The 4 Step Approach
I want to share with you how I generate trading ideas, and how I then take these ideas and turn them into a trading strategy.
When developing a new trading strategy, I use a 4 step approach to this method.
How I Get Started Finding Trading Ideas
First I try to identify a potential trade. Once I locate a potential trade, I usually determine whether or not the trade is even possible.
Second, I determine that the trade setup actually will work, I have to test the idea. We’re going to discuss exactly how to do that in this article.
Then it’s on to step number three, where I spend some time developing the rules of the trade. I like to develop very clear-cut rules. Developing clear-cut rules ensures that this idea matures into a strategy. Doing this will help me know what to do and when to do it.
Step number 4, I develop the tools I need to manage the trade. As a trader, having the right tools at your disposal will make trading easier.
If you’re not aware, I have developed several tools to help me with this process. For example, when selling put options, I use my Put Options Calculator. When I use the PowerX Strategy I have the PowerX Optimizer. Using tools like these enable myself to be a more profitable trader. These tools remove the guesswork from trading.
Once I have the 4 steps defined and in place, I like to start trading the idea with a small position. I will start with a few shares only.
A New Trading Idea to Test
Let’s talk about the trading idea that I have.
As you may know, I have been doing very well at selling put options. In the last 5 weeks, I was able to grow a small account of $25,000 account by 43%, into $36,000! I had 16 or 17 winning trades in a row.
I started with the Idea of selling options.
In case you’re not familiar with the concept of selling options, there’s a few things to understand. Selling options requires the underlying stock to have decent price movement, or volatility.
The volatility needs to be high… But why?
When volatility is high, the cost of the option premium increases. This means it costs more for traders to buy these options. So higher option premiums allow us to sell this premium for a higher amount.
As of writing this article, we are still in crazy market conditions. The VIX, or volatility index has been high for sometime but is showing signs of coming down.
Knowing that we need high volatility to sell options got my thinking about where we can find this in the market…
This is where I had the thought that volatility is usually high for stocks around earnings, right? As you know, when a stock is ready to announce earnings there’s uncertainty. This uncertainty always leads to higher volatility.
So I thought, “Ah,that might actually be a good idea!”
Remembering my recent luck with selling puts, I recognized the perfect opportunity. Selling call and puts around earnings to take advantage of the implied volatility.
Some of my readers have been asking if they should sell calls
I thought, yeah, you know what? We could do this.
Selling calls and put on the same stock is called a “Strangle”.
So the idea here is that I’m trading strangles around earnings. Why?
Let’s discuss this trading idea, so that you have a little bit of a background
The concept is that before a company announces earnings, uncertainty is high. And because uncertainty is high, volatility is high. Right after earnings, we should see a crash in volatility. After the earnings report, there is no more uncertainty, meaning no more volatility.
Sometimes there is a larger reaction to the earnings report, but most of the time there is not. It’s very surprising because often there’s no major reaction after earnings.
This is something we want to take advantage of.
This is the point where I thought to myself, “who is actually buying options right before earnings?”
Well, the answer to that question? Institutional Traders who want to hedge against negative earning reports
So How Do We Test This Idea?
So how do we test this idea? Because again, step number one is having an idea. And step number 2 is now start testing.
So what I’m going to discuss is my current trading account. This week there were three companies that reported earnings, Starbucks, UPS and Caterpillar. Typically when testing, I’m going with the smallest contract size possible.
Back-testing option strategies can be difficult on most platforms, this is why I put on a few small trades.
To test this earnings idea, I took on 3 small trades, and I’m up to $185 already.
I started these trades on Monday and today is Wednesday. So in only three days I made $185. Now you might say, “That’s nothing.” But you see, the margin needed for these trades was $5400.
So if you do the math that is 3% in three days, or 1% a day. If I could keep that up, making 1% a day, that would be more than 200% in a year. So you would more than double your account in a year. This idea is sounding better and better!
Finding the Right Stocks
I want to actually pick a few stocks that are reporting earnings in the next few days. One of the stocks that is reporting earnings tomorrow is United Airlines.
Today there should be high volatility and it will be gone tomorrow. So let’s take a look at United Airlines.
Typically I do not want to be in these sorts of trades very long.
Since the earnings are tomorrow, I’m choosing option contracts that expire in two days from now.
Now, keep in mind that right now I’m just discussing the idea. I don’t have the specific rules yet, but we have a concept to work with.
Right now United Airlines is trading at $31. So the idea is that I’m selling deep out of the money puts and calls. So finding an option contract with a Delta of 0.67 will have 90% probability of success. I can actually go to the 27 strike , that’s more than a 10%-15% move.
So for this trade I would sell the 36 and the 27 strike price. The idea here is that if United is reporting earnings tomorrow, it will trade within this range for the next 2 days.
So is this trade possible?
You can see the probability of selling the calls and puts, by using one of the tools built into your broker platform. This tool is called the Risk Profile
So tomorrow, if the price stays between the 36 and the 27 strike prices, the probability of success is 80%.
That means there’s an 80% probability that the strategy will result in a profit IF, there is no major move.
That doesn’t sound too bad. For one contract, the margin impact is only $368. So based on my margin, I can make 10% in 2 days.
It seems that we could be even less aggressive and choose strike prices a little bit out of the money. But you see, this is the general idea.
Let’s consider another example.
Let’s look at another earnings play. Qualcomm is reporting today. There are options that expire in two days from today.
So the idea is that these types of positions trade within a certain range. I mean, is it risky? I don’t think so, because if you look at Qualcomm, any movement on earnings is typically less than 5%.
These example positions are not like Google. Larger stocks like Google may have a 10% or greater than expected move.
So once again, the idea is that the movement of this underlying stock will not be significant.
So as we can see, Qualcomm is trading around 78, so I’m looking for a strike price below, somewhere around 71. This movement would be about $7. That’s almost a 10% move. We can get $0.16 – $0.17 per contract. On the upside we’re looking for 6 dollars, around the 85 strike price.
So if Qualcomm would stay within this range over the next two days, we can collect $50 in two days. I would probably trade 20 contracts so that I can collect $1,000 in the two days.
I don’t know about you, but that’s a pretty sweet deal…
Conclusion
I wanted to show you how I go from an idea, to testing the ideas, and then to developing the rules.
We will delve into developing the rules of this trade in a future blog post. Right now I’m sharing right now a trading idea, and the trading idea is based on selling options.
So again, the idea is that right before earnings, volatility is high. Because uncertainty is high before earnings, and that after earnings volatility plunges. Based on this same trade idea, I was able to earn over 3% in 3 days. With margin it would probably be 3% per day, which is amazing, right?
So right now we have an idea and we’re in the testing phase. As I continue to take these positions I am looking for trades that also don’t work out. This will help me to develop the rules.
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