Here is the step-by-step routine that I follow each market day when looking for new short-term option buying opportunities.

1) I wake up at 5am Australian time (3pm New York time – 1 hour before the close) and go to the computer.

2) I then pull up the ‘real-time’ charts in my watchlist and check the DOW, S&P 500 and Nasdaq Comp to see if the day’s sentiment is bullish, bearish or neutral. I then check each individual stock chart for my core Call or Put buying ‘trigger’ which is either a higher trough or a lower peak.

3) As I go I make a list of those stock codes that fit this criteria so I can analyze their charts further.

IF NO STOCKS FIT THIS CRITERIA MY ROUTINE IS COMPLETED UNTIL THE NEXT MARKET DAY!

IF THERE ARE STOCKS THAT FIT THIS CRITERIA, I CONTINUE ON.

4) I then focus on each of these charts and analyze the underlying long and short-term trend, long and short-term moving averages, RSI, bollinger bands, potential breakout patterns or candlestick reversals and last but not least, volume.
– I’m looking for ‘evidence’ of an imminent upside or downside move.

5) I then try to cull this list so that only the highest probability trades remain.

6) I then run the remaining stocks through my Volatility Cone to establish whether implied volatility is low, high or fair.

7) I then take another run through my remaining stock charts and choose the single best opportunity, taking all factors into consideration including my GFI (’Gut Feel Indicator’).

I then login to my trading account and check out strike prices, expiry months and delta.

- If the options on the stock I have chosen have high implied volatility, I will be looking to buy the current month deep ITM options, with a delta as close as possible to 1.

- If the options on the stock I have chosen have low implied volatility and the stock has formed a reliable break-out pattern, I will be looking to buy the next month out, ATM options with a delta close to 50.

- If the options on the stock I have chosen have relatively ‘normal’ implied volatility, I will be looking to buy the next month out, ITM the money options with a delta of 75-80.

9) Once I have found the strike price and expiry month I want, I then work out roughly how many contracts I can buy considering per my capital allocation for the trade (usually 10-15% of my short-term trading bank).

10) I then pull up the order form I need and fill everything out except for the limit price.

11) I then wait until 3.45pm and as long as the stock is trading within the top 1 third of the day’s range for calls OR the bottom 1 third of the day’s range for puts, I enter in my limit price (usually the ‘ask’ price for tight spreads or ‘in between’ the bid and ask for wider spreads) and pull the trigger.

12) Once the order is filled, I then place a 20% trailing stop on the option, which will close out the trade ‘at market’ if hit.

13) I then fill out my trading diary, which includes the details of the transaction and exactly ‘why’ I got into the trade and what my exit scenarios will be, and attach a copy of the stock chart.

ROUTINE COMPLETED!

NOTE: If I am currently in a trade/trades this process will also include analyzing that/those particular stock charts and making my decision to either stay in or exit the postion(s).

Now the reason I just shared my daily routine with you was to illustrate the importance of ‘consistency’.

When you follow a trading system and analysis sequence consistently, you get to a point where you know EXACTLY what you need to do and EXACTLY what you are looking for.

This keeps you objective, focused (i.e. not jumping around all over the place looking for trades) and also supports you making the best possible use of your time.

Afterall, who wants to be staring at a computer screen all day? I have found success in letting my trades come to me on my terms and that fit in with my ‘routine’.

Chapter 3: Understanding the Profit/Loss Patterns over Time. This chapter evaluates the profit and loss in terms of Time Units (typically day and week) feeding into Time Spans, Average Profit versus Average Loss, Standard Deviation, Sharpe Ratio, Median P/L, Percentage of Winning Days versus Losing Days, Drawdown and Correlation Analysis. This section focuses on the core metrics of trade performance, for a given period:

