In general, there are two types of option trading systems: discretionary and mechanical. A discretionary option trader follows no set rules but chooses, enters and exits an option transaction using all of his expertise or gut feeling. A mechanical option trader is one who applies objective rules to his knowledge of stock selection, entry, and exit. Typically, this system is turned into a computer program to fully automate the option trading system. The obvious benefit of automated option trading is the elimination of human emotions from the trading process, which reduces human errors.
I shifted from discretionary to mechanical option trading years ago and only started becoming consistently successful in option trading when I established my personal mechanical option trading system called the Star Trading System.
So, what are the necessary procedures to design your own automated trading system for option trading? Here is a guideline…
The Stock Market
In order for a stock to qualify as a candidate for option trading, enumerate all of the conditions you believe must be met. Ensure that all of these criteria can be measured. Example: a. last closing greater than $10; b. last price increase over the previous three days d. PE must be favorable. Finally, create a charting software with these criteria so that you may execute a scan of all stocks that qualified within seconds everyday. Advancements in technology have made it feasible to screen stocks in mere seconds. Previously, traders had to spend hours comparing each stock against a spread sheet to identify trading candidates.
Option Selection Methodology
After selecting a stock, you must evaluate whether option qualifies for your option trading strategy. Your individual option trading technique could be based on OTM options, ITM options, or even bullish or bearish spreads.
Now that you’ve selected which stock to monitor and which option to purchase, it’s important to establish the criteria under which you’ll make the decision to buy. It may be as simple as entering at the opening of the market or as complicated as observing the underlying stock’s movement for a predetermined period of time prior to entry. Whatever it is, it must complement your individual style of option trading.
Now that you have an open position, you must decide what conditions must be met for you to take profit or place a stop-loss order. You must establish two distinct types of exit procedures: Stop Loss and Profit Taking. Stop loss in option trading may be based on a simple percentage loss of the option position or on a percentage loss of the underlying stock. Profit-taking can be determined by either the stock’s target price or a percentage gain on the option position. After that, you would want to determine how your broker can automate this process for you. People frequently violate their own stop-loss or profit-taking points owing to emotional engagement; as a result, several brokers offer capabilities that automate very complicated stop-loss and profit-taking algorithms. If your broker does not support such automation and you are unable to properly implement your own stop loss or profit taking strategy, you may wish to transfer to a broker who does.
Now, name this option trading method and paper trade it for a minimum of six months. Do not expect to succeed on the first attempt. Developing a lucrative method for trading options requires time, knowledge, and experience, and cannot be rushed. It took me years to develop my Star Trading System to the point that even novice traders can follow it easily and consistently win.
Enjoy turning your option trading theory into an option trading method and observing its performance. Whether or if the system is profitable, I have no doubt that the experience will be immensely rewarding.