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options trading system

Options Trading System – 5 Steps To Better Options Trading

Options Trading System

Options Trading System

What is an Options Trading System?

 

Before sitting down to write this post, I thought I would search the Internet to see what information existed on options trading systems. I was shocked to find that there was barely anything posted on the subject. Seriously! There are hundreds of websites, brokerage firms, and trading services that want to sell you their system. The reality is that very few are able to describe what an options trading system actually is.

At its core, an options trading system is a method of generating buy and sell signals through a tested method of stock analysis. The system can be based on any type of option strategy and includes both fundamental and technical analysis. Options trading systems might focus on changes in underlying stock price, volatility, time decay, unusual buy/sell activity, or a combination of these elements. 

Essentially, it is a checklist of criteria that must be met before trades are entered. When all conditions are met, a signal to buy or sell is generated. The criteria are different for each type of option trading strategy. Whether it is long calls, covered calls, bear spreads, or selling naked index options, each has its own trading system model. An option trading system that is worth its salt will help you weed out false signals and build your confidence in entries and exits.

How Important is an Options Trading System?

The options market is very complex. Trading options without a system is like building a house without a blueprint. Volatility, time and stock movement can all affect your profitability. You need to be cognizant of each of these variables. It is easy to be swayed by emotion when the market is moving. Having a system helps to control your reaction to those very natural and normal emotions.

How often have you sat and watched a trade lose money the instant your buy order filled? Or, have you ever watched a stock skyrocket in price while you are pondering over whether or not to buy it? Having a structured plan in place is crucial to make sound and objective trading decisions. By creating and following a good system, you can hone your trading executions to be as emotionless and automatic as a computer.

Advantages of an Options Trading System

Leverage – Trading options gives your account leverage on the stock market. With options, you can control hundreds or thousands of shares of stock at a fraction of the price of the stock itself. A five to ten percent change in the price of a stock can equate to a gain of one hundred percent or more in an option. Try to focus on percentage gains versus dollar amount gains in your trading. It requires a fundamental shift in conventional thinking, but it is crucial to managing a successful trading system.

Objectivity – A good options trading system is based on measurable criteria that trigger buy and sell signals. It takes the subjectivity and second guessing out of your trading so you can focus on preset factors that make for an explosive trade.

Flexibility – Nearly all options traders will tell you that options allow for flexibility in your trading. Opportunities in the options market make it incredibly easy to profit from short-term positions. With earnings events and weekly options, you can build strategies for overnight gains with clearly defined risk. There are a several ways to profit in any kind of market condition from trending to range bound.

Protection – An options trading system based on the appropriate strategy for prevailing market conditions can act as a hedge against other investments. Protective puts are commonly used this way.

Risk – A good options trading system limits risk in two important ways. The first way is cost. The price of options is very low compared to buying the same amount of stock. The second way is related to stops. A good system will cut losses quickly and keep them small.

Any Option Trader Can Develop an Options Trading System

As a trader, it is important build a system that utilizes different types of option strategies–iron condors, broken wing butterflies, calendar spreads, back ratios, straddles, strangles, and collars. It might sound like a foreign language right now, but work on the vocabulary one lesson at a time.

Break it down piece by piece and make it your own. Each term has a specific application for yielding profits under certain market conditions. Learn them all at your own pace to enhance upon and build your options trading system.

The more tools that are in your toolbox, the more prepared you will be for changing market conditions. If the market were to behave in the same way every day, then trading would be child’s play. In order to get started in developing your options trading system, you have to create a trading plan or blueprint to guide you in the right direction.

Begin with a basic system and tweak it to define your trading criteria and hone your system. It takes time and experience to build a successful option trading system that can return one hundred percent or more in consistently profitable trades. When you are satisfied with the parameters of your system, you can look into having your own software made for automated trading.

