Creating An Option Trading Strategy

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Create Your Own Trading Strategies

There are many excellent trading strategies out there, and purchasing books or courses can save you time finding one that works, but trading can also be a “do it yourself” career. Many traders spend hundreds or even thousands of dollars looking for a great trading strategy, but building your own can be fun, easy, and surprisingly quick.

To create a strategy, you’ll need access to charts that reflect the time frame to be traded, an inquisitive and objective mind, and a pad of paper to jot down your ideas. Then you formalize these ideas into a strategy and “visually backtest” them on other charts. In this article, we go over the process from start to finish and offer important questions to ask along the way. Once you’re done, you’ll be ready to start creating your strategies in any market and on any time frame.

Time and Place?

Before a strategy can be created, you need to narrow the chart options. Are you a day trader, swing trader, or investor? Will you trade on a one-minute time frame or a monthly time frame? Be sure to choose a time frame that suits your needs.

Then you’ll want to focus on what market you’ll trade: stocks, options, futures, forex, or commodities? Once you’ve chosen a time frame and market, decide what type of trading you’d like to do. As an example, let’s say you choose to look for stocks on a one-minute time frame for day-trading purposes and want to focus on stocks that move within a range. You can run a stock screener for stocks that are currently trading within a range and meet other requirements such as minimum volume and pricing criteria.

Stocks, of course, move over time, so run new screens when needed to find stocks that match your criteria for trading once former stocks are no longer trading in a way that aligns with your strategy.

Creating and Testing Strategies

Creating a strategy that works makes it much easier to stick to your trading plan because the strategy is your work (as opposed to someone else’s). For example, suppose that a day trader decides to look at stocks on a five-minute time frame. She has a stock selected from the list of stocks produced by the stock screen she ran for certain criteria. On this five-minute chart, she’ll look for money-making opportunities.

The trader will look at rises and falls in price to see if anything precipitated those movements. Indicators such as time of day, candlestick patterns, chart patterns, mini-cycles, volume, and other patterns are all evaluated. Once a potential strategy is found, it pays to go back and see if the same thing occurred for other movements on the chart. Could a profit have been made over the last day, week, or month using this method? If you are trading on a five-minute time frame, continue to only look at five-minute time frames, but look back in time and at other stocks that have similar criteria to see if it would have worked there as well.

After you determine a set of rules that would have allowed you to enter the market to make a profit, look to those same examples and see what your risk would have been. Determine what your stops will need to be on future trades to capture profit without being stopped out. Analyze price movement after entry and see where on your charts, a stop should be placed. When you analyze the movements, look for profitable exit points. Where was the ideal exit point, and what indicator or method could be used to capture most of this movement?

When looking at exits, use indicators, candlestick patterns, chart patterns, percentage retracements, trailing stops, Fibonacci levels, or other tactics to help capture profits from the opportunities you see.

Depending on how often you want to look for strategies, you can look for tactics that work over concise periods of time. Often, short-term anomalies occur that allow you to extract consistent profits. These strategies may not last longer than several days, but they can also likely be used again in the future.

Keep track of all the strategies you use in a journal and incorporate them into a trading plan. When conditions turn unfavorable for a certain strategy, you can avoid it. When conditions favor a strategy, you can capitalize on it in the market.

Additional Things to Consider

Using historical data and finding a strategy that works will not guarantee profits in any market. It is for this reason that many traders do not backtest their strategies, applying the strategy on historical data. Instead, they tend to make spontaneous trades. This is a lack of due diligence. It’s important to know a strategy’s success rate because if a strategy never worked, it is unlikely to start working today suddenly. That’s why visual backtesting – scanning over charts and applying new methods to the data you have on your selected time frame – is crucial.

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Many strategies don’t last forever. They fall in and out of profitability, and that’s why one should take full advantage of the ones that still work. If something has worked for the past few months or over the course of the past several decades, it will probably work tomorrow. But if you never looked to the past to test that strategy, you might not even realize it was there, or you might lack the confidence to apply it in the markets tomorrow to make money. Knowing that something has worked in the past will thus also give a psychological boost to your trading.

Trading needs to be done with confidence (not arrogance), and being able to pull the trigger on a position when there is a set-up to make money will require the confidence that comes from looking to the past and knowing that, more often than not, this strategy worked.

Keep in mind you do not need to look for strategies that work 100% of the time. In fact, if you do, you’ll likely find no workable strategies. Look for strategies that net a profit at the end of the day, week, or year(s), depending on your time frame.

