Accredited Investing Education

How we develop a options trading plan

Video Transcription

My name’s Eric Hale. I’m a coach with OptionsANIMAL. Today, I’d like to share with you our approach to trading the market using options. One of the most
common characteristics that you’ll find among successful traders is that they do have a trading system or process that they use that helps them control
emotions.

The emotions of greed and fear and even hope sometimes can be very powerful and sway our biases and make us do things sometimes that are not smart. By
having an option trading system, it allows you to control your emotions and be more successful. What I’d like to do now is take the next few minutes and
review the approach that we at OptionsANIMAL use to trade options.

Our first step involves determining the direction. We determine the direction by doing three different types of analyses. We do fundamental analysis,
technical and sentimental analysis. Let me take a moment and explain what each one of these are.

Fundamental analysis involves using the financial information that’s disclosed typically on a quarterly basis by all publicly traded companies. This gives
us insight into the health of a company by looking at financial data such as debt and income and profit. We look at specific characteristics like debt to
income ratio and maybe price to earnings.

This information can give us an overall appreciation for where the company’s standing and help us determine a potential valuation of the company. Based on
that, we can use the fundamentals to determine a bias of where we think the company might trade in the future. We don’t just use fundamental analysis
alone. It goes hand-in-hand with the second type, and that’s technical analysis.

Technical analysis involves using the price action of an equity. We look at things like 52-week range, the high and the low. We look at technical
indicators such as exponential moving averages and the cross-overs of those moving averages. We also look at things like the RSI, or the Relative Strength
Index, or the MACD, also known as the Moving Average Convergence-Divergence, and Bollinger bands.

These things can all help give us an indication. Of course, those along with trend lines and level support and resistance, can help give us an idea from a
technical standpoint on where the stock has traded in the past, and help us develop a sentiment of what the stock might do in the future.

The third and final analysis involves information that’s really exclusive to options traders for the most part. One of it involves looking at where traders
are putting their money with regards to buying calls. We can look at the volume and open interest on calls and puts. Calls are generally used when a
trader’s bullish, and puts are generally used when a trader’s bearish. By looking at the put-call ratio for both the volume and open interest, we can help
get an idea of whether traders may have a long-term bullish or bearish sentiment.

Another aspect that’s completely unique to options traders is the ability to look at these volatility indices. This right here is a recent snapshot of the
Chicago Board Options Exchange Volatility Index, also known as the Fear Index or the VIX. This utilizes … well, it’s a calculation that’s done based on the
options on the SPX. The SPX is a symbol for the cash-settled options on the S&P 500. By looking at the pricing of different options across different
strikes and months, we’re able to do a calculation and determine what’s called a volatility indices, or volatility index.

People who study the VIX know that you tend to see low points in the SPX when you see high points in the VIX. High VIX would indicate a fair degree of fear
in the market. It’s helpful for us to look at things like the VIX to get an overall indication of the market, but these indices, very powerful indices, are
also available for equities. Now, this is an example of what’s called the CBOE VIX on Apple, and this is a volatility index that is specific to Apple. It
does the same sort of calculation that’s done on the SPX, but only for the Apple AAPL stock symbol.

Now, the CBOE posts a few of these, but there are other sites, other places and other sources to get this sort of information. For example, your broker
might have it, or you can go to some websites such as Livevol.com or IVolatility.com. They have similar, different, but similar sort of indices that give
us a feel for the market’s overall fear or sentiment on a particular equity.

We put these three things together, fundamental, technical and sentimental analysis, to determine a direction. Then once we have a sentiment, our
direction, we look at the different possible trades. Generally, stocks can either go bullish, they can bearish, or they can go stagnant. Of course,
stagnant trades would be going sideways, but also trades can be explosive, meaning that they could make a pretty big move up or down. We’re just not sure
which.

Basically, one of these … actually, not even one of these. Sometimes you might thing that a stock’s going to be bullish or stagnant, or bearish or
stagnant, or bullish or explosive. Depending on which two strategies … In fact, we tell you, it’s pick two strategies, one or two, and then you have a
number of different possible trades. Let me show you.

We have over 20 different strategies that we teach at OptionsANIMAL that can be used to take advantage of any trend that a stock can follow. They start
with the basic and simple long call and long put, or you could add both the long call and the long put and create either a straddle or a strangle. That
sort of a strategy, the straddle or strangle strategy, takes advantage of an explosive move in an equity. You know that it’s going to move up or down.
You’re just not sure which.

