The Importance of a Good Trade Plan

I’ve wanted to write this post for a while now because I think it’s really important for traders, especially new traders. So many times on various forums I see new traders asking what to do about a trade they have already put on. The questions typically fall into one of two categories: 1) My trade is in trouble, what do I do? or 2) When should I take off this trade? My response to these types of questions is: “What does your trade plan say to do?” and the conversation generally ends. This may seem like an answer that isn’t helpful but I think it actually is helpful. When someone asks a question like that, it’s tough to give a useful answer if you don’t understand the purpose of the trade and, more importantly, the risk tolerance of the trader. This is where a solid trade plan is important. A trade plan should lay out very clearly the goals of the trade as well as the risk management of the trade. When the trade is closed, the standard of evaluating the trade should be the trade plan. There is no one standard or criteria for success or failure that applies to everyone. Trades, ultimately, reflect the trader. What is a good trade for me may not be a good trade for you and vice versa. Your risk tolerance may be quite different from mine. But all of these things can be included into a trade plan built for a specific trade by a specific trader.

The time to consider what you do in a trade is before the trade is put on, not after. The market can move quickly and taking time to figure out what to do in the moment can lead to bad decisions. And while it’s perfectly reasonable to make changes to a trade plan, those changes should happen in between trades, not while a trade is on. Changing course mid-trade, in my experience, leads to more negative outcomes than positive. Could you get lucky and do well? Yes. But decisions made in the heat of the moment are usually based on the emotion of the moment. Our goal as traders is to be as mechanical as possible and to do that we need a solid plan that covers all situations before we enter a trade.

The Anatomy of a Good Trade Plan

Now that I’ve established the importance of a good trade plan, it’s fair to ask, “What’s in a good trade plan?” I will first attempt to describe the parts of a good trade plan and then look to an example. Here are the elements I consider to be vital to a good trade plan:

  • Entering the Trade
  • Profit Target
  • Maximum Loss
  • Maximum Time
  • Adjustments

ENtering the Trade

While this may seem really basic, you’d be surprised how many new traders don’t really think about this part. But setting up a trade is vital to the success of the trade. What is the structure of the trade? Where does each set of contracts start? At the money? In/Out of the money? Are the positional Greeks important? There is no one right answer here because there are so many different trades. But this shouldn’t be a pure guess. How you put on a trade should be intentional. If you can’t state this specifically, I strongly suggest taking a step back and think about why you think this is a good trade. I do not suggest blindly copying someone else’s trade (and I say this as one who shares all of my trades online). It’s not a bad thing to learn by what others are doing, but it’s really important that you understand what the other trader is doing and why. Putting on a trade without understanding the setup and goal is very dangerous. My standard for this (and for the entire trade plan) is that you need to be able to explain what you are doing and why to someone else clearly. If you can’t do that, you most likely don’t really understand it yourself. This is one of the reasons I put my trade reviews online. I force myself to explain what I’m doing.

Another very important concept in this part of the plan is trade size. Trading is, ultimately, a risk management business and the first element of risk management is the size of the trade. Many traders will tell you that the worst losses they took were either put on too large or were allowed to grow too large via adjustments. Knowing the initial size of the trade as well having a risk cap on the trade is a critical step to keeping losses under control. You can’t lose what you don’t risk.

Profit target

The goal of every trade should include profit (or at least the possibility of profit in the case of a pure hedge). But what’s important here is to define specifically what the profit goal is. “This trade should make a profit” is not good enough. The plan should state a specific goal. That goal could be a raw amount or a % of the size of the trade. This helps answer part of the question “When should I take the trade off?”. If you are asking this question when a trade is profitable, you either did not set a profit target or are second guessing yourself. Neither is good in the long term. Again, the time to change your plan is between trades, not while they are on and the market is moving.