The Bottom Line

Strategies fall in and out of favor over different time frames; occasionally, changes will need to be made to accommodate the current market and our personal situation. Create your own strategy or use someone else’s and test it on a time frame that suits your preference. By looking back, you can give yourself some great starting points to make more money and avoid losses as you become more experienced. Track all strategies that you use so that you can use these strategies again when conditions favor it.

10 Steps To Creating Your First Trading Strategy

By Galen Woods in Trading Articles on December 20, 2020

Most new traders start by learning the trading strategies of other traders. I began my trading career this way as well. But, many traders ask, how do I get started with my trading strategy?

The good news: Creating your first trading strategy is easy.

The bad news: Creating a profitable trading strategy is hard.

Start with the right expectations. Forming a trading strategy is easy. Learn a few trading tools and indicators, and you can do it.

However, it’s not realistic to think that your first trading strategy will make you rich.

Finding an objective trading edge is tough. On top of that, you’ll realise that trading profitably goes beyond your trading strategy.

Then why should you still form your trading strategy? Why not just use the trading strategy of a successful trader?

Traders might share their tools and approaches. But no trader can or will guarantee your profits. Every trader is different. Hence, you can only benefit from a unique and personal blend of trading tools.

The best and most sustainable approach is to develop your trading strategy.

Follow these 10 steps to forming your first trading strategy:

Step 1: Form Your Market Ideology

Before you jump into creating your own trading strategy, you must develop an idea of how the market works. Most importantly, you need to answer this question.

Why do you think you can make money from the markets?

Form your market ideology by reading widely. Read about both technical and fundamental analysis.

Avoid get-rich-quick claims.

Doubt theories that claim that people are perfectly rational.

Your ideology will define every step that follows. Give it the attention it deserves.

Regardless, I urge you to follow one principle in your first trading strategy.

Keep it as simple as possible.

You don’t want to be overwhelmed by a complex strategy right from the start. Moreover, a trading strategy with more moving parts is harder to manage and improve.

Step 2: Choose a Market For Your Trading Strategy

Forex? Equities? Options? Futures?

If you choose to trade forex, understand what you are buying and selling with a currency quote. Make sure you learn about the different models of forex brokers. Know how the margin is calculated.

Or if you choose to trade equities, you must know what a share means. You must know the difference between a blue-chip and a penny stock.

The point is there’s a lot to learn about each market. But you cannot start to learn in-depth until you choose your trading market.

Although I recommend futures trading for intraday traders, the choice is yours. The only rule is that you must understand the market you choose to trade.

Step 3: Choose A Trading Time Frame

Before you gain any trading experience, it’s hard to decide on a trading time frame. You will not know if you are more suited to quick scalping or daily swing trading.

Hence, you can start by considering your circumstances. If you have time to watch the market for extended periods, try intraday trading.

When you trade fast time frames, you get fast feedback to shorten your learning time. Even if you end up with longer timeframes, what you learn from intraday price action will still be useful.

Of course, if you are not able to watch the market for extended periods, start with end-of-day charts. With sustained effort, you can learn enough to decide if swing trading is for you.

Step 4: Choose A Tool To Determine The Trend (Or Lack Of)

You don’t trade when you see a Pin Bar. You trade when the market is rising, and you use a bullish Pin Bar to trigger your trade.

You don’t trade when you see a Gimmee Bar. You trade when you judge that the market is going sideways, and you use a Gimmee Bar to enter the market.

Decide on a tool to help you judge the market context. (i.e. trending or not, up or down)

You can choose price action tools like swing pivots and trend lines. You can also use technical indicators like moving averages and MACD.

Step 5: Define Your Entry Trigger

Even with the right market context, you need an objective entry trigger. It will help you enter the market without hesitation.

Both bar and candlestick patterns are useful triggers. If you prefer indicators, oscillators like the RSI and stochastics are good options too.

Step 6: Plan Your Exit Trigger

You need to plan how to exit when things go wrong. The market can go against you, causing you losses beyond your imagination. Having a stop-loss is critical.

You also need to plan how to exit when things go your way. The market will not go your way forever. Hence, you need to know when to take profits.

Step 7: Define Your Risk

Once you have your entry and exit rules sorted out, you can work on limiting risk.

The primary way to do so is by position sizing. For a given trading setup, your position size determines how much money you are putting on the line.

Double your position size, and you will double your risk. Watch your position size carefully.

Step 8: Write Down Your Trading Rules

At this stage, your trading strategy is simple. You might be able to memorise the trading rules. However, you must still write down your trading rules.

Having a written trading plan is a robust method to ensure discipline and consistency.

It also provides a record of your trading strategy. You will find it useful when you are trying to refine it.

Step 9: Backtest Your Trading Strategy

With your written rules, you can now backtest the strategy.