In calculating the metrics, it becomes clear if your strengths are in trading long debit spreads, short credit spreads, directional trades (be it up/down) or non-directional trades. Trade in line with what you are intuitively profitable at, be that debit/credit spreads or directional/non-directional trades. The metrics help you guard against trading counter-intuitively in opposition to your strengths. Chapter 4: The Risk Components of an Individual Portfolio. The emphasis of this chapter is on Historical Volatility, Correlation and Implied Volatility and Value at Risk (VaR). While it is educational to understand how these various risks can be aggregated up into a single, portfolio measure of exposure, it is not useful for option traders trading retail portfolios from home.  Why?  To re-simulate the test scenarios on the portfolio cited in the text, requires specific types of data. The Account Statement of most retail option trading platforms only record each trade’s profit, loss and date. The additional data of each day’s Historical Volatility, Implied Volatility, Correlation coefficient values and Standard Deviation/Variance values will need to be sourced from outside the trading platform.  Unless you are trading multiple portfolios on behalf of other individuals, VaR simulations make sense. If you are trading just your own portfolio, it more useful to get an Implied Volatility tool that forecasts IV rising or falling by X% over 30-60-90-120 days.  This is a much more affordable way to assess the total impact of IV and Correlation in IV on your portfolio.Chapter 7: The Risk Components of an Individual Trade. The section to focus on here is the Core Transaction-Level Statistics. This includes the Trade Level P/L, Holding Period, Average P/L, Weighted Average P/L, Average Holding Period, P/L by Security or Asset Class and Long Side P/L versus Short Side P/L.  The main point here is to monetize the Average Holding Period of a long or short position. For example, as a guideline:

In conclusion, the critical points to focus on are the 3 types of targets at the portfolio level, the core metrics of trade performance, identifying your intuitive trading orientation and monetizing the average holding period of long and short trades for efficient trade turnover.  Translating these specific elements of trading risk into methods you can rely on every day, builds the required consistency in the profit and loss of your trading account.