Maximum loss

This is probably the toughest plan element in terms of execution. But you need to know when enough is enough. Even with the best plan, not all trades will succeed. Losses are a part of the business and taking them properly is critical to successful trading. It’s very easy in the heat of the moment to talk oneself into making more adjustments to try and save a trade and avoid taking a loss. And sometimes it can work. But many times, this is where bad losses happen. The one trade that took out 3 months of profits. I speak from first-hand experience. This is another critical part of a risk management strategy. This is why you need to know up-front how much you should risk on a given trade. As I stated above, size the first element of risk management but a close second is the max loss. If your trade hits or exceeds the max loss of the trade plan, especially at an adjustment point, it’s time to close the trade and move on. The ability to move on from a trade that didn’t work out is very important. It’s so important that I did a separate blog post on it called “Pets vs Cattle“. I use this analogy all the time to remind myself to take a loss before it becomes a bad loss. I don’t always succeed but I continue to work on this part of my trading as it does make me better. But what’s important here is that in order to execute properly on a max loss, it needs to be explicitly defined in the trade plan.

Maximum time

This is an element that I think gets overlooked by many traders. Unlike stock trading, options trading is very sensitive to time because, unlike shares, options contracts expire. Some specific trading strategies, like the wheel, can go all the way to expiration. But in many options trades, the risk/reward changes significantly as expiration gets closer and that should be reflected in a trade plan. The kinds of trades I do work better if I stay away from expiration week or “Gamma Week” as it is sometimes called. For more examples of why this can matter, feel free to read a blog post I did on this earlier called “Why I Avoid Expiration Week“.

Bottom line: It’s important to understand the risk of a given trade as expiration approaches and factor those risks into a trade plan. This may mean you have a point where you simply exit the position by a given point in time regardless of profit or loss because the risk/reward has changed enough that the trade no longer makes sense. One way to judge this is to ask yourself “Would I put this trade on as a new trade given the risk/reward?” If the answer is no, you should exit the trade.

Adjustments

This can be the most complicated part of the plan but it is vitally important. But I will start with this statement: Adjustments are not required in all trades. A valid trade plan can simply have exit points based on the initial entry to the trade. Doing so makes the trade plan and execution easier. The downside is that you may miss out on some potential winners. There is no perfect answer here. But if you are going to adjust, you need to have a set of conditions that would cause you to adjust, as well as know the adjustment up-front. When the market is moving against your position is not a time to figure out what you need to do. Ideally you have one specific adjustment per condition. You might have two but in that case, you should have specific criteria to help you decide which adjustment to deploy. And when first starting out with adjusting, keep it as simple as possible to help you execute properly. You will have time to make adjustments to your plan as you trade more (but only in between trades). The adjustments part of the plan should have specific conditions that trigger an adjustment. These conditions can be the price of the underlying, or a certain Greek value like delta. But timing is really important when it comes to adjusting. Knowing when to adjust is more critical than how to adjust, in my opinion. Adjusting too early can lead to reversals that kill your trade. Adjusting too late can lead to throwing more money at a bad situation and taking larger losses than you planned. The speed of the market can certainly affect how you may adjust. When the market is moving very fast, especially on the downside, an adjustment involving multiple legs may not be possible as prices are just moving too quickly. These situations are rare, but they happen and a trade plan needs to account for them. Sometimes all I can do is grab a put and hang on. But that’s really not specific enough. How many puts? Which puts? What expiration? How long do they stay on? All of this must be part of the trade plan.

Another important element here is to know when not to adjust. Did the market just open? Maybe it’s a good idea to wait a bit and see if it reverses. Is the trade profitable? Maybe it’s a good idea just to take it off and move on to the next one. How many times have you adjusted this trade? Maybe it’s a good idea to just take the loss and move on. How long has the trade been on? Does the trade still have time to work post-adjustment? As you can see, this part can get complicated, and some of these elements you will learn as you trade more and get more experience.

An Example of a Good Trading Plan

So now that I’ve talked about the elements that make up a good trade plan, I want to show an example. PLEASE NOTE: This is just an example of a trade plan. This is not a trade recommendation. I have no idea of your level of expertise, risk tolerance, account size, etc. The goal here is show how one might put the elements of a trade plan together. I hope I can show that here. This particular trade is one the trades I’ve done regularly over the past year or so with reasonable success.

