with the roll up, but it does extend the time we could hold the position by three months. Whether that is worth the trade-off depends on the anticipated holding period for the trade.

The rolling of strike prices and expiration is something easily accomplished. The transaction costs for options trades have come down substantially for the individual trader in recent years. That opens up a great many possibilities for playing the market directionally and managing positions efficiently.



Randy