There must be a more compelling reason for you to trade stock other than just for the movement, if only 20% is unique to the underlying equity in question.  Consider this, in context of the Fundamental Analysis or stock picking software that you bought on a per $1 basis.  For each $1 dollar you spend, you “outsourced” the analysis at a cost of 80 cents, only to receive back 20 cents worth of work. Shouldn’t the 80:20 rule of “outsourcing” be the other way round? The problem is that you are still stuck with 80% of the work, to analyze price movement!  Plus, the more you use FA techniques/stock picking software, the more trading capital is stuck in equities alone.Now, you can say “special” research papers help you pick stocks.  Let’s have a look at some of the more common fundamental metrics in these research subscriptions:1. Dividend Yield: the problem is in the variability of yields as firms are in different stages of their business development.  A Mature company that dominates in a well established sub-segment/sector is able to afford a different dividend yield; versus, a Young company in a growth-oriented field; versus, a Small firm in a growing area that may not be able to afford a dividend payout.  Bear in mind there is nothing special about firms that pay a dividend.A company that gives away a portion of it’s retained earnings – which is what a dividend is – effectively gives away part of its valuation, which means it is not worth as much as a company that does need to give investors candy to commit capital to it.  So, a dividend paying stock has to be far superior to a non-dividend paying stock for reasons other than the dividend.  If it is not, there’s no point looking for dividend paying products to trade, there are plenty of non-dividend paying Indexes to trade.2. Price/Book Ratio: the problem is this metric varies across industries and from company to company, as the asset base and capital structures of companies change over time. It lacks cross sector applicability and accounting complexity arises from a firm’s capital structure as it changes due to acquisitions/divestments/CAPEX for new product lines; or, product line cut-backs, as recently seen in the restructuring of major US car companies.3.  Price/Cash Flow Ratio (the cousin of the P/E): accounting laws on depreciation vary across Asia, Europe and US.  As accounting rules are driven by tax codes, which change considerably across regions despite adoption of global accounting standards, there is a lack of uniformity in homogenizing a fundamental ratio that will fit as a common benchmark across geographies. These metrics fail to help you compare say a Dell parented in the US to an Acer parented in Taiwan; but, is listed as an ADR in the US, even though both are competitors in the same sector as computer manufacturers. Furthermore, the current dislocated cost of capital in credit markets, impairs the ability of corporations to optimize the operating cost of their balance sheets.  In essence, corporations are left with the working capital cash flows remaining on their balance sheets, as testament to their financial strength. Do not waste your money on Fundamental Analysis software or research paper subscriptions.As there is a fundamental flaw in fundamental analysis and stock picking, how do you select trades? Trade the options of a broad-based Equity Index to replace single stock exposure.  To replace Fundamental Analysis, use the Relative Strength measure based on Point & Figure methods.What is Relative Strength?  It is nothing more than taking one price as the Numerator, divided by another price as the Denominator, then multiplied by 100.  RS = (Price 1 / Price 2) x 100.  Typically, RS calculations use daily closing prices.  Though simple in its mathematical construction, RS is ingeniously powerful when it is applied not only within a sector; but, across sectors and between asset classes.Let’s start of within a sector.  For example, if you choose 2 semiconductor stocks trading at different prices, how do you know if one stock is outperforming the other in the same sector, when the 2 stocks have price changes at different rates; plus, the sector’s price itself is also changing?SOX = Semiconductor Sector Index, trades up from 452.24 to 467.81.Numerator1:      Price1 = BRCM 33.15    RS1 = 7.33    Price2 = 33.80    RS2 = 7.23Numerator2:      Price1  = TSM 9.91    RS1 = 2.19    Price2 = 13.43    RS2 = 2.87Common Denominator:      SOX  Price 1 = 452.24           Price 2 = 467.81BRCM’s RS1 = (33.15/452.24) x 100 = 7.33. BRCM’s RS2 = (33.80/467.81) x 100 = 7.23.  TSM’s RS1 = (9.91/452.24) x 100 = 2.19.  TSM’s RS2 = (13.43/467.81) x 100 = 2.87.BRCM’s price rises from 33.15 to 33.80 and TSM’s price also rises from 9.91 to 13.43.  Simply because BRCM is a larger stock, does that mean it benefits from the SOX trading up? No, the RS reading (RS1 compared to RS2) shows BRCM’s RS reading dropped (7.33 down to 7.23) against TSM’s RS reading, which increased (2.19 to 2.87).  RS confirms TSM as the outperformer rising in price strength versus BRCM’s weakened price.  RS is constructed on pure price rules.  Using an Index as the denominator, acts as a much more durable benchmark and is structurally more reliable, compared to any “magical” TA indicator; or, combination of income statements, balance sheets and cash flow statements touted in stock picking programmes.You can replace BRCM or TSM with Indexes or ETFs.  Using Indexes with Relative Strength enables a common denominator to compare Equities against Bonds, Commodities and Currencies, to crossover into asset classes other than stocks to trade.  It’s not that Relative Strength is infallible.  But compared to the fundamental metrics cited above, Relative Strength fails the least.  Break the mould on what you learnt about stock option trading.Is there an example of an optionable and consistently profitable portfolio that trades using Relative Strength across multiple asset classes? Yes.  Follow the link below, entitled “Consistent Results” to see a retail online option trading portfolio that excludes the use of single stocks and Fundamental Analysis, using broad based equity Indices, Commodity ETFs and Currency ETFs.  There is no need to trade FX directly. Just trade the options of Currency ETFs.

Calls are useful in speculation, and puts are useful in hedging. It is all going to depend on the strike price of the underlying asset on the expiration date. If all of this makes perfect sense to you, there is not much need to read on, but if it sounds a bit hazy, a little review might be in order.

