Options Trading

Gaining Options Momentum

Options trading can be overwhelming for beginners. They tend to move quickly and have a lot of moving parts. I started out my career as an options trader, so it has become second nature to me. However, over time I have realized that having so many variables can cause options trading to be very hit and miss for new traders. Without a specific system to follow it can be impossible to determine what is working, what is not, and why. To alleviate that I've been considering for a long time how to design a system that options traders can follow... systematically.

Below are the rules I've put in place. I call this the Wanderer Options Navigator (WON). The rules are as simplified, yet as specific, as I could make them. They are designed to both limit risk, and maximize gain. Risk management remains a core objective of Wanderer, and we think this strategy effectively accomplishes that.

In this post I'll go through the basic rules of the strategy, and by the end you should be ready to start pulling the trigger on trades yourself.

Know the Rules

  • Wanderer Buy or Sell Signal
  • Short-Term Moving Averages headed the right direction
  • Option Bid/Ask spread of 5% or less
  • 3% Trade Size
  • At-The-Money Strike Price, Roughly 25-45 Days Until Expiration
  • Stop Loss at 25% Max
  • Sell First Half at 25% Profit
  • Sell Second Half on a 20% Trailing Stop

More In Depth

Rule #1 - Wanderer Buy or Sell Signal

The Wanderer signal is a momentum indicator (see here for more info, and here to add it to your TradingView charts). When it triggers, we can feel pretty confident that the stock's momentum is headed our way. Obviously, this isn't the case with every trade, but by sticking to this, we increase our odds of at least some follow through of the current move.

Rule #2 - 20 and 50-Day Moving Averages headed the right direction

This goes hand-in-hand with the Wanderer Signal. If there is a buy signal we want to see both a rising 20-DMA, and a rising 50-DMA. This is sort of added protection that what we are buying has the short-term momentum headed our way. With a sell signal, obviously then, we want to see a falling 20- and 50-DMA. Do not enter an option trade with the MAs headed the wrong way.

Rule #3 - Option Bid/Ask spread of 5% or less

Switching gears now to the options side of the trade. When looking for an option to trade, you want to find a stock whose option bid/ask spread is under 5% wide. In an illiquid stock you'll find that an option market exists, but that the spread is very wide. This means you'll be losing both on the way into a trade, and the way out. The tighter the spread the better. An example of a good spread would be $4.00 Bid / $4.10 Ask. Ten cents wide, divided by $4.00 gives you a 2.5% spread. Not bad.

Rule #4 - 3% Trade Size

This is a rule, but really just a rule-of-thumb. If you are totally new to options trading, a 1% portfolio size option trade is reasonable. I think 3% is a pretty good level for most traders. Occasionally you'll go on a run of losses. At 3% trade size, a long string of losses still won't be too damaging. But if you were trading 10% size, a string of losses could mean real trouble to the size of your account. Remember, 3% refers to the size of your portfolio. If you are trading a $100,000 portfolio, then you'd trade $3,000 worth of options on a trade. If the calls you were buying are $3.00 each ($300), you would buy 10 contracts.

Rule #5 - At-The-Money Strike Price, Roughly 25-45 Days Until Expiration

You shouldn't need to spend any time agonizing over what strike price to buy. Simply pick the at-the-money strike. For expiration, keep it right around a month or a little more remaining. Do those two things and you won't have a lot of time decay to contend with.

Rule #6 - Stop Loss at 25% Max

Now that you've made your trade, it's time to manage it. Number one rule in all of trading is to manage your risk. Our Wanderer method puts a hard cap of 25% on your trade. That's it. There is nothing else to think about. If the trade has gone against you 25% then clearly something wasn't right. End the trade and move on to the next. There are three ways to do this. One is simply to watch your trade. Two is to set an alert on your charts near where you calculate the risk to be ~20%, then go in and manage the trade if that alert triggers. Three is to set a stop loss order. In the past I haven't been a big fan of stop orders, and I'm still not, but I recognize that they can be useful. A couple of tips for using stops with options. Only use day orders, and don't place the order until after the market opens for the day. Also, use a stop limit order, with the stop one price and the limit a few cents lower. Lastly, set an alert on your charts about where you think that will trigger, and try to go in as soon as you can to double check that your stop has filled. If you can't be around to do any of these things, simply close out your options trade before you leave.

