Options Trading Strategy

In the following, we would like to outline one of the possible options trading strategies. This strategy obviously would influence your trading to a certain extent. In formulating this strategy, we have embodied a set of trading rules, the most important of which you will find below. This summary should give you a clearer picture in regards to:

• The types of signals you can expect from a trading system;
• The frequency with which the system might issue them;
• The maximum length of time the system may remain in a position.

We have drafted the trading rules with the following objectives in mind:

1. Firstly, to avoid wherever possible the risk of loss. Remember: if an option expires worthless - which happens frequently - losing your entire premium is a very real possibility;
2. Secondly, to reduce substantially the risk of a significant drop of an option's contract price due to the erosion of its time value (a stark reminder that options are decaying assets).

Here are three key rules you may apply to the trading signals:

1. The trading signals are always for options with expiration dates at least 3 months into the future. With 3 or more months left to expiry, the erosion of an option's time value (time decay) has not yet affected its price to a significant degree, and it still remains liquid (See examples below);
2. The trading signals always apply to in-the-money options. In-the-money options are less affected than out-of-the-money options by short-term volatility of the underlying security;
3. The trading signals are always issued for around-the money strikes in order to ensure high liquidity.
4. Finally, here is a key rule in regards the closing of a position:
   
   Whatever the status of a current signal, you always close a trade and go to cash if you have been in the position for more than 30 days. For instance, assume you initiated a trade 23 days ago. You now have a maximum of 7 days remaining until the trade must be closed.
   
   True, this is a very restrictive rule. The reason to implement it is the overriding impact the time decay factor starts to exert on an option (with expiry in 3 months) after the first 30 days. If after 30 days you are still in a losing options position, your chances of making a profit on that position become very remote. It would be much better to take an early (i.e., relatively small) loss and then look for a new, potentially more profitable trade.
   
   The only exception to this rule is - if after 30 days in a trade - you are in a winning position and the market is moving in your favor.

Now, here are two examples of how these rules may be applied to actual trading situations:

Example 1:

It is July 14 and the next options expiration day is set for July 16. The QQQ are currently trading at $35.80. According to the rules, the trading signals you could issue today are "Buy Calls with a $35 strike price and expiry in September", or "Buy Puts with a strike price of $36 and an expiration date in September". That is the most risky signal you could issue given the current market situation. Of course, you could also issue the signal "Buy Calls with a $34 strike and expiry in October". On the other hand, the rules would prevent us from issuing the signal "Buy Calls with a $36 strike and expiration in August". This would be too risky and thus contrary to the strategy.

Example 2:

Today is July 19 and the QQQ are currently trading at $35.80. The previous options expiration day was last Friday, the next expiration is set for August 20. According to the rules, the only signals you could issue today would be: (1) "Buy Calls with a strike price of $35 and an expiration date in October"; or (2) - Buy Puts with a $36 strike and expiry in October".

Options trading is a very risky business. The trading rules are put in place in recognition of this fact. The above rules serve to protect invested capital by limiting the amount of risk while still maintaining a high level of profit potential.

Here is a cardinal trading rule: never allocate all of your trading capital to options. In all of your trades, invest only a predetermined and fixed amount of your trading capital in options. This is a key strategy to help you protect your profits and limit losses. Click here to read more about it.