Obey These 3 Option Trading Rules

I've decided to invite AJ Brown, from TradingTrainerHomeStudy.com, as he was a great guest blogger and hit a very hot topic...options! You can read his last article on OTM, ITM, or ATM, which was a great success. I asked him back today because options are getting much more play in this economy and he has 3 great rules for trading options that he would like to share with you today. Comments are welcome and expected, and just as before, he will be responding to ALL comments!

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The most difficult part of trading options (or anything else) is controlling your emotions so you can make smart trades.

There's always this tug-of-war. On the one hand you have logic and common sense. On the other, you have fear and greed. Problem is, fear and greed are too often the winners! (I know; I've been there.)

With that in mind, here are three option trading rules I suggest you obey to eliminate emotional decisions.

Rule #1: Be an End-of-Day Trader

Do some people make money day trading? Absolutely. But for most people I advise against it. Here's why...

Watching the market real-time can send your emotions soaring and diving like a roller coaster on a rickety track. Sure, it's thrilling. Sure, you'll experience something like a gambler's high. But it ain't going to do your trading account any favors.

Personally, I recommend that you not watch the market during the day. I do recommend that you analyze potential trades end of day, after the market closes. This way you don't get sucked into the frenzy of the market and you can plan your trades in advance of the next trading day.

Let me get specific for you about my particular timeline.  Once trading ends for the day (for me that includes the after hours session too) I begin the process of pairing down my watch list to my pick list and to, finally, my hot list.

I have a funneling filtering system that starts out more black and white / robotic and get more subjective as the number of candidates is reduced to a few.

My pick list is derived from my watch list by taking a line chart setup and quickly flipping through my watch list candidates looking for basic tradeable patterns that stand out.  I'm looking for the low hanging fruit like clear reversals, or obvious trend continuations or better yet sideways consolidations.  I also use programmable algorithms in my broker's charting software to help this mechanical narrowing down of my watch list into a pick list for the day.

On a given day, a watch list of say 70 to 110 candidates should be narrowed down to roughly ten symbols on your pick list.  If there's more or less, and it's a typical day with no external stochastic shocks affecting the market, then I know I have to adjust my filtering to be either more strict or lenient.  It's an iterative process.

Once I have a pick list, I complete a full analysis where I evaluate each ticker using the appropriate templates to match the chart's personality to see if their is a possible entry setting up for the next trading day.  I'll use volume and support / resistance price thresholds to validate the template confirmations, and if all is a go, I'll add the ticker to my hot list to trade the next day.

But, it doesn't stop there...  I'll actually submit my hot list to my investment group.  They'll evaluate my hot list picks and me theirs.  We'll actually meet live (usually by telephone or even VOIP connection) and quickly run through the positons looking for a yay / nay concensus on each.  It's these group picks that I actually trade the next day.

A quick note about trading in a group.  To me, trading in an investment group is the holy grail of trading.  A group holds you accountable, gives you support, and offers you a diverse perspective.  I have found more than not that successful traders trade in an investment group of one sort or another.

Rule #2: Stick to Your Money Management Rules

Money management rules prevent you from risking too much capital on any single trade. Sticking to your money management rules keeps you in the market for the long-term.

Most traders find themselves risking too much money on trades they think will "go big." But if you've been trading for any time at all, you know that what you think and what actually happens are often wildly different, which is why it's never wise to risk a big portion of your trading account on just one trade.

A better approach: Create money management rules that disperses risk among multiple trades so that you never lose big on any one trade. Then, after you've created your rules, stick to them.

Consider setting a hard limit on the amount of risk any one of your trades might have on your portfolio.  Say 2%.  Then work backwards to determine positon sizing and hard fixed stop loss placement.  For instance, if 2% is your max portfolio risk then your position size can be 10% of your portfolio if you employ a 20% fixed stop loss.

A quick note about option trading.  In directional optional plays, generally you have to allow the option room to breathe to not get stopped out prematurely.  A fixed stop loss set at 15 to 20% below the option buy price, I have found, is the perfect compromise.  As the stock appreciates, the fixed stop loss can eb ratched up.

Rule #3: Use Automated Exit Strategies

Once you're in a trade, you need to use automated exit strategies. An example of this would be a stop loss order or an automated alert that's triggered when your option hits a certain price threshold.

If you're obeying Rule #2, then you will already know exactly where to set your stops or create an alert. The advantage of using automated exit strategies is it takes the guesswork and emotion out of the decision.

You won't sit there debating with yourself whether to get out of a trade or not. You won't watch the value of your position erode to nothing. You'll get out when you've decided in advance to get out.

All of the most profitable traders use automated exit strategies because it takes an emotional decision and reduces it to a mechanical decision. This is ultimately what you want because it will do two things for you: avoid exorbitant losses... and... lock in profits.

A quick note about automatic trading strategies.  They key here is to plan your exit and then exit based on your plan.  A stop loss is probably the most basic of automatic exits.  Careful though... stop losses don't guarantee and exit at that price, just the triggering of an order at that price.  A sell stop limit order has you select the trigger price to sell as well as the limit sell order price to sell at.  Limit orders don't guarantee a fill.  So, you can use a sell stop market order that has you select the trigger price to sell and then sells at the market.  Your guaranteed a fill at whatever price is possible.  Consider this, with the advent of more advanced trading platforms and respective orders, our ability to automate exits has grown.  We now have contingent exits, which work really well with options (example: sell the option contingent on the stock doing XYZ) as well as more triggering scenarios above and beyone price threshold crossings (example: sell the option when the three day simple moving average crosses down below the five.)

These are the three rules I use to eliminate the emotional element from my trading practice. Remember: Obey these three option trading rules and you'll be way ahead of everybody else.

Best regards always,

A.J. Brown

P.S. If you didn't get it before, get my free report called 7 Financially Devastating Mistakes Most Option Traders Make