Trading Rules

Levels of Risk

Risk is everywhere. There is, in reality, nowhere without risk. Every thought can trigger risk. Every act can be risky. Every result, happy or sad, is a balance between risk and reward.

For any trade, low risk to high risk, there are two rules that rule them all:

  1. Have a defined rule for entering a position.
  2. Have a defined rule for exiting a position.

I’ve traded outside of those universal rules on occasion, and have always regretted it.

High Risk: Options Contracts

Most of my options trading rules are straight out of research conducted by Tom Sosnoff‘s Tastytrade financial network, with the exception of the exits rules, where I’ve expanded on his methods. The rules are intended for smaller accounts, and has the goal of many base hits rather than the occasional home run amid a lot of strikeouts. The Long Options rules are entirely my own.

Trading Rules

Short Vertical or Iron Condor Spreads.

  • Set the short leg or legs somewhere where needed to get sufficient return; from delta 16 to 30 is optimal. The higher the delta, the greater the risk and the smaller the odds of success.
  • Select an underlying stock; the higher the Implied Volatility Rank, the greater the potential return. (This is similar to the IV Percentile found on many trading platforms.)
  • Set the width of the wings so as to be as close as possible to a third of the credit received.

Entry timing: As close as possible to 45 days prior to expiration, giving preference to monthly options. Generally, I won’t enter after 43 days prior to expiration.

Due diligence before entry:

  • Avoid ex-dividend days
  • Ensure that the potential loss is within the trader’s guidelines for managing trading funds.

Exit rules:

  • Up to 21 days prior to the options expiration
    • Exit at 50% of maximum potential profit (25% for earnings plays).
    • Exit at 50% of maximum potential loss.
  • 21 days prior to the options’ expiration
    • Exit if profitable.
    • Hold the position if unprofitable.
  •  Fewer than 21 days prior to the options’s expiration
    • Exit if the position returns to profitability or at expiration.

By Tim Bovee, December 21, 2021, Portland, Oregon

Earnings Plays

  • Enter a position on the final trading day before the earnings announcement.
  • Select highly liquid stocks with options having an implied volatility rank of 30% or higher.
  • Select liquid monthly options expiring within two week before or after the 45th day prior to expiration.
  • If the stock has a directional bias, pick a direction for the expected move. There are many ways to do this. I use Elliott wave analysis, and sometimes check out the Zacks Rank and Expected Surprise Prediction percentage.
  • Directional strategies: For lower risk (and lower returns), short bull put spreads if a rise is expected, short bear call spreads if a fall is expected. For higher risk (and higher returns), short puts if a rise is expected, short calls if a fall is expected.
  • If the stock has no clear directional bias, use a non-directional strategy: For lower risk, iron condors. For higher risk, strangles.
  • The short strikes for each strategy should be far enough out of the money to enclose the expected move. Otherwise, follow the guidelines set in the “Short Vertical or Iron Condor Spreads” section, above.
    • The expected move is calculated by taking the value of three positions and weighting them according to their distance from the at-the-money (ATM) mark.

      1. Using the options closest to expiration…
      2. take the price of an ATM short straddle and multiply it by 60% (0.6)…
      3. take the price of strangle one strike price away from ATM, and multiply it by 30% (0.3)…
      4. and take the price of a strange two strikes away from ATM, and multiply it by 10% (0.1).
      5. The expected move is the average of the weighted prices — add them together and divide by 3.
      6. Note that the expected move doesn’t anticipate the direction of the move — could be up, could be down.
      7. Trades are best placed at a time as close to the earnings announcement as is feasible.
  • If the position is profitable, exit at 25% of maximum potential profit or on the 21st day prior to expiration for any amount of profit.
  • If the position is unprofitable 21 days prior to expiration, continue to hold the position until it become profitable to any degree or until expiration.

By Tim Bovee, December 21, 2021, Portland, Oregon

Long Options

  • Upon receipt of a buy signal, a long call or long put position should be entered no fewer than 70 days prior to the position’s last day of trading.
    • The closer to the last day of trading an option is, the cheaper the option’s price will be.
  • The option traded should be at the money or slightly out of the money at entry, with a Delta close to 50% being the preferred positioning.
  • The option must be sold upon receipt of an exit signal.
  • A position must be managed no less than 63 days prior to the contract’s last day of trading.
    • Management consists of exiting the trade, whether it produces a profit or a loss.
    • If the stock is expected to continue to moving in a profitable direction for the option, then the position can be reestablished with a later expiration date.

