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our journey to demystify the complex yet rewarding world of options trading.

Step 1: Pick a Smart Trading Strategy

The difference between success, failure, and mediocrity on Wall Street is your ability to pick a smart trading or investing strategy and stick to it. Jumping into the market without first carefully defining your strategy is akin to driving a car with a blindfold on—and, likewise, you will crash at some point. Just as critical is remaining faithful to your strategy during drawdowns—because you will reap the benefits of constancy in the long run.


How to Pick a Smart Trading Strategy

I use a 3-step process: brainstorm, backtest, analyze. The objective of the brainstorming step is to identify big-picture concepts to backtest such as these:

  • Over a 45-day period what was the maximum up or down movement of the S&P 500 over the last 12 years?
  • During the last 10 years what was the typical stock move the day after Home Depot’s earnings report?
  • What are the most actively traded stock options by year for the last 10 years?
  • Does a spike in the put/call ratio for the SPY have any predicating ability for its future movement?

If I am stuck for ideas I might surf seekingalpha.com, stocktwits.com, or twitter.com.

Once I have a diverse list of 10 or so questions I start backtesting. Typically I do some sampling in Excel and then use a backtesting tool such as Quantopian or write my own software scripts. Brokers typically offer tools as well.

Through analysis of the big-picture backtesting results I narrow my list to a few concepts worth digging into further to more precisely define my trading strategy. For example, I might find out that over a 45-day period the S&P 500 dropped more than 5% only 3% of the time. Those odds are good—so maybe my strategy would be to sell put options 5% out of the money expiring in 45 days.

I then backtest my refined strategy and analyze those results in terms of probability of success (wins vs. losses), total risk per trade, estimated return on capital, and difficulty to execute (i.e., Do I need to be glued to my computer all day?).

Implementing Your Strategy

After you have settled on a trading strategy compatible with your financial goals, risk tolerance, and skills it’s time to roll—virtually, at least. Typically I suggest paper trading for a while, less to see if your strategy works than to practice executing trades and managing your emotions. Trust me—it’s an important, time-honored step toward getting your head in the game.

When you’re ready to commit hard, cold capital I suggest starting with a small account, typically $2,000. If you can demonstrate success in different market conditions with a small account, your odds of success with a larger account are good. At this point you should step back and let your strategy do its thing. Monitor performance but refrain from adjusting your strategy too often—backtesting is your proof that your trading strategy works.

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