The following describes the steps involved in placing a trade:
Select Strike Price and Expiration Date of Option Contract
Once a stock is found that meets the criteria given by one of the established or experimental technical analysis techniques, it is time to look for an option trade. First determine the amount that the stock can be expected to move in the given direction. This can be determined by looking at previous bounces off support or resistance in the stock’s recent history, and taking the average of the movements after each bounce. Also determine if there is any overhead resistance for a bullish trade or nearby support for a bearish trade, and if this would limit the expected move. In addition, determine the amount of time this expected move will likely take, again by looking at the average amount of time each bounce took in the recent history.
Based on this information, select a strike price and expiration month for the option. For the expiration month, allow for the expected amount of time determined above, plus an additional two to four weeks. For the strike price, the most likely choice is one strike price in the money. The exact strike price should be chosen based on the percentage of profit that will be earned based on the expected price movement. Calculate the expected profits for each of the in-the-money options and pick the one that gives the highest return percentage.
The at-the-money call option will usually yield a high profit percentage, but also has a much higher chance of showing a big loss. Therefore, do not trade the at-the-money option.
If the selected option has an open interest of less than 100, do not make the trade. Such illiquid options usually have a wide bid/ask spread and therefore require a much bigger move in order to become profitable.
Decide on Number of Contracts
Decide how many contracts to buy based on the limits established in the money management section. Early on, this will usually be just 1 or 2 contracts.
Plan Exit Strategy
Before executing the trade, decide the exit strategy both to the up side and the down side.
On the down side, a stop loss should be set either at the level determined by the maximum loss per trade, or just below the support line that the stock just bounced off of (just above the resistance line in the case of a put). If the stock breaks its support / resistance, it invalidates the signal that resulted in getting into the trade in the first place, and there is no longer any reason to stay in the trade.
On the up side, use the expected movement in the price of the stock calculated when deciding which strike price to purchase. If this expected movement brings the stock up against a resistance level (down to support for puts), place an order to sell the option that is triggered by the stock trading just below that level. If there is no overhead resistance (nearby support), then place a trailing sell stop order that is triggered by the stock trading just below that level.
Execute the Trade
Trades should be executed during market hours, preferably towards the end of the day. Do not make trades at the beginning of the day since stocks tend to be more volatile early in the day.
To open a trade, place a limit order for the desired contract, with a limit price in the middle of the current bid/ask spread. If it doesn’t get filled, cancel it and just place the order at the ask.
Enter Stop Losses
Enter the stop loss, limit, and trailing stop loss orders that were calculated as part of the exit strategy. Do this immediately after opening the trade.
Write Journal Entry
As soon as the orders described above have been entered, create a blog entry for this trade. Address the following:
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List the option being purchased, strike price, expiration month, purchase price, number of contracts, and the current price of the stock.
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Describe why this is a good trade.
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Write down the expected movement in the stock price, and the expected amount of time it will take.
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Describe the exit strategy.
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List the maximum loss for the trade as well as the expected profits.
Once the trade has been closed, create a new blog entry and address the following:
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Describe why the trade has been closed.
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List which previously entered exit order was executed, and how it was triggered.
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List the exit price and the current price of the stock, as well as the profit or loss realized in the trade.
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Analyze whether this trade was executed correctly according to the plan, or whether any mistakes were made that the plan would have avoided.
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If everything was done according to plan, analyze whether anything in the plan should be updated.
