Getting entries (and exits) right is one of the most important things when it comes to options trading or trading in general. Even with the best adjustment techniques, you won’t be able to make back what you lost from a bad entry. Therefore, your focus should lie on making the best possible entries. This can’t be said often enough. In the following article, I will walk you through everything you need to know about opening and closing positions.
Before you are ready to send out an actual entry order, it is important that you set up and potentially analyze your position first! Regardless of your trading system, you should always review potential trades before putting them on. Never just jump the gun!
One very important aspect of preparing for a potential trade is creating a trading plan! Here is a list of some essential parts that every trading plan needs to have:
- Define your risk: Before opening any position, you should always define your risk. An appropriate risk level is a point from which on the odds of your potential position no longer are on your side. It is very important to set this risk level before you enter the trade, otherwise, you won’t be able to do this objectively.
- Define your reward: It is just as important to define your reward as it is to define your risk. Not doing this often leads to the common trading error of letting a winner turn into a loser. If you never take profits and just want to ‘let the winner run’, you will very likely let it run all the way into a loss. Don’t let this happen to you! Always set profit targets and stick to them.
- Define your risk/reward: This shouldn’t be too hard after you have defined your risk and reward. Having a good risk to reward ratio can be important, especially in stock trading. However, it isn’t the only factor to consider. In options trading, the probability of profit (POP) should be considered as well. If you have a very good probability of profit on a trade, your risk to reward ratio probably won’t be the best. But that’s okay as long as the POP is good enough. But in stock/Forex… trading, your risk to reward ratio should usually be at least 1 to 2 (risk 1 to make 2).
- Define your exit: You should ideally create a concrete exit plan before opening a position. This exit plan should tell you how you will close your position. Two possible variations here are: closing the entire position at once, legging out of the trade (closing position in 2/3/4… steps). Alternatively, you could decide that you want to adjust your position if certain predetermined criteria are met.
- Define your position size: This step is extremely important and sadly a great number of traders trade way too big. Ideally, you should never risk more than 1-5% (1-10% for very small accounts) on a single trade. With risk, I do not mean allocate. You may very well allocate over 5% on a single trade. But you should not risk more than 5% on one trade. No matter how good of a trader you are, you will not win on every single trade. You will always have losers. Therefore, it is important to diminish the risk of blowing up by trading small. You never know when your next loss will happen. If you risk 100% of your account capital on one trade and that trade ends up being your next loser, you will lose all your money at once. You should never risk this disaster!!!
- Define your entry price: Another major aspect of a trading plan is the desired entry price.
I can’t emphasize the importance of a trading plan enough. Trading without a plan and thus without defining your risk/reward/position size… can be quite dangerous. A trading plan allows you to objectively define your edge. As soon as you open a position, it will be very hard (close to impossible) to think and judge your trade completely objectively. Therefore, it is very important to create a trading plan BEFORE entering into any trades. Doing this will allow you to trade much more mechanically and diminish the influence of your emotions on your trading decisions.
Furthermore, a trading plan is the only way to make sure that you are actually trading with your edge. If you have a certain set of criteria (aka. your edge) that you always trade after, you can get a good idea of how good your strategy is working. But if you only pay attention to your trading edge half of the time, you won’t be able to monitor the effectiveness of your trading style/edge. If you purely trade with your edge in mind and always have a good trading plan, you will get direct feedback on if your edge is working or not. A (big enough) set of losing trades will tell you that the edge isn’t working as intended and winning trades will do the opposite.
However, if the reasoning for your trades is inconsistent, then so will be your results. A (big enough) set of losers won’t give you an idea about the effectiveness of your trading system if you are only using the system on some of your trades.
So make sure to always have a trading plan before you open any positions!!!
First, after you have defined all your trading aspects, you are ready to actually send out an entry order.
But just as important as having a plan, is actually sticking to it. Traders should always be disciplined, stick to their plans and avoid improvisation. Further down in this article, I will present a few order tricks that can help you with sticking to your plan.
A Brief Note on Liquidity
Before we get into specific entry and exit orders, I just want to emphasize the importance of liquidity one last time.
