Option Investor
Trader's Corner

Getting More Winning Trades

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I've followed you for several years now and believe you are the best techniician as I have seen for swing trading short term times frames on options. You also have been generous enough to share your entry and exit philosophies as well. Mostly I just observe and no longer trade options directionally, having been burned badly in the past.

I'm wondering what your success ratio is for every directional short term (one to several weeks) option play you make. I'm sure you track this. What's a realistic number for a lesser expert than yourself?

You're kind or too kind in your assessment of my work. I don't try to create and keep a "track record" because:

1.) the suggestions I make in my weekly OIN columns are usually not specific enough for me to track them like a money manger could who is in control of an account. Moreover, I could suggest getting into a trade, but don't have the means (like with an ongoing intraday commentary), to indicate a suggestion to exit.

2.) I am not allowed to publish such a track record anyway by the regulations that we are governed by in the Market Advisory space.

Personally, I have done well but don't trade as actively these days. I find that I don't want to spend the days glued to my trading screen here along the California coastline. This is another reason that I like trading the bigger price swings; e.g., week over week, such as we saw in the recent 7-week decline. And, for me anyway, it tends to be the case that if I am in the market as a usual circumstance, my advice to our Subscribers gets skewed by my position; for example, if long OEX calls, tending to see the market more through a bullish lens.

I would say the following regarding a realistic assessment of what you could or "should" make in trading in terms of a success ratio: I stress all the time that the way I trade, which began when I only traded index futures, is to ONLY enter trades where I make an evaluation that my profit potential is 2-3 or more times greater than what I have to risk.

The foregoing reasons are why I mostly like to buy pullbacks to a recognizable technical support area or adopt bearish strategies after a rally to a resistance area that I can identify on the charts. These are the entry points where I can also set exiting stops at just above or below my entry. For example, at the recent S&P 100 (OEX)low made in the 545 area ...

When successful in executing trades where profit potential could be reasonably projected at 2-3 (or more) times what I have to risk, and I always set stops; I only need to be right or make a profit half of the time or LESS.

Now, what's WRONG! with this picture !!??
Well, for one thing, most traders would consider it an impossible goal to make money on one-half, or perhaps even one out of three of their trades.

The answer to this question or dilemma is to trade LESS; and, WAIT for the few opportunities that come along where a trade set up looks something like the above; in terms of, for example, aspects related to why we might find buying OEX calls at 545 to be compelling: reasons included, a 2/3rds (66%) pullback of the October to early-March decline that took place over a relatively short 7 weeks (they always 'slide' faster than they 'glide'); an oversold condition; very bearish "sentiment"; a bullish hourly price/RSI divergence..

A second part of "what's WRONG with this picture !!??" is that most of us lack the patience and DISCIPLINE to WAIT for the few high-potential trades. I'm not preaching to the "undisciplined" masses or anything. It's the recognition of how hard it is. After all, it's quite likely that one of our attractions to options trading, at least index options (and taking positional trades), is that we like the leverage involved and the ACTION too!

And, saying we should wait for "ideal" trade setups, is like saying that in the heat of battle, we should wait until we see the whites of their eyes.

For all of the psychological reasons that I've referred to, there has been a significant movement toward "systems trading" or trade entry using a set of objective guidelines. This approach attempts to raise the winning track record in trading and take out the emotional factors (fear, greed, etc.) that leads to being, as you say, being "burned" in trading.

I end this rather long discussion or answer here that is a, more or less, a direct response to your question.

NEXT, I want to discuss trading systems as a matter of possible interest, to the few who use or might take up, systems trading.


You may well know that, as a trader, you are pitted against some quick reacting fellow traders that seem to place orders in a heartbeat. Ever wonder why the order flow at market turning points is so fast? besides the fact that there are a number of sharp professional traders that do this for a living on or off the exchange floor, there is also an order flow from trading system "signals" that are generated in an instant.

Suppose you sense that market momentum MAY be starting to shift no sooner than you sense it, let alone react to it, buy or sell orders are streaming in. Ever wonder why? Well, one reason is the number of computerized trading systems that are being used.

Technical trading systems are a product of the computer age, in that computer power is what has allowed System Testing And Development which I may refer to my its acronym "STAD".

Trading systems are typically composed of a set of entry and exit conditions that are set up in specialized software. The most widely used such software is TradeStation. This company has been and is still, in the forefront of this activity and the company provides seminars on the System Trading And Development approach moreover, there are a substantial number of TradeStation user groups out there that meet and swap ideas.

