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Take Inventory - Then Build A Trading System.

Posted by Pete Stolcers on June 16, 2006

In today’s option trading blog I want relect back on my first days as a pro. I remember sitting in front of the screen and wondering – now what? Where do I start?

Successful traders have a systematic decision-making approach that they have refined. They follow the same steps time after time. Some have quantitative earnings models that end with a physical tour of the company. Others have software programs that identify pricing relationships and disparities. Others might have technical analysis filters that target inflection points. The list is endless, but ultimately, they all have a system. A standardized routine with a well defined beginning, middle and end exists.

Before you start your quest, take inventory and identify your trading style and expertise. Look closely at your successes and failures. What characteristics are common to all of the good trades? How about the bad trades? This process will help you recognize situations to seek and avoid. A trade log can help you with this step. At very least look at an end-of-month statement and try to recreate the scene. Once you “know” yourself the path will become clearer a sense of direction will result. You will be able to identify the required tools. Some may exist, some may need to be built. Here’s an example.

Two traders have “taken inventory” and both have expertise in the pharmaceutical industry. One trader may be very risk adverse and he develops a program that tracks the correlation of drug stocks and it identifies spread divergences. He executes his system by being long one stock and short the other. This is known as “pairs” trading. The other trader may be a risk taker with keen analytical skills. He develops a resource of medical journals that review recent breakthroughs. His tactic is to find biotech companies that could make it big. He scales into positions and knows that for every three that don’t work out, one goes up ten fold.

Here, two individuals have similar backgrounds and each develops a very different system. The point is, go with what you know and consider your strengths and tendencies. Determine your trading style before you take the first step.

This process could take days or years. The more systems and styles you have been exposed to, the better. The more “experimenting” you have done with real money, the better. Risk tolerance and trading style can only result from experience.

There are search, news and charting tools that can fit into your system and you don’t have to reinvent the wheel. However, don’t be drawn in by “black box” solutions that have all the answers. They don’t exist.

It is possible that you can identify with an existing system that someone else has devised, but it is rare. Take my system for instance. It works very well for me but I know what makes it tick. Amongst other things, it filters out bad set-ups that I have been tempted by in the past and it takes advantage of my chart reading skills. I’ll be the first to tell you, it’s not easy. For that matter, trading is not easy.

If you are trying to build a system or you have one that works for you, please share your experience.

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Option Trading Comments

  • On 05/03, Bill K said:

    I been selling puts on OTM options using excellent stocks that have been beaten down.
    They must have good sales margin must have positive earning reports with positive surprises far out numbering miss’s for the last three years but five is even better.
    It has been working but I also believe that we are in a unique market now. Do you think this will work in a normal or bull market in a bear market, it seams it would be risky am I reading this right. Let me state up front that i am a beginner and use mostly fundamentals and sell puts only on stocks I would buy and at prices I think are reasonable but then I might be reading these company’s wrong and if they have a wreck I could be a casualty.
    all comments are appreciated

  • On 05/07, Pete Stolcers said:

    Your approach is very sound, but since October 08, this has been the best period EVER for the strategy. Implied volatilities were at all time highs and if you picked solid companies, you did very well.

    The strategy works best in bull markets or flat markets that have found support after a decline. It does not work well when the market is falling. That’s why it is important to sell put credit spreads below a support level. That way you have a chance to see if the demand for the shares is still there. If support is broken, you have to buy back the spread and move on.

    Congratulations on your trades.

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