Liquidity is by far the most important aspect of trading. Without liquidity, there is no market! Liquidity is the ability to easily enter and exit positions in assets. Liquid assets usually have huge volume and a lot of open interest (more on that further down).
The Bid/Ask spread is the spread between the highest price that someone is willing to buy an asset for and the lowest price that someone is willing to sell for. The more liquid an asset is, the tighter this Bid/Ask spread becomes. A 1 penny wide Bid/Ask spread is obviously much better than a $1 wide Bid/Ask spread. I want to show you the impact of a wide Bid/Ask spread on an illiquid asset with a brief example:
Let’s say you normally don’t trade very liquid assets and thus the Bid/Ask spread for a typical trade of yours is $0.5. Furthermore, you normally trade 100 shares/contracts. This means that you lose about $0.5 (per share/contract) because you have to buy at the Ask price and sell at the Bid price. So per usual trade, you leave about $50 on the table just because of a wide Bid/Ask spread. Now let us say, you make around 100 trades in a year. This would mean that you leave about $5000 on the table just because of wide Bid/Ask spreads alone! $5000 without even considering the costs of commissions and losing trades.
As you can see, trading illiquid assets is a fatal trading mistake. Always make sure to only trade liquid assets with very tight Bid/Ask spreads.
Trading liquid assets won’t only save you money, it will also save you time because you usually are filled much faster on them. Often, you can even get filled at the mid-price on very liquid assets.
Hopefully, this convinced you to only trade liquid assets in the future!
How to get filled faster:
Waiting for fills can be annoying. But before you change your order price, I recommend having some patience. As long as you aren’t trading on a super short-term basis, you don’t have to rush into the next position. Just give the market some time to move in your direction. I often send out an order slightly above the market and then go do something else. You don’t have to sit in front of your computer screen and wait to receive the fill (as long as you aren’t trading for the very short-term).
Here are a few helpful tips to get filled faster (mainly for options trades):
1. You may have noticed that not all options on an option chain have the same volume/open interest. Some strike prices have much more volume than others. It can be a good idea to choose these strike prices to receive faster fills at better prices. However, only do this if the strike prices fit the setup of your overall strategy. Don’t adjust your entire strategy just to pick strike prices with more volume.
Here is a screenshot of the different volume of different options:
2. *Try to leg into trades. Instead of sending out an open order for your entire position, you could try to break the position into pieces. For example, for iron condors, you could open the call side and the put side separately. But note if one of your sides receives a fill, you are exposed to additional directional risk. If the underlying price moves a lot, the price of the other side of your trade may change as well. This can impact your initial entry target price negatively (or positively).
3. *Besides, splitting up the different legs of your trade, you could also split up the contract size. For example, instead of ordering 100 contracts at once, you could order 50 contracts twice. Alternatively, you could split up the order even more. But if you can’t receive fills at the desired price, you may end up only having a fraction of your planned position.
4. Place your orders at round numbers. Placing orders at round numbers can often help with receiving fills faster. For example, instead of ordering at $1.49 or something similar you could try to order at $1.50.
*Only if your broker fees are per contract. Don’t do this if you have to pay a commission for each order.
Definitions of Order Types and other Important Terms:
When your broker successfully executes an order, that order is considered filled.
The total amount of shares/contracts traded over a given period of time (usually one day). This shows how active a market is.
The number of outstanding option contracts that weren’t closed yet. This usually indicates how deep a market is.
The price for the last bought contract. This is a good way to get an idea of what orders are getting filled, especially for wide Bid/Ask spreads.
GTC (Good Til Cancel)
If you select GTC when ordering, your order will run until it is filled or you cancel it manually. Brokers often cancel these orders automatically after very long times (e.g. half a year).
GTD (Good Til Date)
A GTD order works just like a GTC order with the only difference being that it will be canceled at a certain, predetermined date (unless the order is filled or you cancel it manually).
If you choose DAY when ordering, your order will run until the market closes that day, except if you get filled (or cancel it) before that.
EXT orders are orders that also work during extended hours (pre-market and after-hours).