Rule #7 – Sell First half at 25% Profit

Exactly like it sounds. When you've reached a profit of 25% you sell half of your position. Traders new to options often sell too early, or hold too long, forgetting that you don't have to close a trade all at once.

Rule #8 – Sell Second Half on a 20% Trailing Stop

Once you have reached the 25% profit level you will sell your first half, and then use a stop at 5% profit. As your profit climbs, you move the stop higher. At 40% profit, move stop up to 20%. Do this continuously until the trade runs out of steam and stops you out. Over time we've found that this results in around half of our trade's second half stopping out for less than 25%. However, the profits from the trades that continue to run, result in an overall higher return.

These are the rules of the Wanderer Options Momentum Strategy. We've designed this to be as simple as possible to follow along with, and to be as hands-off as is possible with options trading. As with all of our trading at Wanderer, we consider risk management to be the most important aspect, and this system is no different. But, a system like this is not automated, which means that the trader himself is the automator. We suggest you follow the system robotically. When it is time to buy, you buy, when it is time to sell, you sell. Don't second guess. After you have a long history of trades, you can begin to tweak the system to suit your needs, and we'll list some possible ways to do that, but in the beginning, just follow the rules.

WON Rules

Trade Example

Below is an example of the Wanderer Option Navigator (WON) in action. On August 23 AMD printed a Wanderer buy signal along with rising 20- and 50-Day moving averages. With those momentum conditions met, I purchased a 3% sized position in the Oct15 $110 calls for $5.70.

Options AMD

For the next couple of days not much happened. The calls were up a little bit, and down a little bit, but not enough to hit a target or a stop. During this time I had a sell order placed at $7.10, which is a 25% profit. On the morning of the 27th, AMD stock rallied and the order to sell 1/2 of the position at 25% was filled.

At this time I placed a stop limit order for the second half at $6.00, which would be a 5% profit on the remaining position. Throughout the day the stock continued to move higher and I continued to move the stop higher along with it. When the calls reached 35% profit I moved the stop up to +15%.

The next morning, on August 30th, the stock opened higher and quickly ran up to what would turn out to be the high of this move. At that point the options showed a profit of 62% and the option's sell stop order was moved up to 42%. After the quick morning run, the stock turned lower, hitting the stop order just a few minutes later to close out the trade.

options amd

This example should give you a good idea of how the Wanderer Option Navigator works. When looking at this chart's buy signal no thought was given to outside influences. It didn't matter if the overall market was going up, or going down, or if there was news on CNBC. Nothing but trade momentum was taken into account. Wanderer buy signal, rising moving averages, good options market—execute trade.

Two-Week Performance

From 8/12 - 8/26 Wanderer initiated 26 option trades based on the criteria listed above. We are using the Wanderer Option Watchlist which you can find here to add to your own TradingView watchlists. The stocks listed here will generally have options available that meet our 5% Bid/Ask rule. Certainly there are many more, and you can feel free to add your favorites to the watchlist. Trades were selected without regard to overall market performance, sector performance, or any other factors outside of the rules listed.

Analysis of Overall Market

Let's begin by looking at what the overall market did between the opening of the first option trade on 8/12, until the closing of the final option trade, which ended up being ORCL calls on 9/13.

DJI = -1.8% during that time, with a max range of -2.5% to +.4%
SPX = +.2% during that time, with a max range of -1.4% to +1.7%
NAS = +2.3% during that time, with a max range of -1.5% to +4.1%

You can see pretty clearly that during that roughly one month period there was no trend to the market. It was quite choppy, with an initial move lower, a rally, and another drop.

