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Many of the questions I receive, no matter how complicated the trade is, can be answered by going back to the basics of a complete trade from start to end. These steps are as follows:

1. Identify an Opportunity
2. Find a Low Risk Approach
3. Create a Plan
4. Take Action

I found that whenever I get confused about a position(s) and don't know how I ended up getting to point "C" when I was trying to get from "A" to "B," it is because I took my focus off the basics. The four steps I am mentioning can be used as a guide for every single trade you place, regardless of complexity or goal.

1. Identify an Opportunity

This is the most difficult of all of the steps as it is the one where you have to bring your own tastes and biases to the table. Do you like to sell vertical spreads to receive a premium? If you like to ride big trends then there is a different approach in looking for opportunities than that of a stagnant stock. Those who prefer Elliot Wave will most likely scan for candidates using a software package that will assist in the search. Some people have a handful of stocks that they prefer as they have been watching the names for years and feel they know like their children.

Others tend to gravitate towards indexes. As there are two types of risk, systematic and non-systematic risk, some prefer to eliminate the risk an individual stock has (non-systematic) by using indexes which move like the market as a whole (systematic). If you have ever been certain that the market was going to go up or down big and were correct, but lost money because the stock you chose didn't follow the market trend, then indexes can be very tempting.

Personally, I like to play the most bullish or bearish equity(s) for market direction plays and indexes for option selling strategies, BWBs, etc. This is a personal choice and not a recommendation as each individual has to trade what feels right to them.

Many new to trading get stymied at this step not knowing what name they want to trade and have no idea where to start looking for candidates, but most get stymied at the next step.

2. Find a Low-Risk Opportunity

For most people trading in the markets this is not even a step that they use. Most will simply buy a stock and hold it. Some will take an extra step and stop buy with their "Filled Order Verification" at their local house of worship and ask a special favor, but prayer is not considered by the SEC as a hedge. Still others will think they are hedged with their Stop-Loss order for protection, but have also learned the hard way that a stock stop-loss order is not always a perfect hedge.

Those understanding options have virtually an unlimited choice of strategies to chose from where they can literally customize their risk and reward characteristics. This is the POWER of options and the benefit you worked so hard to achieve a thorough understanding of.

Being bullish on stock XYZ is fine, but what do you trade? Yes, you can go out and buy the stock and hope it advances, but usually the second it is purchased it is at a lower price than where you purchased it and the sweating begins. Here is where the evaluation begins. You go out and compare the various strategies against what you think the stock is likely to do. Sometimes a long vertical, a short vertical a time spread or straddle may be the appropriate strategy. Other times you want to reduce risk as you are less certain about the probability of the trade's expectation/goal coming to fruition so you do not want as much "skin" in the game. Perhaps a BWB, gamma scalping or another strategy may be more appropriate.

Yes, when looking at the trade in hindsight you will often wish you had picked a different strategy. That is part of trading. I know a guy on the trading floor that has been married 7 times and all of those marriages that so blindly started out with high hopes ended with him looking back wishing he'd chosen someone else. That is life with trading, marriage (sometimes), etc., you will have to just accept this. Almost every trade I have ever made could have been more profitable (or less of a loss) had I picked a different strategy at the beginning. All you can do is make the best decision based on the information you have at the time the trade is initiated.

3. Create a Plan

This is perhaps the most important of all the steps. Almost everyone successful at trading has an entrance and exit strategy prior to hitting the "send button" to initiate the trade. They know that their absolute risk is $X. They are willing to risk $1/2X, so they have a stop loss or are watching the trade. When the trade gets to $2X, $3 or $4X they will get out at a profit. The key is discipline. You have to be disciplined if you want to be successful as a trader, but this is really where most people who fail error.

I have seen two types of traders: those who are successful and pay strict adherence to their loss exit points, and those who rationalize and lose. If you have ever had a trade lose a lot of money and you held on (against better judgment and beyond where you promised yourself you would get out) only to get bailed out and make money by sheer luck, you have the propensity to rationalize why this trade (that is melting in front of you) will also come back "just like 'JHK' did 6 months ago." Don't get caught in this trap.

I know of a couple of traders who never used technical analysis. They went into the pits unarmed with knowledge of hedging principles. They couldn't find north with a map and a compass, yet they make money seemingly buying and selling at random. The sole reason they made money, even though they didn't have a plan (or a clue) was because they used strict adherence to money management rules and their stop exit points. They were not smart enough to rationalize, so they didn't.

4. Take Action

Some people get caught up in the emotions of trading. They are looking in real dollars at how much they can lose if they are wrong, which creates a sort of paralysis. On the trading floor we call this an inability to "pull the trigger." This, in small quantities, is healthy. Fear is good as it prevents us from doing stupid things. I personally could use a larger dose of fear than I experience as I have been known to let greed overcome my fear, and the results were disastrous. But like anything in an overabundance, fear can sometimes prevent people from ever doing anything.

If you find yourself having problems "pulling the trigger," simply trade small contract size and scale up as your level of comfort increases. Do not worry about commission costs of trading only one contract of a spread and how those commissions will eat up a good deal of your profits; consider it a cost of education. It certainly will be less expensive than the 30 sessions of therapy you would otherwise have to undertake to get verbally desensitized and pumped up to take action.

Take action when it comes time to get out because of a loss. I know of many who once they are facing a loss get lock-brain and can't function. This happened to me one time while on the floor while I was trading with too much risk and it made me sick to think I was about to lock this loss in. I had a mentor of mine say to me, "Just close it out and if you still like the trade, buy it back in 30 seconds." Once I closed out the trade an 800 pound emotional anvil came off my shoulders and my ability to think again came back. Instead of feeling pain I looked at what I did wrong and began to see opportunity again. I did buy the position back (and lost even more), but now I could handle the trade as it was almost a new trade in my mind and the other one was behind me in the past.

In addition, sometimes taking no action is taking action. If you do not see a trade that makes sense to you, fighting the urge to do something, anything, is taking action. Sometimes fighting the urge to trade for the sake of trading requires more energy than actually trading, so it is action.

Lastly, when you have the time take action and learn a little more about trading. Take all the magazines in the bathroom and toss them. I know they are interesting and kill time, but they are not making you a better person or trader. Get a copy of your texts in the bathroom instead, or subscribe to a magazine like Stocks and Commodities. Keep learning. Sign up for a new class, buy a book. This is action. I was at a seminar in Chicago once and one dedicated student had taken a trip to France and spent the entire week in her hotel room reading options books. That is perhaps a little overboard as we all need a little break in life, but that is taking action, and I have no doubt of her future success.

Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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