TRADE: 23-day SPX Narrow Calendar

ENTRY: I enter this trade near the end of the trading day on Wednesday. This is a trade that starts at the money with the shorts 23 days out. Where I put the longs depends on the VIX at the time I open the trade.

  • VIX under 12: The longs go 14 days away from the shorts*
  • VIX between 12 and 15: The longs go 7 days away from the shorts*
  • VIX between 15 and 20: The longs go 5 days away from the shorts
  • VIX between 20 and 25: The longs go 3 days away from the shorts
  • VIX over 25: Do not put on the trade due to very high volatility.

* Not really narrow at this point, but a standard calendar. Rules still apply.

The reason for this is that the longer the distance between the shorts and the longs, the more the trade is exposed to volatility (position Vega). The higher the volatility, the less Vega exposure I want for it. I understand that in exchange for less Vega exposure, I get less Theta decay. That’s a trade-off I’m willing to make.

As for size, I want to risk around $3000 on the trade.

If VIX is up more 2 points or more on entry day, I will probably delay entry until Thursday. If volatility keeps going up, skip the week and wait.

PROFIT TARGET: The profit target for the trade is 10% of the original risk of the trade. Within the first week I’m willing to take 8% I bump the target up at 6-7 days in the trade.

MAXIMUM LOSS: My max loss for the trade is 15% of the the original risk of the trade. In the first two days, it’s 12%.

MAXIMUM TIME: I want to be out of this trade no later than Monday of expiration week.

ADUSTMENTS:

Under normal conditions, I adjust if the trade crosses either expiration break-even or if the the market appears to close within 5-10 points of an expiration break-even. I’ll go on the lower end of the range mid-week, I adjust closer to 10 going into a weekend. The adjustment here is to add a new set of calendars equal to the number of calendars put on originally about 30 points past the break even point. Optionally, I can move half of the calendars to the new place to keep the risk the same instead of doubling up.

Once in a double, my new adjustment points are the centers of each calendar. If the underlying crosses either one, the adjustment is to take off the other structure, returning back to a single calendar. From there I could go back to a double if desired.

I usually don’t go to a double more than twice and at that point will consider just closing. Three times would be the absolute most and only then if I like the graph going into the 3rd double.

EXCEPTIONS:

  • If the underlying moves down more than 1.6 standard deviations in a day and an adjustment is needed, I consider buying a put to flatten the deltas about 80%.
    • I usually buy the put in the later expiration of the calendar or later if needed. The expected life of the put is 20% of the time left on it at the time it was bought.
    • I keep the put until the underlying gets back to the center of the nearest calendar or if the expected life is exceeded. If the expected life is hit, I could roll it out for more time or just sell it.
    • The goal of the put is to just keep the trade from getting out of hand in a fast down market.
  • If the trade is up at all at an adjustment point, I will close the trade entirely.
  • If the trade needs adjustment before the first weekend, I will consider closing the trade. This decision is based on the graph at the time (experience counts here)

This is an example of a trade plan that covers lots of cases. If for some reason the plan can’t be executed due to something unexpected, in my experience, it’s best to close the trade and re-evaluate the plan. This happened to me once on an SLV trade where there were no options available to do my upside adjustment. They just weren’t on the market. I hadn’t accounted for that in my plan so I just closed the trade. This is part of the learning process.

To a new trader, I can easily see how this can be overwhelming. There are trades that can have simpler plans. Most of the complexity is in this trade is in the adjustments and, like I said, not all trades need adjustments. But the goal is to show what I think is a good trading plan. Every trade needs a plan. Then the trick is to properly execute the plan. As the famous boxer Mike Tyson once said, “Everyone has a plan until they get punched in the face”. But building a plan and executing that plan is how to become consistent. The important thing with a new trade is to start small. One-lots are perfectly fine. Keep the risk under control while developing and executing your plan.