Market Returns

Analysis of Wanderer Trades

Now, let's breakdown the Wanderer trades a bit.

Wanderer Total Portfolio Return = 6.3%

This is a significant profit versus the overall market, beating the Dow by 8% and the Nasdaq by 4%.

We made a total of 26 trades during this two-week period.

We made 17 call option trades versus 9 put options trades. Again, despite this discrepancy, trades were chosen at random, at different times of day, so long as they met the criteria. No other consideration was given to making the trade and no trade was passed up if it the chart was seen, and the account had purchasing power remaining.

Two stocks had earnings announcements during their trade. DKS calls gapped higher, while the DG calls gapped lower. Obviously, two trades is not enough to base a conclusion upon, as to whether or not it is statistically a good idea to hold trades through earnings or not.

There were 16 wins and 10 losses for a 62% win percentage.

The average win was .97% and the average loss was .92%.

Additional Trading Results

We've continued to trade options using nothing but this system for the past few weeks. As of 9/15 we've now made a total of 41 trades, with 26W and 15L (63.4%W). During that time the total portfolio return is 11.1%, while the Dow has fallen 1.9%, and the Nasdaq has risen 2.7%. While this is still not a statistically significant sample size, it is promising to note that the W/L percentage has remained steady, and that the average percentage gain per trade has been slightly increasing. Also worth noting that the overall market has continued to be quite choppy, with no discernable trends.

Advanced Trader Adjustments to the Rules

Up to this point I have not made any personal adjustments, and do not currently have any plans to do so. Advanced traders, however, could consider some of the following possibilities.

Exit trade 1 day before earnings

Quarterly earnings reports can, and do, produce wild stock price swings. In addition to that, implied volatility often decreases, regardless of directional stock price movement, which results in lowered premium for the option.

Tighten original stop loss to 20%

Instead of 25% you could try and tighten the stop loss to 20%, which significantly lowers the dollar loss on a losing trade. However, this does run the risk of stopping out prematurely. Closing trades closer than 20% appears to stop out a significant amount of trades that would have eventually turned around.

Only enter trades using options that are within a specific stop loss level

When trading stock we enter trades with a stop loss of around 4-7% on average. The reason for this number is because this is the level that our Wanderer Indicator often triggers a signal after bouncing off of support. By using this specific support level, we can increase our chances of a winning trade. Unfortunately, a 4-7% move in stock price is often too far away for an option trade. The risk at that level would often be in the 50%+ range. There are trades that will trigger nearer a significant support level, though. There aren't as many trades in this range, but by waiting, and only trading those setups you may find that works for you.

Close trades that are not performing within the first three days

If the Wanderer Indicator has not produced the momentum we were expecting, it may be a good choice to simply close that trade. Time decay becomes problematic eventually, and the likelihood of getting a follow through move decreases as time goes on. This is especially true with long put options, since the overall tendency of the market is to move higher.

Close trades in thirds

You may find it useful to change up profit taking. You could consider closing 1/3 at 15% and using a trailing stop of 20% from there. If the trade pulled back from 15% to stop the balance out on your 20% trailing stop at -5%, you would still have a slightly profitable trade.

Overall, we believe that if you stick to the Wanderer rules listed at the beginning of this article you will realize strong profitability over time.

Wrap Up

Trading options can be hard, which is why we made WON easy. By following the rules outlined we believe you'll manage your risk effectively, as well as set yourself up for strong gains over time. With a system like this it is important, however, that you stick to the rules for each trade in order to gauge its overall effectiveness. We understand that eventually, as you gain more experience trading options you'll find ways to tweak the system so it suits your personal trading style, but in the beginning we recommend being very robotic about it. Decide on a trade size that you are comfortable with, and use that to make each trade, whether calls or puts, whether the market is rising or falling, and whether or not the stock is trending on Twitter.

We will continue to update WON progress here: WON Update