Five Steps to Get Started With an Options Trading System

Pick a strategy - You can pick any strategy to start building a system. Buying calls and puts is the easiest way to get started. As you learn and experience more about how prices move, you can add new strategies to your trading to enhance your system. Adding covered calls and protective puts to long equity positions is a logical next step and can supercharge your account by generating monthly or weekly cash flow.

My SPX Method is one of the simplest and most profitable systems I have in my trading war chest.

Trade  – Once you have defined the basics of your strategy, it is time to trade. Start small, one or two contracts, and keep detailed records of your transactions. Be sure to include what the underlying stock price was at the time of your option purchase or sale. Your records will help you analyze how you are doing and where you can improve. When you add new trading criteria to your system, you should be able to see an improvement to your statistics. If you do not, it is time to reassess your defined criteria.

Evaluate  – Evaluate your successes and failures. The frequency of your analysis will depend on how much you are trading. If you are trading actively, then a weekly or monthly review is important. Compare your losses with your winnings. Zero in on the key factors that make up a winning trade and try to fine tune your criteria to enhance your executions. As painful as it may be, analyze your mistakes, too. Fine tune your criteria to eliminate making those same mistakes again. Analyzing your mistakes is just as, if not more, important as studying your successful trades.

Adjust – When you have a losing streak or spot a potential weak area in your option trading system, adjust it. There is no shame in being wrong. That is part of the business of trading. The shame is in being blind to your mistakes and repeating them. By feeding your ego and justifying your weakness with excuses, you are guaranteed to fail in trading. By acknowledging your blind spots and making adjustments, you can keep your system in line with changing market trends and conditions. It sounds so simple, but it requires perseverance and discipline.

Learn – A trading system is not static. Keep your mind active by always learning. The more you study the stock market and options trading systems, the more you will know and the better off you will be. If an options trading system was like a tic-tac-toe system, then we would all be wealthy. Thankfully, options trading is not as boring as a child’s game. Learn something new every day and absorb it into your options trading system. I do.

Options Trading Case Study – Unusual Option Activity In AXL

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I just recently hosted a webinar, where I went over what is unusual option activity and why I feel every options trader should follow it. The quick answer to the why, is that to me this is as close to a “real time” trading indicator than anything else out there. Money being put at risk is different than someone coming on TV saying they “like” the stock. I go back to the school of thought of follow the money and I will show you why following the money paid of in American Axle Manufacturing Holdings (AXL).

On November 11, 2010 I noted unusual buyers coming into the November $11 calls, where 5472 contracts traded that day with an open interest of 1,394 contracts. Pretty obvious buyers where coming in with trades hitting the offer (indication of buyers) at 10 cents and implied volatility moving higher by 16%. Here are a few reasons why this is unusual.

1) Market was very bearish that day, with the S&P 500 closing down 1.56%

2) Shares of American Axle closed down 4.15% closing at $10.39

3) Call buyers coming into November calls with three days to expire

4) The options trading activity was 3x the normal amount of options traded during the last 22 days

If this does not make sense, I will break it down. The traders paid $10 for each option contract to control 100 shares of (AXL) stock at $11 before November expiration. The total amount of money put up yesterday was $54,000 for this trade. This is not to much money, but here’s the thing, they only had three days to be right so they were risking $54,000 for an all or nothing trade. With the market and shares that weak, what could they be possibly betting for, a bounce?

Well shares did bounce the next day, a good 7.31% with shares currently trading at $11.15 as I write this. The reason for the bounce? JPMorgan Chase (JPM) came out before the market open with an Upgrade on shares to an Overweight from Neutral, while raising their target price to $14.

Pretty interesting, that less than 24 hours before there were buyers of calls to own shares above $11. Currently the price of those November $11 calls are trading at $.30x$.35, a 200% gain on the trade. So do you think this was lucky or someone knew ahead of the rest of us? Leave a comment below.

Here is what I provided to my members in my live chat room: (click to enlarge)

 

If you are interested in learning how you can track this activity on your own, then you will want to check out our course on how to track unusual option activity and trade it. Click here to learn more about it.