As usual, I’d love to hear what you think about trade plans. Feel free to comment here or reach out to me directly at midway@midwaytrades.com

Why I Primarily Trade SPX

Those out there who follow my trades, especially my weekly series This Week @MidwayTrades will notice that I primarily trade one underlying vehicle: options on SPX, the S&P 500 Index. I occasionally do small spec trades in other underlyings but anything I do regularly and of significant size is always in SPX. This is not the way a lot of retail options traders operate so I thought it would be worth a blog post to explain why I spend so much time trading options of one underlying. Let me say up front, none of this is to say that there is anything wrong with playing lots of different options. I always say if you can consistently make money trading a different way, that’s the right way for you to trade. But in this post, I will spell out why I prefer to trade SPX whenever market conditions allow it (which is most of the time).

1. Liquidity

To me, liquidity is essential. Without liquidity, do you really know the worth of your position? I would argue no. Market prices are set when buyers and sellers agree on a price and if no one else is participating in a market, it’s tough to tell the actual price of something in that market. The CBOE (Chicago Board Options Exchange) tracks activity of nearly 3000 underlyings that trade options. I personally would only be interested in trading options in the top 100 in terms of volume. You can find this list here for your own inspection. This is for equities. I found stats on indices here. You will find that SPX is not only well in the top 100, but top 10-15 depending on the time frame. With all the available options out there to trade, why spend time and money fighting to get a fill on a low volume/open interest contract? Price slippage is very real and I rarely, if ever, have to give in more than $.10 of a reasonable mid-price for SPX, usually less.

Outside of good fills, good liquidity also gives far more options to trade (i.e. more strikes, and more expirations). SPX not only has Friday weekly expiration but Monday and Wednesday as well. I used to avoid the non-Friday expirations, but recently I’ve found that I get good fills on Wednesday as well. This makes it easier to put on multiple positions in a single account without stepping on other trades in the same expiration which can lead to confusion when closing or adjusting trades.

2. High Prices

I see lots of traders who head to the bargain basement because the option prices are cheap. It’s certainly tempting just as it is trading stocks. But there’s a downside to this. In stocks, it’s usually that the stock has a low price for a reason (low quality). But for options it means there isn’t much in the way of premium. As a trader who likes to sell premium, this means I have to trade a lot more contracts to generate enough premium to make it worth the risk. And while commission costs have come down significantly even this very year, they still add up vs the amount I want to make selling premium. A quick side note: when I say I sell premium that doesn’t mean just selling options or even that I open a trade for a net credit. In my non-spec trades, I am always selling more time premium than I am buying (thus being positive theta) and in many cases I am also selling more volatility than I am buying (unless volatility is extremely low as it is right now in which case I set up my trades to be positive vega and I’m a volatility buyer). But the price of the option starts with the price of the underlying. At the time of this post, SPX is a $3100 index. That means that even trading a one lot can involve over $1000 in margin. As I’m trying to make 7-10% of that as a successful trade, this means I can trade fewer contracts to make a decent amount of money on a trade. This is one of the reasons I prefer SPX to the ETF for the S&P 500 SPY which is priced at about 10% of SPX. Yes, the prices are lower, but I would need to trade 10 contracts for every 1 of SPX and that is 10X the commission to my broker. There are other reasons I prefer SPX to SPY that will come later. But the bottom line is, outside of unusual small spec plays, I prefer to trade underlyings above $80/share. Below that it’s tough to get enough premium to sell to make a decent profit.

3. Diversification

A nice feature of a large index like SPX is that it represents many different companies across different sectors by design. The S&P 500 consists of (to no one’s surprise) 500 stocks. That means that by trading this underlying I get a certain amount of sector diversification built-in. Is it perfect? Of course not. The index can get out of balance at times. But it’s rarely so out of whack that one stock or one sector will destroy it. I still have to be aware of what’s going on and be ready to take action if something does happen to move the index but it’s less impactful than say, earnings or news on one stock which can move it several standard deviations in a day.

And that’s another advantage: SPX doesn’t have earnings events in the same way that individual stocks do. Individual components have them all the time but they are spread out over many days so the effect is muted. That isn’t to say that there are no events that cause a move. The biggest one these days is Fed announcements. I do keep track of Fed meetings and am a bit cautious adding new positions right on top of them. There’s a nice site that keeps track of economic news on a daily and weekly basis called Econoday and it’s not a bad idea to keep a browser tab open to it on your trading station. Other news can move the index as well, the recent trade war has certainly moved the market and has been unpredictable at times, but I have found the risk to be more manageable than individual stocks.