If you have a discretionary trading strategy, backtesting can be an arduous process. You need to replay the market price action and record your trades manually.

If you have a mechanical trading strategy and a coding background, you can speed up this stage.

Nonetheless, looking through the trades one by one is a great way to develop your market instinct. Doing so can also help you think of ways to improve your trading strategy.

Step 10: Plan How To Improve Your Trading Strategy

Your first trading strategy will not be profitable. But it’s okay. Your trading strategy is a living object. It is not static.

With your growing experience and knowledge, your trading strategy will improve.

But let’s not leave this to chance. Plan how you will obtain feedback and improve your trading strategy.

Forward test your trading strategy. Plan to take good notes of your market observations. Record your trades and keep your chart images in good order.

Avoid drastic changes to your trading strategy.

For this final step (which might take forever), remember that your aim is to achieve positive expectancy with every trade. Not positive profits for each trade.

Let statistics work for you. Don’t force your will on the market.

Conclusion

Follow the 10 steps above, and you will find yourself with a basic trading strategy.

This strategy is not the Holy Grail. But it is formed with your experience and according to your trading style.

Keep working on it, and you will stand a chance to succeed.

Creating Option Combinations

Buying and selling calls and puts together gives you the ability to create powerful trading positions.

Option strategies put you in control of defining specific price points to target. Go ahead and browse through a few examples of what’s possible when using options to trade.

Bullish Strategies

Bearish Strategies

Market Neutral Strategies

Option Strategies

Generally, an Option Strategy involves the simultaneous purchase and/or sale of different option contracts, also known as an Option Combination. I say generally because there are such a wide variety of option strategies that use multiple legs as their structure, however, even a one legged Long Call Option can be viewed as an option strategy.

Under the Options101 link, you may have noticed that the option examples provided have only looked at taking one option trade at a time. That is, if a trader thought that Coca Cola’s share price was going to increase over the next month a simple way to profit from this move while limiting his/her risk is to buy a call option. Of course, s/he could also sell a put option.

But what if s/he bought a call and a put option at the same strike price in the same expiry month? How could a trader profit from such a scenario? Let’s take a look at this option combination;

In this example, imagine you bought (long) 1 $40 July call option and also bought 1 $40 July put option. With the underlying trading at $40, the call costs you $1.14 and the put costs $1.14 also.

Now, when you’re the option buyer (or going long) you can’t lose more than your initial investment. So, you’ve outlaid a total of $228, which is you’re maximum loss if all else goes wrong.

But what happens if the market rallies? The put option becomes less valuable as the market trades higher because you bought an option that gives you the right to sell the asset – meaning for a long put you want the market to go down. You can look of a long put diagram here.

However, the call option becomes infinitely valuable as the market trades higher. So, after you break away from your break even point your position has unlimited profit potential.

The same situation occurs if the market sells off. The call becomes worthless as trades below $37.72 (strike of $40 minus what you paid for it – $2.28), however, the put option becomes increasingly profitable.

If the market trades down 10%, and at expiry, closes at $36, then your option position is worth $1.72 ($172). You lose the total value of the call, which was priced at $1.14 and cost $114, however, the put option has expired in the money and is worth $4.00 an option – or $400. Subtract from this the total amount paid for the position, $228 and now the position is worth $172. This means that you will exercise your right and take possession of the underlying asset at the strike price.

This means that you will effectively be short the underlying shares at $40. With the current price in the market trading at $36, you can buy back the shares and make an instant $4.00 per share for a total net profit of $286 per share on the put leg. Then subtract the other $114 for the call leg and your total net profit is $172.

That might not sound like much, but consider what your return on investment is. You outlaid a total $228 and made $172 in a one month period. That’s a 75% return in a one month period with a known maximum risk and unlimited profit potential.

This is just one example of an option combination. There are many different ways that you can combine option contracts together, and also with the underlying asset, to customize your risk/reward profile.

You’ve probably realized by now that buying and selling options requires more than just a view on the market direction of the underlying asset. You also need to understand and make a decision on what you think will happen to the underlying asset’s volatility. Or more importantly, what will happen to the implied volatility of the options themselves.

If the market price of an option contract implies that it is 50% more expensive than the historical prices for the same characteristics, then you may decide against buying into this option and hence make a move to sell it instead.

But how can you tell if an options implied volatility is historically high?

Well, the only tool that I know of that does this well is the Volcone Analyzer. It analyzes any option contract and compares it against the historical averages, while providing a graphical representation of the price movements through time – know as the Volatility Cone. A great tool to use for price comparisons.

Anyway, for further ideas on option combinations, take a look at the navigation in the side bar and see what strategy is right for you.

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