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.

Keeping risk in mind, I have divide my holdings into three levels: No risk, low risk, mid-risk, and high risk. See the About page for more.

Only the mid-risk and high-risk positions have formal rules, and that’s what I shall discuss here.

High Risk: Options Contracts

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.


Trading Rules

Positions: Short vertical or iron condor spread.

Short leg entry goal: delta 16 to 24, adjusted for greater risk (the high deltas) balanced against greater reward (the lower deltas).

Implied Volatility Rank (IVR) 25% or greater. (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 diligence before entry:

  • Avoid earnings announcements
  • Avoid ex-dividend days

Exit rules:

  • Normal exit rules apply up to 21 days prior to expiration.
    • Exit
      • at 50% of maximum potential profit, calculated as this way:
        • (credit_received – current_debit) / credit_received
        • where credit received is maximum potential profit and current debit is the cost of exiting the position. If it’s negative, the position is a losing one at present.
      • 21 days prior to the options’ expiration
        • if the position is profitable, even if minimally so
      • if the share price is outside of the range of profitability, defined by the breakeven prices, by one day or more using the 14-day average Rate of Change (ROC) and calculated as follows:
        • Days_from _profitability = Distance_from_breakeven / ROC
  • The sudden-death exit rules apply fewer than 21 days until expiration.
    • Exit
      • if the price moves beyond the range of profitability by any amount.
      • if the position becomes profitable by any amount
      • in all circumstances on the Monday prior to expiration (i.e., all positions are closed by five days prior to expiration).

It is important to remember that a position can be within the range of profitability and yet still not be profitable. The range defines profit upon expiration. A number of movable metrics are involved, including the implied volatility and normal time decay in the options.


The upside of this rule set is that there is consistently an 80% to 85% or so chance of the position being profitable, with clear rules for management in those 15% to 20% of cases where the positions moves outside of the zone of profit.

The downside of the rule set is that the credit upon entry is relatively low compared to other strategies, and therefore the risk/reward ratio tends to be higher. The brokerage sequesters more of your funds to support each trade. It’s a common decision traders must make.

In earlier strategies, I would insist on a risk/reward ratio no higher than 3:1. That guideline has been tossed out. I’ll accept the higher risk, limiting it by the percentage of trading funds that I want to commit to a single position.

The positions are actively managed, so in practice, it would take a catastrophic move for a position to reach the maximum potential loss.

 

Mid-Risk: Managed Shares

Robinhood came to the rescue. Robinhood Markets Inc. is a brokerage founded in 2013 with the goal of easy trading online without trading fees. I underlined the no trading fees part because that change overturns the long-standing preference most private traders have to holding stocks for the long term. In traditional brokerages, each trade into a position produces fees, and each trade out produces fees. Stocks generally aren’t leveraged, and trade in and out enough, the trader will find his exits have been eroded away.

Robinhood, by eliminating trading fees, liberates the trader from the buy-and-hold  restriction, making it possible to follow trading signals closely, even if it turns out to be a buy signal on Wednesday and a sell signal on Thursday. It puts an end to the two ancient laments, “Well, if I had bought Amazon back in the day, I’d be a millionaire today,” and “I know the markets down 10%, but if I just hold on long enough, it’s sure to come back.”

Adherence to trading signals in Robinhood’s first advantage.

By allowing quick trading without a financial penalty, Robinhood also allows for diversification over a period of time rather than static diversification. Exchange traded funds provide diversity in a holding, but under a buy-and-hold scenario the diversification is limited to the holdings of that fund. If I hold fund A for a week (during a buy signal), and then switch it for fund B for three weeks (during a buy signal), and so forth with funds C, D, E and F, then I’ve achieved a higher degree of diversification than a single fund will allow.

Diversification over time is Robinhood’s second advantage.

By allowing quick trading without a financial penalty, Robinhood also allows for diversification over a period of time rather than static diversification. Exchange traded funds provide diversity in a holding, but under a buy-and-hold scenario the diversification is limited to the holdings of that fund. If I hold fund A for a week (during a buy signal), and then switch it for fund B for three weeks (during a buy signal), and so forth with funds C, D, E and F, then I’ve achieved a higher degree of diversification than a single fund will allow.

Diversification over time is Robinhood’s second advantage.

And so I came up with a plan, and trading rules, for managing stocks by closely adhering to trading signals on exchange-traded funds, providing diversification both statically and over time.

Here, the, are my trading rules for a self-managed alternative to the robo advisors.


Stock Trading Rules: Mid-Risk

Introduction

The goal of this rule set is to create a highly diversified mid-risk portfolio of exchange-traded funds, managed daily  according to crossovers in the Directional Movement Indicator (DMI) technical analysis tool that signals trend changes. A buy signal is generated when the DMI+ (uptrending) crosses above the DMI- (downtrending). A sell signal is when the DMI- crosses below the DMI+.  Investopedia gives an explanation of the DMI system, here.

This sort of strategy is possible solely because of the emergence of no-free brokerages. I use Robinhood — Robinhood Markets Inc. — a brokerage founded in 2013 with the goal of easy trading online without trading fees. I underlined the no trading fees part because that change overturns the long-standing preference most private traders have to holding stocks for the long term. In traditional brokerages, each trade into a position produces fees, and each trade out produces fees. Stocks generally aren’t leveraged, and trade in and out enough, the trader will find his exits have been eroded away.

Robinhood, by eliminating trading fees, liberates the trader from the buy-and-hold  restriction, making it possible to follow trading signals closely, even if it turns out to be a buy signal on Wednesday and a sell signal on Thursday. It puts an end to the two ancient laments, “Well, if I had bought Amazon back in the day, I’d be a millionaire today,” and “I know the markets down 10%, but if I just hold on long enough, it’s sure to come back.”

Adherence to trading signals in Robinhood’s first advantage.

By allowing quick trading without a financial penalty, Robinhood also allows for diversification over a period of time rather than static diversification. Exchange traded funds provide diversity in a holding, but under a buy-and-hold scenario the diversification is limited to the holdings of that fund. If I hold fund A for a week (during a buy signal), and then switch it for fund B for three weeks (during a buy signal), and so forth with funds C, D, E and F, then I’ve achieved a higher degree of diversification than a single fund will allow.

Diversification over time is Robinhood’s second advantage.

Method

My holdings consist of a portfolio of five exchange-traded funds picked from a pool of funds. For signaling, I use the DMI applied to a daily chart.

I use a large pool of more than 90 exchange traded funds, including U.S. general index funds, sector funds, international global and country-specific funds, and a few futures-oriented funds in metals and agriculture.

When I have exited a position, I select a replacement that meets the following criteria.

  1. The DMI is showing a buy signal.
  2. The most recent date that the signal for each symbol switched from sell to buy is preferred over earlier signal dates. If the number of symbols on the most recent signal date is insufficient fill out the portfolio, use the next most recent date. For any selection date where there’s a choice of symbols to use, make each selection using a random number.
  3. Each fund in the portfolio, wherever possible, represents a unique sector compared to the others.

More briefly, the selection criteria for my five positions:

1) Buy signal. 2) Newest trend. 3) Unique sector.

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.

License
Creative Commons License

All content on Tim Bovee, Private Trader by Timothy K. Bovee is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.

Based on a work at www.timbovee.com.