Obey These 3 Option Trading Rules

I've decided to invite AJ Brown, from TradingTrainerHomeStudy.com, as he was a great guest blogger and hit a very hot topic...options! You can read his last article on OTM, ITM, or ATM, which was a great success. I asked him back today because options are getting much more play in this economy and he has 3 great rules for trading options that he would like to share with you today. Comments are welcome and expected, and just as before, he will be responding to ALL comments!


The most difficult part of trading options (or anything else) is controlling your emotions so you can make smart trades.

There's always this tug-of-war. On the one hand you have logic and common sense. On the other, you have fear and greed. Problem is, fear and greed are too often the winners! (I know; I've been there.)

With that in mind, here are three option trading rules I suggest you obey to eliminate emotional decisions.

Rule #1: Be an End-of-Day Trader

Do some people make money day trading? Absolutely. But for most people I advise against it. Here's why...

Watching the market real-time can send your emotions soaring and diving like a roller coaster on a rickety track. Sure, it's thrilling. Sure, you'll experience something like a gambler's high. But it ain't going to do your trading account any favors.

Personally, I recommend that you not watch the market during the day. I do recommend that you analyze potential trades end of day, after the market closes. This way you don't get sucked into the frenzy of the market and you can plan your trades in advance of the next trading day.

Let me get specific for you about my particular timeline.  Once trading ends for the day (for me that includes the after hours session too) I begin the process of pairing down my watch list to my pick list and to, finally, my hot list.

I have a funneling filtering system that starts out more black and white / robotic and get more subjective as the number of candidates is reduced to a few.

My pick list is derived from my watch list by taking a line chart setup and quickly flipping through my watch list candidates looking for basic tradeable patterns that stand out.  I'm looking for the low hanging fruit like clear reversals, or obvious trend continuations or better yet sideways consolidations.  I also use programmable algorithms in my broker's charting software to help this mechanical narrowing down of my watch list into a pick list for the day.

On a given day, a watch list of say 70 to 110 candidates should be narrowed down to roughly ten symbols on your pick list.  If there's more or less, and it's a typical day with no external stochastic shocks affecting the market, then I know I have to adjust my filtering to be either more strict or lenient.  It's an iterative process.

Once I have a pick list, I complete a full analysis where I evaluate each ticker using the appropriate templates to match the chart's personality to see if their is a possible entry setting up for the next trading day.  I'll use volume and support / resistance price thresholds to validate the template confirmations, and if all is a go, I'll add the ticker to my hot list to trade the next day.

But, it doesn't stop there...  I'll actually submit my hot list to my investment group.  They'll evaluate my hot list picks and me theirs.  We'll actually meet live (usually by telephone or even VOIP connection) and quickly run through the positons looking for a yay / nay concensus on each.  It's these group picks that I actually trade the next day.

A quick note about trading in a group.  To me, trading in an investment group is the holy grail of trading.  A group holds you accountable, gives you support, and offers you a diverse perspective.  I have found more than not that successful traders trade in an investment group of one sort or another.

Rule #2: Stick to Your Money Management Rules

Money management rules prevent you from risking too much capital on any single trade. Sticking to your money management rules keeps you in the market for the long-term.

Most traders find themselves risking too much money on trades they think will "go big." But if you've been trading for any time at all, you know that what you think and what actually happens are often wildly different, which is why it's never wise to risk a big portion of your trading account on just one trade.

A better approach: Create money management rules that disperses risk among multiple trades so that you never lose big on any one trade. Then, after you've created your rules, stick to them.

Consider setting a hard limit on the amount of risk any one of your trades might have on your portfolio.  Say 2%.  Then work backwards to determine positon sizing and hard fixed stop loss placement.  For instance, if 2% is your max portfolio risk then your position size can be 10% of your portfolio if you employ a 20% fixed stop loss.

A quick note about option trading.  In directional optional plays, generally you have to allow the option room to breathe to not get stopped out prematurely.  A fixed stop loss set at 15 to 20% below the option buy price, I have found, is the perfect compromise.  As the stock appreciates, the fixed stop loss can eb ratched up.

Rule #3: Use Automated Exit Strategies

Once you're in a trade, you need to use automated exit strategies. An example of this would be a stop loss order or an automated alert that's triggered when your option hits a certain price threshold.

If you're obeying Rule #2, then you will already know exactly where to set your stops or create an alert. The advantage of using automated exit strategies is it takes the guesswork and emotion out of the decision.

You won't sit there debating with yourself whether to get out of a trade or not. You won't watch the value of your position erode to nothing. You'll get out when you've decided in advance to get out.