The Stock Option market has its own unique language. Like many other activities, an understanding of the terminology used is essential. In many cases, it is a rather simple concept hidden behind an unknown term that leads to confusion, and makes the activity appear a lot more complex than it actually is. The following are a few definitions that might help take away some of the mystery.
– Calls: A call is basically a contract giving you an option, but not an obligation to purchase a block of stocks at a set price on or before a certain date. In understanding a call, it is important to remember that you are not obligated to make the purchase. You can exercise your option or not.
– Puts: A put is the opposite of a call in that it is a contract to sell a block of stock at a set price on or before a certain date. Again, this is a choice. You can make the choice not to sell.
– Holders: This is the name given to the buyers of the contracts. It is the holders that give the option trading market its name since they are the ones who actually are in a position to make the decision to exercise their options.
– Writers: Since it is a “trading” market, two parties are necessary. If someone is buying, than someone else must be selling. The writers are the sellers of the contracts. It is important to remember that the writers are not the ones with the options. They do have an obligation to honor the contract if the holder decides to exercise his option.
– Long Position: In stock trading, long position means that you are holding the stock in anticipation of it increasing in value.
– Short Position: In stock trading, short position means that you are holding the stock in anticipation of it decreasing in value.
– Underlying Asset: The underlying asset, or as it is sometimes called, the underlying, is the actual stock or security that is the object of the option contract. The contract is said to derive its value from the intrinsic value of the underlying asset.
– Strike price: This is the price at which the option contract will be purchased or sold. If you purchase an option to buy, or make a call, at $10 , but the value of the underlying asset is only $8, you are $2 under the strike price, and most likely would not wish to exercise your option.
– Speculation: This is the risk taking side of option trading. It is generally associated with calls and long positions. It essentially means that you are expecting a stock price to rise higher than the strike price.
– Hedging: This is the cautious side of option trading. It is generally associated with puts and short positions. You are anticipating that the value of the underlying asset will drop below the strike price. It is called hedging because it is often used to protect an investment, or hedge your bet, by maintaining an option to sell at a certain strike price should the underlying asset take a serious drop in value. In other words, you are able to bail out before your loss becomes too large.
– Expiration date: This is the date on which your option must be exercised or it will be lost. It is the deadline. In the stock option market it is usually the third Friday of a month.

The above are a few of the terms that are used in the stock option trading market, and by understanding them completely you should be better armed to take a closer look at this interesting investment opportunity.

Now, let’s compare the above spreads with these other types of spreads.

Clearly, there are more spreads that require the Implied Volatility to be differentiated between Calls versus Puts, compared to the use of a combined IV. So, in choosing a data provider of Implied Volatility, make sure you get the IV data of Calls that is set apart from the IV of Puts; as well as, data that combines the IV of Calls and Puts together. That means 3 sets of IV data in one service.We have just established the structural logic for decoupling the IV of Calls from the IV of Puts. How do you apply this to a trade? Here’s how.

Is there a working example of a consistently profitable portfolio that treats Implied Volatility of Calls separate from the IV of Puts? Yes. Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that applies this logic.To conclude, I’ll use an analogy. Though an egg comes in one shell, the yolk is separated from the white, for a different purpose that distinguishes the individual parts of that same egg. Treat Implied Volatility of an option’s anatomy in the same way.

For a long time I couldn’t say those words as I struggled just to hold on to my capital, let alone make it grow.

Though there were several reasons why I struggled (including being grossly undercapitalized and at the same time placing too much of my trading bank on individual trades) the main reason for my struggle I believe was a lack of focus.

By ‘lack of focus’ I mean that I was constantly jumping around trying to implement too many different option trading strategies from basic call and put buying, to putting on multi leg spread tades, believing that the more complex the strategy, the greater my chance of success.

I had become a ‘Jack Of All Trades & A Master Of None’ and the only people that were making money from my option trading were my brokers.

One day a friend of mine (a very successful futures trader) said to me, “You don’t need to know everything about trading the markets to make money and be a success. You just need to ‘focus’ and become an expert in one or at most a few different trading strategies and know exactly when and how to use them. The rest is just practice!”

Those words rang loudly in my ears and from that point onwards I narrowed my focus.

I decided that I would go back to the very basics of option trading and only buy calls and puts with the intention of becoming very good at picking the short-term direction of stocks.

Today, almost 2 years later and after going through a steep and often expensive learning curve, buying calls and/or puts is what brings in the largest portion of my current monthly income.

