Important Announcement

Trading Rules

A critical part of any option trading system is the trading rules. These rules define what I will and won't do regarding trading a particular strategy.  The trading rules cover such things as:
  • What I will trade - what stock or ETF
  • When I will trade - under what conditions
  • When I enter a trade - any technical indicators for entry
  • When I will exit a trade - rules for locking in a profit or minimizing a loss
  • Rules for my daily, weekly and monthly activities

Let's look at some examples of each of these.  I'm going to outline some example trading rules and how they might apply. I use many of these, but others may appeal to other traders.

What to Trade

For options strategies, we already have some limitations imposed. We must be using a stock or ETF that offers options. But what about narrowing down the choice a little further? What underlying stocks will I choose? How about ETFs? Index options?

In addition, I will want to have rules about picking option positions for my strategy.  I might define requirements for open interest or option volume. I might define rules for where to select strike prices.

Here are some example rules.

  1. I will only trade strategy 'X' on stocks that have an average daily volume of 500,000 shares or more 
  2. I will only trade strategy 'X' on stocks that are in a favorable industry group as defined by Investor Business Daily
  3. I will only trade strategy 'X' on ETFs that follow the major indices (ex SPY, DIA, QQQQ, IWM)
  4. I will only trade this strategy on the RUT index options
  5. I will only trade this strategy on options with an open interest larger than 1000
  6. I will select a short strike that is 1 strike out of the money
  7. I will only trade $2 wide and $5 wide spreads

Desired conditions

These trading rules would further refine what to trade.  For example, I might have a rule that says I'll only trade this bullish strategy on a stock, ETF or index as defined above but it must also be accompanied by a bullish trend.  In other words this set of rules might define what would be in your watchlist for that strategy. Example rules might look like the following:
  1. My watchlist for this strategy will be made up of stocks (or ETFs or indices) that in in a bullish trend as defined by higher highs and higher lows.
  2. I will only trade this strategy when the stock, ETF or index is trading in a sideways trend for more than two weeks
  3. I will only trade this strategy when the S&P volatility (VIX) is at the lower end of its range

When to enter

I'll want to have trading rules that define the exact timing of my entry. These might include any technical indicators that would trigger an entry. There might even be rules about when not to enter. For example, I may not want to trade over earnings announcements or at certain times when key economic reports are released (FOMC meetings come to mind).

Here are some example trading rules for when to enter:

  1. I will only take a bullish entry on the bounce off a diagonal up trending support line or moving average
  2. I will only take a bearish entry on a break through an established support level on above average volume
  3. I will NOT take a trade on a stock that is releasing quarterly earnings while the trade is expected to be open
  4. I will only take a trade that offers an ROI of > 15%

Position sizing

Position sizing is simply the implementation of my money management rules. I might have rules dictating that I will only risk a certain percentage of my account. For example...

  1. I will only risk 1% of my account on any one trade as defined by the absolute maximum loss of the spread
  2. I will only risk 1% of my account on any one trade as defined by my stop loss amount of $x
  3. I will only risk 10% of my account total on this strategy

When to exit

Trading rules for exit should include rules for exiting when profit targets are reached, when loss targets are reached or for any other reason that might trigger an early exit.

  1. I will exit this trade when the cost to close is $X
  2. I will exit this trade on a break of support (or resistance)
  3. I will exit this trade when I can lock in 80% of my profit target
  4. I will exit this trade if 1 week goes by and the expected behavior does not occur
  5. I will exit short spread positions at least by 4 days prior to expiration

Rules for routines

Here, I want to have a framework that offers some routine and can guarantee some consistency to my longer term trading. I might define daily activities such as searching for new potential trades, monitoring for exits, etc. I might define weekly activities like updating my watchlist, looking for new trades, tracking my current results. These aren't so much rules as a list of activities that remind me what to do.

Daily routines

These are things I would do every day like reviewing my current trades, reviewing the day's market action and determining a posture or expectation for the next few days forward.

Weekly routines

Weekly routines would be focused on reviewing the week that passed in the perspective of an ongoing trend, reviewing closed trades, updating watchlists, updating trading logs and trade journals.

Monthly routines

Monthly activities might include things like record keeping, reviewing monthly performance and determining ongoing success rates, gain/loss rates, etc. This can also be a good time to review events of the month, thoughts on trend, lessons learned, etc. I have often taken the first Saturday following expiration to do this.

Your turn

OK. Now it's your turn. What will your trading rules be? Rules should be something well thought out and ones that you will be willing to follow. A trading rule makes no sense if you constantly second guess it or routinely disregard it. Rules should be simple in definition, yet very specific so someone else could understand and implement them.

How do you go about creating your own trading rules? Start simple. Begin with one strategy. Define some simple rules for each of the categories listed above. Test the rules over a period of time, first by paper trading and then trading a very small lot size. Don't make adjustments to the rules until you've placed 5-10 trades over a few months time.

The goal for the initial trading rules is not to see how much money can be made. It is to understand the system better, understand yourself better and learn to follow rules consistently. As you grow as an options trader, you can slowly begin to enhance the rules to optimize your success rate.

The measure of success should never be the amount made in a give month or even the percent return on investment. These will fluctuate month over month. The measure of success should be on overall successful trades as a percentage of the total. What the overall long term expectancy is from this strategy and trading plan with a year or more worth of data.

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