How to Trade Options: 12 Principles of Daily Trading Discipline

Whoever told you that trading is “easy” is probably inexperienced and lazy; or you have gained experience but are still lazy, seeking to trick an even more inexperienced and lazy person. You need more than “Believe and Achieve” mantras.

Maintaining profitable trading results requires cultivating daily trading discipline. Like any other demanding profession, online options trading from home is no different. Choose a principle to practice each month. There are 12, so you have a year to build up your skill gradually.

1. Become a Puritan price. The ONLY reason the price exists and changes is because of Supply and Demand. When there are more buyers with reasons to buy than sellers with reasons to sell, the price must rise. If there are more sellers with reasons to sell than buyers with reasons to buy, the price must fall. If buyers and sellers have the same or no reason to commit, the price does not change. Pure price trading techniques are faithful to this inescapable economic law.

2. Risk of diluted concentration. The S&P 500 represents just over 3/4 of the market capitalization in the entire mutual fund universe. The top 100 stocks in the S&P500 (with minimal changes in inclusion/exclusion) represent ~43% of what mutual funds use to build their funds, meaning the vast majority of mutual funds gravitate toward the same stocks in their holdings . Since the top 100 stocks are large-cap oriented, two-thirds of these funds are large-caps and only one-third of these funds choose to exclusively include small or mid-cap companies. Large caps tend to have weaker relative strength compared to small and mid caps. They sold him “Diversification of the sector”, printed in the marketing brochure. But it is actually intensifying exposure to weaker relative strength, given cap-weighted concentration, even if the large-caps it holds holdings in are spread across sectors.

3. Being “in” but missing the trend: the style addict. Fund managers typically stick to their style. An equity fund is not going to become a fixed income fund. The statutes of your company are predefined in the type of fund house with which they operate. A high-growth fund is still a high-growth fund, even when high-growth funds perform poorly, while small- and mid-cap funds outperform in relative terms. It’s not the fund manager’s fault, you financed the fund with your money to manage it. This also partly explains why high fund manager turnover can affect fund performance, as the fund manager wants to change styles but is limited. Diversify away from what the news tells you is “Trendy.” Replace reliance on funds with the use of optional indices/ETFs.

4. Limit the fundamentals: the game of paper poker. The psyche of the investors behind the supply and demand is expressed in the price, beyond the fundamentals. Investors sold fundamentally strong stocks, after the unfortunate incident of 9/11 and it was repeated with the financial pandemic of 2008, heading into 2009. Benjamin F. King: Market and Industry Factors; Journal of Business, January 1966: “Of the movement of a stock … 20% is peculiar to a stock.” A fundamental analyst cares about paper (balance sheet, income statement, and cash flow statement), only to explain 20% of price action. As valid as all the FA work is, would you play against the house armed with only 20% odds with the paperwork done by the analysts?

5. Divorce the underlying. You may think you are intimate (either “love” or “lust”) with the marketed product. So, look for patterns, configurations, indicators that simply don’t exist. Love is indeed blind. It is more sensible to understand the cyclical/seasonal behavior of the asset class in which the underlying is found; and how the underlying behaves near support/resistance levels with changes in supply/demand. You don’t really know the underlying. Marrying an underlying imposes opportunity costs of not negotiating with other more valid candidates. Stocks aren’t going to “love” you back.

6. Define losses first, before gains. Manage risk ABOVE and BEFORE profit AND as finite. No matter how well planned a trade is, it is possible that it will never reach its profit target. Some choose to use an absolute loss rule of 1% of the original trading capital, to define the absolute risk per trade. For example, if your trading capital is $50,000 USD, 1% equals a maximum loss of $500 USD per trade you incur; versus accepting a 50% loss on the P/L of that specific position.

7. Doubling accelerates losses. Doubling only accelerates the average cost towards losses, known as “catching a falling knife.” The break-even point will continue to move away, while chasing the price. Trade for profit. Do not trade to break even with odds stacked against you. Only add a winner, if the entry criteria and Reward/Risk Ratio repeat the settings of the original winning trade. Limit Adjustments – Ever tried to “adjust” the edge of a knife?

8. Keep the learning real and thematically consistent. Counter fixation with “magic” tricks from “technical analysis wizards” by learning from trades you’ve lived. Price signals tend to be the strongest. Add depth to your understanding of price dimensions. Set aside 1%-2% of your portfolio for ongoing self-education. With everything you learn, if you have difficulty relating it to some field or function on the trading platform, unlearn it if you cannot relate what is taught to what you can trade on the platform. You will have to drop the “L” plates from “L”-earn, to win.

9. Get rid of software crutches. The software is not a substitute for critical thinking. Break down the logic in the software (how, what and why). Black box software cultivates an addiction for repeatedly mindless subscriptions. Break the habit, rely on your logic to reason – you have profitable trades that you thought of yourself. As you “outsource” the administrative tasks associated with trading (for example, keeping records of exchanges), don’t outsource your brain.

10. Plan operations with business discipline. Most plans cover entries, exits, stops, and profit targets. Still, no one walks into a business with a few bullet points. Your trading plan must address the defining reason of “Why Trade?” What is your motivation (every day, month and quarter)? For example, create the children’s education fund, pay household expenses or self-directed retirement? How robust do you want your home business to be? It is reflected in the construction of your portfolio and trading plan.

11. Unrealistic expectations. Build wealth slowly and consistently. Forget dreaming of chasing home runs. Trading is a life endeavor. The markets will outlive all of us.

12. Scrooge: Cheap is not smart. Volatility dominates the price-yield relationship. Don’t make choices about options simply based on cost alone. Options are not priced just on bid and ask. Options work based on what you pay for them. For example, buying high(er) Deltas may not be the cheapest, but may give the required directional bias. Think back to a given amount of Theta decay, what that buys you. Just like in real life, shopping on sale can lead to more trash than you have room to store. Don’t end up with junk inventory of Calls and Puts in your portfolio. Be smart, look for value.

As you exercise tighter daily trading discipline, you should see these hallmarks of more stable portfolio performance:

• Earnings should gradually increase, depending on the size of your account. If it’s in the tens of thousands, the winnings should steadily climb like a ladder from the low hundreds to the high hundreds; then, go from the highest hundreds to the thousands. If your account is above $100K, earnings should increase from hundreds to thousands.
• Winnings that jump from the low hundreds to the thousands indicate an over-reliance on gap plays, which don’t help you consistently increase profitable results.