See my essay “Trading Rules: Long Options” for an explanation of my thinking behind this ruleset.

By Tim Bovee, October 3, 2021, Portland, Oregon

Short Naked Puts and Calls

  • Set the strike price somewhere from delta 16 to 30. The higher the delta, the greater the risk and the smaller the odds of success.
  • Select an underlying stock whose Implied Volatility Rank (IVR) is 25% or greater. The higher the IVR, the greater the potential return. (This is similar to the IV Percentile found on many trading platforms.

Entry timing: As close as possible to 45 days prior to expiration, giving preference to monthly options. Generally, I won’t enter after 43 days prior to expiration.

Due dilligence before entry:

  • Avoid earnings announcements
  • Avoid ex-dividend days
  • Ensure that the potential loss is within the trader’s guidelines for managing trading funds.

Exit rules:

  • Up to 21 days prior to the options expiration
    • Exit at 50% of maximum potential profit.
    • Exit at 50% of maximum potential loss.
  • If one these conditions occurs — a loss that is twice the credit received, a move beyond the short strike price, or 21 days prior to the options’ expiration — consider taking one of the following actions:
    • If profitable, exit the position
    • If unprofitable, do one of the following,
      • Exit the position.
      • Roll the position to the same strike price a month later, if doing so produces a net credit after the loss on the current condition is subtracted.
      • Buy options that will offset the short options, converting the position into a defined risk trade.

By Tim Bovee, August 6, 2021, Portland, Oregon

Diagonal Spreads

Unlike the short vertical spreads that have long been the bread-and-butter of my trading, diagonal spreads work well regardless of the implied volatility rank. They’re a good alternative to short vertical spreads in periods when IVR is low across the market.

A long diagonal spread is built from a short option closer in time and a long option with a different strike further out in time. If the options are calls, then the position is bullish. If puts, then bearish.

Here are the rules:

  • Buy a long option
    • 90 to 120 days before expiration
    • Delta around 80
  • Sell a short option
    • 30 to 60 days before expiration, with 45 days being optimal
    • Delta 30 to 50
    • Ensure that the premium of the short option is  equal to or greater than the extrinsic value of the long option. This becomes easier to obtain the deeper in the money the long options is placed.
  • Ensure that the net debit is around 50% of the spread and that it never exceeds 75% of the width.
  • Exit for a win if the stock price moves significantly in the direction of the trade,  rises (for calls) or falls (for puts).
  • Roll the short option to a lower strike (for calls) or higher strike (for puts) if the share price moves significantly against the direction of the trade. (“Significantly” is undefined; I look at the potential loss, the trend on the chart, and then follow my intuition.)

Although maximum profit cannot be determined precisely, it can be estimated by subtracting the net debit paid from the width of the strikes. 

The breakeven point can be calculated by subtracting the net debit paid from the long strike price.

By Tim Bovee, August 8, 2021, Portland, Oregon

Lower Risk: Shares

I no longer follow formal rules in trading shares. Basically, I use the same Elliott wave analysis techniques that I use on the S&P 500 in my daily analyses and try to follow the trends.

Shares are considered to be lower risk than options because they can be traded without leverage and are generally have lower volatility.

On the other other hand, options positions can be positioned in a way that limits the possible loss if the price moves against the trader. Shares can drop to zero. I’ve had it happen.

The one tool that shares offer to mitigate that risk is the stop-loss; setting a price at which shares will be sold if the market price reaches that level.

I use a trailing-stop loss. For long shares, if I set a, say, 3% stop-loss, and the price of the shares rises, then the stop-loss will also rise, reamining 3% below the peak price.

I will use 3% occasionally as a very short-term insurance to limit loss, but my normal practice is to give shares room to maneuver. For that purpose, I use a 20% trailing stop. I’ve based based choice on three research papers:

Han, Yufeng and Zhou, Guofu and Zhu, Yingzi, Taming Momentum Crashes: A Simple Stop-Loss Strategy (September 24, 2016). Available at SSRN: https://ssrn.com/abstract=2407199 or http://dx.doi.org/10.2139/ssrn.2407199

Yusupov, Garib and Shorrason, Bergsveinn, Performance of Stop-Loss Rules vs. Buy-and-Hold Strategy (2009). Available at Lund University: https://www.lunduniversity.lu.se/lup/publication/1474565

Kaminski, Kathryn and Lo, Andrew W., When Do Stop-Loss Rules Stop Losses? (January 3, 2007). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=968338 or http://dx.doi.org/10.2139/ssrn.968338

By Tim Bovee, August 22, 2021, Portland, Oregon

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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