My Initial Trade Setups

There are a number of people out there that offer trading advice.  Many of those services provide trades to copy, but that is not what I intend to do for you.  I will provide you with trade examples, but they are not intended to be copied without doing your own work.  I will not show you every trade I make and tell you to do the same.  I will provide you with a framework to come up with the trades you want for yourself.  I will be a mentor and a coach.  I expect you to come up with your own ideas and to ask for assistance.  But, if you watch how I approach the trades that I like, you will learn something.  And that something should make you a better options trader.

There are many stories playing out in the markets, and each of those stories can be traded in a number of ways.  I’m not going to expand upon the individual stories here, but rather I will give you a guidepost on the framework I take when formulating a trade.

First, you need to form a view on the overall market sector you are looking at.  If you are bullish on a specific tech stock but the tech sector falls, you will need to adjust your trade.

Step 1: The Fundamental backdrop

Without some sort of fundamental backdrop, I cannot enter a trade.  I do not look at deep fundamental analysis, but if I think that retail names will struggle, I am less likely to hold onto a bullish position in an individual retail name.  I need confidence in how the overall marketplace should play out.  With this, I can decide which sectors should perform well and then turn my focus.  Once I determine if I feel that the market and sector on the whole is bearish, neutral, or bullish, I can more explicitly form my entry and exit game plan.

Step 2: The Technical backdrop

This is effectively the “market timing” element of a trade.  Technical traders are looking for signs that now is the time to enter.  Market patterns repeat and technical setups are important.  In the short term, technicals tend to overwhelm fundamentals, so if you are looking at a trade with a short time horizon, then technicals will matter more.

Step 3: The Purpose of the Options Trade

Before you enter any trade, you have to decide why you are using options.  Am I entering this position because the options are mispriced for leverage or because I need defined risk?  If you are using options because that’s your default method of trading, then you need to re-evaluate your trading.  The simplest trade is in the equity itself.  The use of options should be reserved for when you have a need for a characteristic of the options or because you have a very specific view on where the market is going to trade.  If the options markets are not mispriced and you don’t specifically need the benefits of defined risk or leverage, then do not use the options market – you will save yourself a lot of money staying in the equity by maintaining a better liquidity and fee profile if you have a clean trade that does not use options.

Step 4: Finding the Best Options Trade

Now that you have your setup and understand your timing elements, we can start to evaluate the whole options curve.  For each trade setup, you have a menu of ways to trade.  We will review the menu each time we enter a trade and look for the best use of our trading capital so that we can lever our trades appropriately.  Important to any trade is a combination of implied volatility, historical volatility, skew, term structure, and a number of other nuances.  I want to find the best value on the options curve given the setup we are given.  You cannot set a hard rule about which call to buy when the market is bullish or which put to buy when the market is bearish.  The fundamental and technical analysis for the sector and the individual stock will help drive the kind of trade we want to make, but we have to see if the options market is mispricing the Risk/Reward profile of that trade.  If the market is not, then we have to look for a different trade.  Sometimes, the market is simply pricing things to a point where we have no good trade and need to move on and look for a new stock with a new setup, and it will sometimes be frustrating.  This is what I have done for the last 10+ years, and it takes time to understand.  But, if you work hard to learn when the market is giving you a setup you can trade, then we can work on avoiding the pitfalls that everyone makes at some point in their trading career.

Step 5: The Entry

Don’t be impatient.  If you found a setup that looks good but the market isn’t giving you your price, then don’t chase.  The whole point of doing all that setup work was to find a setup and a price that gave a good Risk/Reward profile.  If you don’t get your price, then you’re not getting that Risk/Reward profile.  You will miss out on trades.  Learn from why you weren’t able to get into the trade.  Every step of the process is a learning process.  And when everything lines up and you can enter the trade, there’s still more work to do.

Step 6: Constant Evaluation

Repeat steps 1-4 on your active positions constantly.  If something changes, then we move to step 7 – looking for the exit.

Step 7: The Exit

Once the trade is entered, we will need to constantly observe the fundamental and technical points for both the sector and the individual name.  I find that many people have an easy time putting on a trade, but struggle to take it off.  I like to ask myself the following question: if I didn’t have this trade on, would I enter it at the current market price?  If the answer is no, it’s time to exit.  Particularly with a small trading account, we cannot waste our capital on poorly leveraged trades.  We may not have achieved our initial target return for the exit, but there now may be a new trade in the same or another name that is a better setup and a better use of our capital.  Just because you have a position on does not mean you have to keep it on.  There will be hundreds if not thousands of trades that you will enter in any given year, so don’t get stuck fighting for one trade at the expense of missing the better opportunity the market is providing.



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