Then there’s also the stock-based strategies. Of course, there’s the buying just long stock or the covered call, or protective put, sometimes known as the
married put, along with the collar trade. Those different strategies can be very powerful and involve owning the equity itself.

Then we have the vertical strategies which involve the bull call, the bear call, and the bull put and the bear put. Those generally take advantage of a
direction. Actually, a couple of those on there can take advantage of a stagnant trend as well. If you know a stock’s going to go up or sideways or maybe
even a little bit down, a bull put might actually be a good strategy. Or maybe you knew that a stock was going to go down or sideways or maybe a little bit
up, the bear call could actually be a good strategy. Take advantage of multiple trends.

Then, of course, we have the calendar trades, and then there’s some more advanced trades that can be used for different purposes. Nonetheless, you
determine which strategy you think’s going to work, and then you need to determine how many contracts you’re going to use, what strikes and what months
you’re going to use, and determine the strategy that works best for you.

Once you’ve looked at the particular strategy, you need to determine the exit points. This is probably the most important part of this process. That is to
first determine your primary exit, which is where are you going to take profits? Whether it’s 5% or 20% or 100%. Whatever your definition is, that’s where
you take profits. Oftentimes, I hear students say, “Hey, Coach Eric. I was going to do a trade. I wanted to get a 20% growth, and now my trade’s up 20%,
but I’m still thinking the stock’s going to continue in that direction. What should I do?”

The answer is always the same. It’s follow your trading plan. If you’ve hit your primary exit, you close the trade and then do another trade. The only time
that I say that it’s okay to stay in the trade you’re in is if the very next trade that you do is exactly the same trade you’re in. Chances are that it’s
not, because time’s gone by, and the stock’s moved. If you’re going to do a new strategy, you would take advantage of different strikes and different
months.

Your primary exit, you follow your primary exit, because all too often what happens is, it’s gone up, it’s gone up, and then all of a sudden you wait, and
then it goes down, down, down, and then you find yourself going in the shoulda, coulda, woulda phase, right? Once you hit your primary exit, you take your
profits and you close your trade. If you’re still bullish, great. Do another strategy.

Now, what’s even more important than the primary exit, believe it or not, is the secondary exit. That is, what are you going to do if the trade goes
against you? Are you going to take a loss, and how much? We at OptionsANIMAL differentiate ourselves by being able to take stock trades that are losing and
turn them into winners. The reason we do this is because we define our trading plan ahead of time. What a lot of traders come to realize is that the
secondary exit’s main fact actually requires significantly more capital.

Now, an analogy that I like to use would be, imagine being a pilot who’s flying from New York City to London. You’re flying across the Atlantic. How much
fuel do you put in the tank? Do you put enough to get you just from New York to exactly London? Of course not. You don’t do that. You’re going to think
about, what’s happening with the headwinds? Is there weather that’s coming that possibly could divert you? You’re going to make sure that you have enough
fuel in the tank to follow through on a secondary exit.

Of course, you hope everything goes okay, and you’re able to land exactly where you thought you were. Using another analogy is the weather. If there was a
40% change of rain, would you bring an umbrella? Would you still have your picnic? Well, maybe you would, but maybe you want to bring a tent or something
or a canopy. That’s exactly what we’re talking about here.

By the way, those sort of numbers actually work out well, because we can actually define exactly the probability that we want on different trades. Yes,
when you buy a stock you get a 50% chance of it going up or down, but there are strategies that we use where the probability can be in the 60, 70 or 80%
chance of the trade working in your direction.

Now, if you have a 60% chance of a trade working for you, that means most of the time it will work, but there’s still a 40% chance the trade won’t work for
you, and that’s why you must define your secondary exits. If you can’t follow through on your secondary exit, you need to go back to Step Two, and pick a
different strategy.

Once you determine that you’ve got a strategy that gives you the profit profile that you want and has a secondary exit that you can follow through on, the
next step is pretty simple. Then you place the trade. You send the order to your broker. The order gets filled. You follow through the next phase, and that
is doing the monitoring and adjusting. When you hit your primary exit, you adjust the trade.

When you identify the strategy is not working and the stock is taking a new trend, then you monitor and adjust according to your trading plan, which you
defined already. Then you go back to Phase One, and you do the whole process again.

That, in a nutshell, gives you an overview of how we at OptionsANIMAL teach our students how to trade. If you want to learn more, check us out on
OptionsAnimal.com, and we’ll be happy to show you more insight into this. Thanks for your time.

Eric Hale
OptionsANIMAL Instructor

Options Trading Resources

option course * learning to trade options * options trading 101 * learn trade adjustment online * trading education * options trading example * options trading firms