All of the most profitable traders use automated exit strategies because it takes an emotional decision and reduces it to a mechanical decision. This is ultimately what you want because it will do two things for you: avoid exorbitant losses... and... lock in profits.

A quick note about automatic trading strategies.  They key here is to plan your exit and then exit based on your plan.  A stop loss is probably the most basic of automatic exits.  Careful though... stop losses don't guarantee and exit at that price, just the triggering of an order at that price.  A sell stop limit order has you select the trigger price to sell as well as the limit sell order price to sell at.  Limit orders don't guarantee a fill.  So, you can use a sell stop market order that has you select the trigger price to sell and then sells at the market.  Your guaranteed a fill at whatever price is possible.  Consider this, with the advent of more advanced trading platforms and respective orders, our ability to automate exits has grown.  We now have contingent exits, which work really well with options (example: sell the option contingent on the stock doing XYZ) as well as more triggering scenarios above and beyone price threshold crossings (example: sell the option when the three day simple moving average crosses down below the five.)

These are the three rules I use to eliminate the emotional element from my trading practice. Remember: Obey these three option trading rules and you'll be way ahead of everybody else.

Best regards always,

A.J. Brown

P.S. If you didn't get it before, get my free report called 7 Financially Devastating Mistakes Most Option Traders Make

11 thoughts on “Obey These 3 Option Trading Rules

  1. Good article AJ. I lead a small trading group scattered across the US and we simply use MS Go to Meeting- Everyone can talk, display their screens, etc and it's like $49.95/mo for up to 15 people after a 30 day free trial. We all split the cost, so basically nothing. A great tool for teaching small groups also. Takes about 2-3 min. to set up

  2. If the Market Club IS a club, then why is it not the function of it's Promoters/subscribers (members) not being fcilitated to follow ALL what it offers with it's fellow members?

    I had put this to Adam but it never appeared on the blog or comment. Members can often help each other exactly as outlined by AJ and most such promoters remain ingorant.

    Would Adam have something to say about it?

    Bill N.

    1. Bill,

      I see that your comment was approved on 5/28/09. I'm sorry you didn't get the response you were looking for. We try to have our member's share tips with each other on the blog by commenting back and forth. I will suggest this to our technical team for future implementation, but I do not know of any specific programming plans to create a forums/live chat at this time.

      I think you are also reading the name MarketClub more literally than intended. MarketClub is a suite of tools. Although I think we have a close trading community, we do not place trades as a club.

      Your comment was published. I also know that there are many other members that would back up the forum feature. We will take this feature into consideration and I will pass this along this suggestion to the appropriate department.


      Lindsay Thompson
      Director of New Business Development
      INO.com & MarketClub

  3. A. J. Brown mentioned finding a support group. It may be worth adding that they don't have to be people you know. There are some very useful Yahoo and other email groups where members share ideas and experience. Only one in ten emails will be really useful, but it's very good feedback to see when other people have the same market concerns as you do.

    1. Jon's point is right on about not being a person you know.

      Another point is that they don't have to be local. In fact, I prefer they don't. My trading business (see that I called it a business, not a practice and not a hobby) is structured so that so long as I have an internet connection and phone, I can do it from anywhere. I thoroughly am blessed to have that freedom.

      I have long since moved away from the location my original group was formed in, but we still, to this day meet by telephone and via the internet.

      It's an amazing world we live in now.

  4. I couldn't agree more on the three points raised by AJ. The key to success has to be discipline and eliminating the emotion. Easy said, hard to do. I was not aware though that an investment club is a key to successful trading. I understand that logically and will try to find one in my area. Does anyone know how to find a reputable one?

    1. Hey David,

      I'll tell you what I did originally (over 10 years ago). I cornered those people I had seen over and over at the multiple local seminars on trading, at the water cooler during a break. I wanted to make sure the people in my group had similar backgrounds.

      With options trading in particular, I can't emphasize enough how important a support network of like minded individuals is. There are so many misconceptions (mostly negative) around trading and specifically options trading, that its easy to self sabotage yourself by simply listenting to those not "in-the-know".

      One other tip from my own personal experiences... Nominate yourself as the scribe for your group. Be the one who takes notes and then is accountable for disseminating the notes to your group. I did that for years. Being the scribe may be a little more work, but you will internalize the knowledge and make the connections faster. I was and still am the most profitable trader in my group.

      In the trading trainer community, we emphasize trading groups since they worked so well for me. We actually do everything we can to incentivize the forming of groups by giving our members collaboration tools, processes to follow, templates to use and even myself or other experienced traders commit to look over their shoulders and comment on their picks and open positions nightly. That's how important I believe good investment groups are.

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