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December 27, 2004

Trading Plan v2.0

Here’s my trading plan for 2005 - please use the links on the sidebar (categorized into Expectancy, Money Management & Trading Psychology) for further discussion of the trading principles that I mention below.

Capital

For ease of calculations, I'll use $25,000 as available capital

Margin: 0%

Capital available for: 1 year

• The trading plan should not hinge on capital that might be withdrawn early for personal use

Instruments

Equity Options

ETF Options

Index Options

Time-frame

1-3 months for each option trade

Compounding: An average 2 month option period => the same capital can be turned over 6 times a year

Exceptions: Scenarios where a stop-loss is activated, or the profit-taking strategy requires early closure of the position

Execution

Interactive Brokers ($1 commission per option contract)

Trade entry: Limit orders

Trade exit: Limit stops to implement stop-loss & profit-taking strategies

Expectancy

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

My goal is to maintain a win/loss ratio of 50/50 or better, with average loss of 33%, thus I need an average win of 33% or higher to achieve positive expectancy.

For an average position of $1,500 this translates to an average profit greater than $500 and average loss less than $500.

Position Sizing (Risk Management)

Maximum 15 positions at any time, Maximum 6% of capital per position

• Capital of $25,000 => Maximum $1,500 invested per position

Maximum loss per trade = 2% of total capital, 33% of amount per position

• Capital of $25,000 => Maximum $500 loss per position

If I deploy the entire capital of $25,000 into 15 positions simultaneously, and end up with 100% losing trades, my worst-case loss would be $500 * 15 = $7,500. To avoid this scenario, I would allocate capital (and put limits on the maximum loss) over time, as explained below.

Loss Management:

Deploy capital as follows: $10,000 in Jan '05, and another $3,000 per month, for total of $25,000 by June

If at any time, there's a losing streak of 6 trades (maximum loss of $3000), do not open new positions

Trade Selection (Entry) Strategy

Sources of trading candidate: Option Sleuth & Roundtable posts

• Stock selection
• Unusually active option volumes
• Liquidity
• Daily average volume for equity > 500k shares
• Daily average volume for option (nearest expiration/strike price) > 25 contracts
• Open interest for specific option > 500 contracts
• Contract selection
• Option expiration 1-3 months
• Expected return > 33%

Stop-loss (Exit) Strategy

• As mentioned above, max. loss per position = $500 (33% of capital allocated to position i.e. $1,500)
• The no. of option contracts required to build a position of $1,500 will vary with the stock and the strike prices.

Note: For some option strategies (such as call/put purchases), it's important to also have a time-stop i.e. close the position if the trade is not profitable by a certain time. This will avoid losses from accelerating time decay near expiration, and also allow capital to be deployed in other (potentially more profitable) positions.

Profit-taking (Exit) Strategy

• For a position that involves only one contract:
• Close the position as soon as it meets the profit target of 50%
• For a position that involves 2 or more put contracts:
• Close one contract as soon as it meets the profit target of 33%, and simulaneously move the stop-loss target for the remaining contracts up to the 33% profit level
• Buy back second contract if profit = 50%
• Close all positions if profit hits 100%

Risk Normalization

Posted by galatime at December 27, 2004 07:29 AM

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