When was the last time you met to share trading ideas with a like-minded group of fellow option traders? Probably never, but these groups are out there and are very dedicated to constantly improving their trading systems. There are also books on devising and using trading systems, such as by Martin Pring. TradeStation (the company) has developed some of their own resource materials; for example, basic booklets on designing trading systems, which I found to be excellent in the past.

If I mention TradeStation a lot here its because they are one that has a business model based on selling and promoting this type of trading software. No one has been able to catch up to them in this regard, as far as I know. Others may disagree.

The basics of what "systems trading" is, is the first part of this discussion. While learning how to set up trading systems takes the right software and some dedication, the basics are not all that difficult, particularly such tools as optimization. I think its something that well-informed option traders should at least know is out there as this type of trading is part of the "competition" so to speak.

A trading systems entry and exit conditions must be "back-tested" on historical market data to see how profitable its "trigger" conditions for entry and exit would have been in the past. Back-testing, in turn, allows refinement of the technical rules and is another key part of trading systems -- without computer applications to handle this, trading systems could have not have evolved as a popular means for systematic investing and trading.

Finally, use of the method going forward must be monitored to prevent a serious drawback of the systems approach that of "curve-fitting"; this is finding a set of rules that worked perfectly with the benefit of hindsight and past events but will not necessarily be effective going forward in new types of market conditions and cycles.

I will concentrate on demonstrating some basics of trading systems and not so much on the pitfalls and shortcomings of developing and using trading systems. There are strengths and weaknesses in the "systems approach", but this discussion can be left to a specialized study of trading systems, should you become interested in applying technical analysis in this manner.

I would just note that the obvious appeal and a strength of trading systems very much relates to the common investing and trading pitfalls lack of a plan and discipline in carrying out a plan that includes rigid risk management principles and the difficulties in taming negative emotions like fear, greed and even 'fantasy'; seeing market conditions in a way that reflects our bullish or bearish bias rather than objectively.

As I said, specialized computer applications are required to develop and use trading systems. The one I am familiar with is TradeStation. The TradeStation application product is also probably the best known for trading systems development in use by individuals although many institutional traders also use this or similar software.

The software that allows trading system development and testing doesnt look that different from ordinary charting applications there is a real time (or end-of-day) data feed (e.g., signal), which charts and applies chart markings (e.g., trendlines), indicators and other studies such as fibonacci retracements. The similarity stops here as there is a vast amount more involved and which makes the software a relative memory hog a fast computer is essential and substantial memory (e.g., 512 RAM) is desirable.

Trading systems can be broadly broken down into ones that use
1. technical indicators
or, ones that use
2. chart patterns
or, a combination of both methods.

The validity of each approach stems from a basic principle of technical analysis the knowledge that market cycles repeat and are identifiable. The sample systems I employ might be "applied to" tested on daily or weekly charts, but systems that employ intraday data are not any different in construction. The concept is that systems calculate a certain number of "bars" or trading periods whether this is 5, 10 or 60 minutes, a day or a week.

A popular technical indicator, of the "oscillator" type study, is the relative strength index or RSI. In the past it has been hard to identify how well the RSI worked in terms of its use as a buy or sell "signal". A rule-based trading system using the RSI is demonstrated here as written in the TradeStation programming language (i.e., EasyLanguage):

This forgoing language will likely look "greek" to you! However, its not that complex. First you define some terms or "inputs". Then you define a condition involving those inputs. Lastly, the trading rules are defined; e.g., above its the "BUY RULE" and "SELL SHORT" rule. The sell short rule in options will typically be to buy puts. It doesnt much matter the system is generating a "sell signal" and you decide how you will attempt to profit from a decline.

A common use of the RSI is to buy a market or individual item (a financial instrument) when the RSI is registering an oversold or overbought condition for example, buying below 30 and selling above 70. However, because markets can stay at overbought or oversold readings for some time, the system shown above takes a position only when the RSI crosses ABOVE 30 or BELOW 70 that is only when the RSI is retreating from an extreme. Early exit may be desirable if the RSI moves back into those extreme readings. Such a move is an alternative exit "signal" as shown in the way the system is written.

This next part of systems trading, as well as more on back-testing trading systems and a Conclusion, is "TO BE CONTINUED" in my next week's (Wed, 5/18) Trader's Corner; assuming that I don't fall into the ocean on my next fishing trip between now and then (salmon season has begun).

Good Trading Success!

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

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