Successful traders learn to follow a set of rules consistently. These set of rules are called a trading system. When using stock options, it is very important to use a stock option trading system.
I've backtesting several stock option trading systems and have learned to avoid commonly taught systems that result in a net loss over time. A new stock option trading system I am still backtesting involves high flying stocks Google, CME, or RTP.
The leverage of stock options can cut both ways. You can lose faster as well as win faster with stock options. Therefore, you want to get past the point of trading because of emotions or addiction and trade by your rules. Of course, your stock option trading system needs to be backtested with lots of samples to ensure you have positive expectancy.
Positive expectancy means that when you trade many times over the long run, you will have a net profit. You will be surprised that some stock option trading systems being taught or sold may have a NEGATIVE expectancy in the long run. That is, you will be trading at a net loss. They may have worked in a strong trending market a few years ago but they do not work in our current 2005-2006 slightly trending stock market.
That's why I am focusing on stocks that are expensive and that have a high intra-day range - or average true range. Google, CME, and RTP are in the $200 to $500 range. In fact, there are not many other stocks over $200 that have options besides those three. Normally, options two strikes out of the money are relatively expensive for these stocks - except during the expiration week.
Let's look at a stock option trading system I'm still backtesting:
- On the Monday before option expiration, buy three strangles on Google, CME, or RTP that are 2 strikes out of the money for that expiration. For example, on Monday, May 15th, with expiration Friday on May 19th, Google is at 400. Buy the 420 call and the 380 put. If it is not earnings month, the strangle should cost around $300 to $350.
- You'll have to watch the price quote most of the day for Tuesday, Wednesday, Thursday, and even Friday.
- Try to estimate based on chart patterns whether a certain time is close to the high or low for the day. Better than that, if the price of the total strangle is profitable by $100 or more per strangle, sell one. The normal intra-day range for these three stocks swings enough to cause some profit.
- Repeat step 3 on Wednesday and Thursday. Many times a year, there is a news event that can cause a $10 to $30 move on a single day. These are the home runs you are looking for that will more than cancel the strike outs of the relatively inactive days.
This stock option trading system has precise definitions for entry and relatively precise definitions for exit. Trade like a robot one week a month. I've traded this system a few times and have gained more than 50% twice and lost 50% once. In future articles I will present the detailed backtesting results of this system.
Steve Burke
