It is imperative you trade with a plan. No trader has ever successfully prospered without a trading plan or with a plan that they didnt stick to. A sound trading plan includes, but is not limited to, the following items:

1. Money management rules, i.e. acceptable profits and losses per trade, how much capital you will commit to any one trade and to the market at any one time.

It is important you identify what your stop loss margin is (as discussed last week) and even more important you stick to it. Writing this sort of information into your trading plan will help cement it in your mind. More on money management will be covered in week eight.

2. Stock and option identification rules, i.e. how you will decide which stocks to trade options on and which options you will trade.

You should figure out if you like technical analysis, fundamental anlysis or a combination of both. How big will your watch list be? What price range of stocks will you trade? Do you like trading in the money or out of the money options? What Greeks will you consider?

3. Entry and exit rules, i.e. What will make you enter and exit a trade, what length of time will you stay in the trade and how often will you trade.

Entry and exit rules will depend largely on technical analysis, write down the patterns and indicators you will look for. Deciding how often to trade will be a big factor in your success. Most people over trade, if you have a fixed profit target then once you have met it you should stop trading. Attempting to go for that little bit extra can lead to a big loss, all the more difficult to take if you had already met your profit target!

4. Your own strategy rules, i.e. which trading strategies you will use primarily and which strategies suit your risk profile.

Know thyself as the ancient Greek saying goes is critical when formulating a stock options trading plan. You will tend to trade options and you do anything else in life, for example, if you are cautious by nature you will trade cautiously, if you are impatient in everyday life you will trade impatiently. Therefore consider your unique traits and formulate your plan around them.

Once you have practiced trading options you will discover your own style of trading, and from that you will develop a plan that suits you. Once you have your plan, and you know it works, stick to it through thick and thin. That doesnt mean that a plan cant be changed but you must ensure that you give your plan a chance to work and that you dont change it the first time you take a loss.

Once you formulate and implement a good trading plan you will be well on your to trading stock options successfully. Next week we will discuss trading with the overall market and index options.

US Government required disclaimer: Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of the Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).

This, however, is easier said than done! When entering a trade if you get in too early you may lose some time value of your option. If you get in too late you may miss out on a move in the stock you are trading the options on. The best way to time your entry point is to use good technical analysis. Technical analysis is the technique of reading and analyzing stock charts. Institutional investors are investing millions and millions of dollars in the stock market every day. However they are still human and because it takes a long time for them move that much money predictable patterns emerge in the stock charts. From those patterns future price moves in the stock can be predicted.

Technical analysis is a mix between an art and a science and can be quite complicated. Although the patterns are predictable, of course the stock does not always follow the pattern it should so it is important to use other indicators in conjunction with technical analysis, such as fundamental analysis (discussed in the last article), company news and political and economic events. Because of the complexity of technical analysis I will not go into the how it is performed, there are several good books that I would recommend you read that do that:

“Technical Analysis and the Financial Markets” by John Murphy.

“Getting Started in Technical analysis” by Jack Schwager.

“Technical Analysis: The Complete Resource for Financial Market Technicians” by Charles Kirkpatrick II.

Some of the main technical indicators in charts to watch for are the support and resistance levels, breakouts on volume, moving average crossovers and oversold/overbought conditions. Using and understanding technical analysis is a key component to entering the trade. Next week I will discuss the next step which is, quite aptly, how to decide when to exit the trade.

US Government required disclaimer: Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of the Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).