4. Cash Settlemement

Equity options are generally settled in shares of the stock. Options that expire in the money are usually automatically assigned and shares of stocks change hands as a result. But indicies like SPX do not have actual shares so their options are cash settled. This is another difference between options directly on the index and ETFs (like SPY) based on an index. SPY options are settled in shares of SPY.

Now, it’s reasonable to think that as long as I close my position before expiration, this isn’t really an issue. Except that with share settled options, there is always a risk of early exercise. The buyer of the option, most of the time has the right to exercise their right at any time during the life of the contract (this is known as American style). But since there are no actual shares to exercise, options on indicies do not have early assignment (this is known as European style). I will use SPY as an example since it is an ETF based on the S&P 500. SPY has a dividend based on the dividends of the stocks in the index. One of the reasons that options get exercised early is to capture a dividend. Another can be a buyout. This happened to me once in my early trading days. I was writing covered calls against a position and the company got bought out for a higher price than the strike price on the calls I was writing. The next day, my shares were called away. The SPX doesn’t have real shares and, therefore, has no dividend and, while buyouts can happen to companies in the index, the index itself can’t be bought out so there’s no real advantage to early exercise which is why it’s European style.

5. Tax Treatment

This is US specific so if you are not in the US it may not apply to you. But in the US we have capital gains taxes as part of our income tax system. The basic idea is that selling something for a profit generates income that falls under our income tax. But the US tax code distinguishes long-term capital gains (meaning you held something for at least a year) and short-term capital gains. Most options are held for under a year unless you are dealing exclusively in LEAPs so any profits made by them would be taxed at the short term rate (which is my regular income tax rate vs the long term rate of 15%). But options on “broad-based indicies” (which includes SPX) are treated differently. Any profit I make on SPX options where I held it for less than a year (which is all of them in my case) is taxed 60% at the long term rate and 40% at the short term rate. While this is not a huge advantage for me, it’s a nice bonus. This tax treatment does not apply, however, to ETFs like SPY. Of the 5 points made here, this is the least important, but I thought it is still worth mentioning as a reason to trade options in big idicies.

Conclusion

There are multiple ways to make money in options. My style is mostly around non-directional plays on big indicies. SPX isn’t the only big index out there with options. I have traded options in the Russell 2000 (RUT) which is based on smaller companies than SPX. It tends to be a bit more volatile, but it is quite trade-able and all of these points would apply. As is the NASDAQ index which is priced even higher than SPX. But at the end of the day, each trader needs to find out what works for that particular person. There’s no one right way to trade. But I thought this discussion of SPX may, in addition to helping some folks learn more about options, could lead to other discussions of trading ideas. Feel free to comment below or reach out to me privately at midway@midwaytrades.com.

Good Trading!

Hello, World!

Thanks for stopping my the site. I’m Midway and this site is an extension of my desire to build an online community of options traders and folks who like to talk about and learn about options trading.

I started talking about options trading on Gab a while back and that eventually led me to start a BitChute channel where I post videos about trading. It started with an occasional series called “Trade Review” where I find live trades that demonstrate a principle about options trading. I then did a 17-episode series called “Options Fundamentals” where I go through the basics of options and trading them. The idea is to build up a library of information on options that can be educational and, hopefully, start up discussions. I am about to start a new series called “This Week @MidwayTrades” where I take my weekly trade review sessions and post them online for everyone to see: the good, the bad, and the ugly. Stay tuned for that.

Then I got the idea to start up this site. The idea behind this site is to have a place where I can post longer form blogs as well as a place where folks can download the videos and other materials that went into making the videos. I’m not looking to sell anything, this effort is here to build a community. I will do my best to promote it on places like Gab, Minds, and BitChute. For now, I’m staying in the “alt-tech” world because I’m becoming disillusioned with the big tech social media companies and how much they are working to censor views they do not like. And while this topic isn’t exactly controversial or even political, I still don’t like what they are doing on principle.

If you are interested in contributing content to the site, feel free to reach out to me at midway@midwaytrades.com and we can discuss your ideas.