There are different ways to enter/close positions. Try not to mess these up:
- Buy to open – Sell to close (Long)
- Sell to open – Buy to close (Short)
Most brokers allow you to select a closing order when exiting trades. Try to always do this if available. This will diminish the human error of accidentally choosing the wrong exit order type.
Order for one specific price. If the price won’t drop/rise to your set price, you will not get filled.
Orders at the next available price. This is the fastest way to get filled, but the pricing probably won’t be good.
As soon as the market price reaches one custom set price, you will get filled at the next available price.
The same as a stop order but instead of getting filled at the next available price, you can choose a certain price.
A stop order that moves up with the market price, but not down (for long positions). A stop order that moves down with the market price, but not up (for short positions).
Trail Stop Limit
A stop limit order that moves up with the market price, but not down (for long positions). A stop limit order that moves down with the market price, but not up (for short positions).
Market on Close (MOC)
A market order that is sent out as close as possible to the market’s close.
Limit on Close (LOC)
A limit order that is sent out as close as possible to the market’s close.
More advanced orders exist as well. These more advanced contingent orders allow you to set a lot more criteria than other orders. You can even create order chains that are triggered if your pre-set criteria are met. There are multiple advanced orders. Some examples are: The fill of one order triggers new orders, the fill of an order will cancel other outstanding orders…
These more advanced orders can be especially useful for traders with little time. These orders basically allow you to automate some of your trades from open to adjustments and exits.
But sadly, not all brokers have these more advanced order types available.
I personally recommend limit orders over market orders. Limit orders let you choose your own price and they make sure that you will receive good pricing. Sometimes you won’t get filled at this good price, but that’s still no reason to enter a position at a bad price. I’d rather risk not getting filled than risk getting filled at bad prices.
If you found these brief explanations of order terms useful, I highly recommend picking up my free trading glossary. In it, you can always look up unknown trading terms on the fly.
Exit Levels, Stop Losses and Closing Trades Early
It is very important to take profits! Taking profits actually increases your probability of profit and thereby your win-rate. Even though it might seem counterintuitive, it is actually quite logical. If you take off a winning position, it is a guaranteed winner. If you leave it on, there still is a chance that the trade will go against you and end up being a loser.
To prevent this from happening, it is important to take profits when you have them! Don’t let them turn around. Believe me, the feeling when a nice winning position turns around to become a loser is one of the worst feelings. Therefore, always take profits.
In options trading, I rarely recommend trying to achieve max profit (if there is a max profit). For most overall short option strategies (e.g. short iron condors, short strangles, credit spreads…), 50% of max profit is a very good profit goal.
Taking losses, on the other hand, is a totally different story. Most people say that you should always cut your losses short. This is true to some extent. But cutting losses as soon as a trade goes against you isn’t always the best idea, especially in options trading.
The same concept of taking profits to lock in profits applies to cutting losses. If you take a loss, it is a guaranteed loss. However, if you leave it on the table, it might still turn around and become a profitable position. Due to this, it is important to not cut losses too fast. But this is only possible if you defined and accepted your risk beforehand.
For example, defined risk option trading strategies allow you to easily leave losing positions on until shortly before expiration. You can’t lose more than a certain amount on these positions anyway, so instead of locking in that loss, you might as well wait and hope for a turnaround.
For other positions that don’t have limited downside risk (e.g. undefined risk option strategies, stock trades etc.), you should set a max risk level before entering and then stick to it. You may use stop-losses to do so. But don’t set the stop-loss too close to your entry point as you otherwise, likely will get stopped out too early. (For strangles, straddles and other undefined risk option strategies, a risk level of about 2x of the collected credit could be used).
Just make sure to define and fully accept your risk before opening any positions.
To trade more mechanically, you could/should use special orders like stop-losses, GTC and other orders. I normally send out a GTC order at my profit target (usually 50%) directly after one of my option positions gets filled.
This will automate the profit taking process and eliminate the influence of emotions.
Furthermore, you could use alerts as triggers for adjustments or exits. If your broker provides contingent/advanced orders, you could also use them to automate your trades.
Don’t Forget To Grab A Free Copy Of My Trading Glossary!