Planning Individual Trades
So far in our guide to getting started with options trading, we have covered a number of stages you should go through when first setting out. We have explained the importance of being properly prepared, provided details to what your preparation should involve, gave information on choosing an online options broker, and explained the significance of account trading levels. We have also detailed how to identify trading opportunities and the methods you can use to manage your money and your exposure to risk.
Assuming that you have assimilated and understood all of the above, you should be ready to actually begin buying and selling options. All you need to know now is how to put together everything you have learned and decide which trades to make. On this page, we have provided a step by step process for planning each individual trade you make. Over time, this process will become second nature to you, and you may even adjust it to suit your own preferences. While you are starting out we recommend you follow the steps in the order suggested below.
- Make your Forecast
- Set your Targets
- Choose a Strategy
- Determine Position Size
- Plan your Entry
- Prepare your Exit
Make Your Forecast
Once you have carried out the necessary research and highlighted an opportunity to make a trade, you need to determine how you are going to try and make a return. This basically means deciding what your forecast, or outlook, is on the security you have identified as an opportunity.
If you were investing in stocks then you would be looking for either stocks that were likely to increase in value so that you could buy them and profit from the increase, or stocks that were likely to decrease in value so that you could short sell them and profit from the fall. However, with options there are several different outlooks that you can profit from. You can certainly make options trades where you can profit from a security simply going up in price, or from a security going down in price, but you can also profit from other scenarios too.
For example, if you highlighted a security that you felt was likely to remain at its current price for a while then there are strategies you could use to benefit from that stability. If you highlighted a security that you felt was going to fluctuate moderately over a period of time, but you weren’t entirely sure whether it would go slightly up in price or down in price, then there are also strategies where you could make a profit out of moderate moves in either direction.
This is one of the major benefits of options; no matter what your outlook on any given security there is always a strategy you can use to try and profit from your forecast. If you are confident that you have correctly forecasted what is going to happen to that security, then you simply need to select a suitable strategy, decide how much to invest the trade, and then place the appropriate orders. Before that, though, you will want to consider setting some targets.
Set your Targets
While this isn't a necessary step for every trade you make, it's usually a good idea to set targets. The main target you should be setting is how much profit you wish to make because, without knowing how much you are expecting to make it's impossible to gauge whether or not a trade has been successful.
Another target might be the length of time in which you expect to make a certain amount of profit. This can help you with budget control because, you may not want to have funds tied up in any one trade for too long. The setting of targets will also assist you with some of the later steps in planning your trades which we cover below.
Choose a Strategy
There are almost limitless ways that you can combine various options positions to try and profit from any outlook you have on any particular security. The key to success is really as simple as using the right combination at the right time. Whenever you combine multiple options positions on the same underlying security you create options spreads, and each specific spread is effectively its own unique strategy. Once you have made a forecast on how you expect the price of a security to move, you need to select a strategy that is right based on what your outlook is and any targets you have set.
For a relatively straightforward way to choose an appropriate trading strategy, we would suggest taking a look at our section dedicated to Options Trading Strategies. In this section we have provided a comprehensive list of most of the standard strategies that can be used. To make it as easy as possible for you, we have divided these strategies into a number of different categories. The four main categories are based on what outlook the strategies are suitable for and there are as follows:
- Bullish Strategies
- Bearish Strategies
- Strategies for a Neutral Market
- Strategies for a Volatile Market
If you visit the relevant category, then you will see a list of strategies that you can use to try to make a profit from market movements you have forecasted. Some of the strategies are relatively simple while others are significantly more complex; you just need to decide which is the best suited for the particular trade.
At this point you should take risk management into account, consulting your trading plan if necessary, and ensuring that you are taking an appropriate level of risk. As you gain more experience and become more familiar with all the different strategies, you should be able to decide on a suitable strategy with relative ease. You may also find it useful to use the following – Selection Tool for Options Trading Strategies.
Determine Position Size
Once you have chosen which strategy you will be using, the next step is to size your position and decide how much of your capital you will be risking. Always remember how important position sizing is for controlling your budget. No matter how confident you are that a trade will be successful, you really should limit the percentage of your capital that's on the line. Position sizing isn't just about how much money you are paying at the point of making a trade, but it's also about how much money you are putting at risk.
If you are creating credit spreads for example, you will receive an upfront payment when making the trade, but you will be exposed to potential future losses. Your potential losses must be taken into account when you are deciding on what level to size your position beause, this is ultimately how much of your capital is at risk. Getting this step wrong could potentially lead to losses that decimate your investment capital, so effective position sizing really is vital. Your position sizing should also take into account any targets you have set.
Plan your Entry
With all of the above steps completed, you are now ready to go ahead and plan your entry into the relevant options position. Depending on the nature of the opportunity you have identified, you may need to wait for certain criteria to be met before actually making the necessary transaction(s), or you may have to act immediately.
For example, you might have identified a security that you think will be about to rise dramatically in price, but you first want confirmation of it reaching a certain price point or resistance level. If it doesn’t reach the required level, then you don’t make the trade. If it does, then you will want to make the trade as quickly as possible which is why you need to have carried out the above steps first. If the opportunity requires immediate action, then you obviously will want to go ahead and enter the position accordingly.
To actually enter the position and make the trade, you will need to place the necessary order, or orders, with your broker. It's always a good idea to have some funds deposited with your broker so that you can place orders quickly when you need to. A delay in placing your order because you first have to add some funds to your account could end up costing you money or even result in missing the opportunity entirely.
If multiple orders are required, then you will need to decide whether you are going to try and have all those orders filled simultaneously or use legging to fill them in stages. Once your order is placed and your trade is underway, then you just have one more step to consider.
Prepare your Exit
At the point of entering a position, you should already be thinking about how and when you are going to be exiting that position. There are a number of considerations here, such as whether you are planning to let your positions run until expiration or whether you are planning to close them early.
If you have set targets for a trade then you should also plan for closing your positions if you make the required level of profits or if the specified amount of time passes. If it consists of multiple positions, you should also decide whether you will be closing all the positions simultaneously or legging out of them individually. You may also want to plan at what point you will cut your losses if things don’t go according to plan.
Taking the above information into account, you must then decide how you will go about closing your positions when necessary; there are essentially two ways you can do this. You can either monitor the markets, closing the positions when the time is right, or you can set up automatic exit points where possible, by using stop orders for example. Once your exit is prepared, you should be ready to move on to your next trade.