I also use a couple different spread trading strategies when the market moves sideways, but my main ‘focus’ is on picking the short-term direction of a small number of stocks that I have gotten to know VERY well (through backtesting), and then buying the appropriate option based on risk vs reward and my short-term outlook.

The success I’m enjoying today (19 profitable months out of the last 24) is due to becoming proficient at reading stock charts and developing an option trading system that I am comfortable with and performs well and by applying my trading rules consistently.

Ultimately you only need to know a few different strategies to be able to trade any stock up, down, or sideways.

The options themselves are simply the ‘tools’ to make money from your ‘opinions’ and in my experience the tools that are the easiest to use, have also been the most profitable.

Guy Cohen has extensive experience of both the US and UK derivatives and stock markets.  He specializes in trading and analytics applications ranging from real estate to derivatives and has developed comprehensive business, trading and training models, all expressly designed for maximum user-friendliness. There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number.  The percentages represent how much each chapter makes up of the 302 pages in total, excluding appendices.1  The Four Basic Options Strategies.  20, 6.62%.2  Income strategies.  68, 22.52%.3  Vertical Spreads.  30, 9.93%.4  Volatility Strategies.  56, 18.54%.5  Sideways Strategies.  44, 14.57%.6  Leveraged Strategies.  20, 6.62%.7  Synthetic Strategies.  54, 17.88%.8  Taxation for Stock and Options Traders.  10, 3.31%.Focus on chapters 2, 4, 5 and 7, which makes up about 74% of the book. These chapters are relevant for practical trading purposes.  Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective. Chapter 2: Income Strategies. These strategies construct spreads where part of the spread sells Theta as premium within a shorter term (typically 30-45 days), to collect income.  In its entirety the strategy may result in a Net Debit or Net Credit spread.  There are 13 types of spreads in this category: Covered Call, Short (Naked) Put, Bull Put Spread, Bear Call Spread, Long Iron Butterfly, Long Iron Condor, Covered Short Straddle, Covered Short Strangle, Calendar Call, Diagonal Call, Calendar Put, Diagonal Put and a Covered Put (a.k.a. Married Put).Chapter 4: Volatility Strategies. These strategies use spreads that are indifferent to price direction, so long as price explodes out of range.  For a given explosion in price, the volatility of the spread needs to rise for a Net Debit spread and fall for a Net Credit spread,.  There are 11 spread types are defined in this category: Straddle, Strangle, Strip, Strap, Guts, Short Call Butterfly, Short Put Butterfly, Short Call Condor, Short Put Condor, Short Iron Butterfly and Short Iron Condor.Chapter 5: Sideways Strategies. These strategies involve non-directional spreads, requiring price to drift within a confined range. As price remains range bound, the volatility of the spread needs to rise for a Net Debit spread and fall for a Net Credit spread.  There are 11 types of spreads in this category: Short Straddle, Short Strangle, Short Guts, Long Call Butterfly, Long Put Butterfly, Long Call Condor, Long Put Condor, Modified Call Butterfly, Modified Put Butterfly, Long Iron Butterfly and Long Iron Condor. Chapter 7: Synthetic Strategies. Synthetic strategies mimic the risk profile of a stock, futures or other option position by combining calls, puts with or without stock.  Though typically, most synthetic positions are either long or short stock.  If you have a 401K plan or employee stock purchase plan that is long stock, then it may make sense to consider synthetic strategies, as you are already long Delta.  There is unlimited risk for some synthetic spreads, regardless if the strategy involves stock or not.  There are disadvantages to using synthetics.  12 spread types are defined in this category: Collar, Synthetic Call, Synthetic Put, Long Call Synthetic Straddle, Long Put Synthetic Straddle, Short Call Synthetic Straddle, Short Put Synthetic Straddle, Long Synthetic Future, Short Synthetic Future, Long Combo, Short Combo and Long Box.From a retail option trader’s viewpoint, I prefer to establish positions without the use of stock.  Using stock synthetically in a position makes each trade more capital intensive than it needs to be.  Especially, if your trading account is below USD $50,000.  The use of stock in configuring these positions does not add material merit in controlling risk and there is no added monetary benefit in tying up available trading capital in a stock-dependent synthetic position that could otherwise be achieved without the use of stock.  As an options trader in the first place, you want as little to do with the stock itself as possible, other than to configure the required option position around the underlying product, which can be substituted with a cash-settled Index instead of a stock-settled Index.Out of a total of 56 strategies covered in the book, I have reduced the list down to 35 Limited Risk Spread types that do not need to include stock as part of its original construction.  Limited Risk means there is a cap to the maximum loss – “Capped Risk” is the term used in the book. This should always be the starting point of any strategy you choose to construct. Do not just look at the unlimited profit (Uncapped Reward) side of the strategy without realizing that there is an unlimited loss (Uncapped Risk) side to same strategy.Limited Risk Spreads with “Unlimited” Reward and their Directional outlook.1. Long Call.    Bullish.2. Long Put.    Bearish.    3. Put Ratio Backspread.    Bearish; reverse Bullish.4. Call Ratio Backspread.    Bullish; reverse Bearish.        5. Straddle.    Indifferent/~Neutral.6. Strangle.    Indifferent/~Neutral.7. Strip.    Bearish.8. Strap.    Bullish.    9. Guts.    Indifferent/~Neutral.    1-9 are Debit spreads: IV needs to rise.10. Bull Put Ladder.    Bearish.    10-11 are Credit spreads: IV needs to fall.11. Bear Call Ladder.    Bullish.    Limited Risk Spreads with Limited Reward and their Directional outlook.12. Bear Put Spread.    Bearish.13. Bull Call Spread.    Bullish.14. Long Call Calendar.    Bullish; Indifferent/~Neutral.15. Long Put Calendar.    Bullish; Indifferent/~Neutral.16. Long Call Butterfly.    Indifferent/~Neutral.17. Long Put Butterfly.    Indifferent/~Neutral.18. Long Box.    Indifferent/~Neutral.19. Long Call Condor.    Indifferent/~Neutral.20. Long Put Condor.    Indifferent/~Neutral.21. Long Iron Butterfly.    Indifferent/~Neutral.22. Long Iron Condor.    Indifferent/~Neutral.    12-22 are Debit spreads: IV needs to rise.23. Bear Call Spread.    Bearish.    23-35 are Credit spreads: IV needs to fall.24. Bull Put Spread.    Bullish.25. Short Iron Butterfly.    Indifferent/~Neutral.26. Short Iron Condor.    Indifferent/~Neutral.27. Diagonal Call.    Bearish.28. Diagonal Put.    Bullish.29. Modified Call Butterfly.    Bearish to ~Neutral.30. Modified Put Butterfly.    Bullish to ~Neutral.31. Short (Naked) Put.    Bullish.32. Short Call Butterfly.    Indifferent/~Neutral.33. Short Call Condor.    Indifferent/~Neutral.34. Short Put Butterfly.    Indifferent/~Neutral.35. Short Put Condor.    Indifferent/~Neutral.Other than the 35 Defined Risk Spreads that do not require stock as part of their original construction for entry, there are 6 Defined Risk spreads that need stock to configure their positions. The 6 positions that I have deliberately excluded from the list above are the Long Call Synthetic Straddle, Long Put Synthetic Straddle, Synthetic Call, Synthetic Put, Collar and Covered Call.In conclusion, for new to intermediate traders do not be overwhelmed by the 56 strategies in the book.  It’s entitled the “Bible of Options Strategies” for a reason. What is critical is to get a deep understanding of the Long Call, Long Put, Short Call, Short Put, Long Vertical Call/Put, Short Vertical Call/Put and the Long Calendar Call/Put. That is the 4 Basic Options Strategies, plus the Vertical and the Calendar – the only 2 strategies that floor traders define as true spreads. The other combinations are a mixture of the basics with or without stock.