Keeping a trading diary
-An important part of your option trading education explained
Reasons for exit
This section specifies when you should get out of your position. Hopefully this is when the trade has gone your way and it’s time to take your profit. The absolutely final point at which you have to get out is your stop loss. There might however be reasons to get out before your stop loss or profit taking level is reached. I’ll get to those in a minute but first I want to say something about prices for stop losses and profit taking.
Some of your trades go well and others go badly. On top of this transaction costs sets you back a bit each time you trade. For your trading to be profitable in the long run I believe you have to make more on your profitable trades than you loose on your loosing trades. Very few of us are able to do so many profitable trades and so few loosing ones that that doesn’t matter (exception being that you only trade long stock positions and the market is in a long term upward trend during your whole trading life). If you trade options or futures you are bound to make loosing trades. This means you have to choose your stop loss and profit taking prices so that the potential profit is bigger than the potential loss. If in a particular situation this is not reasonable, it does not make sense to enter into a position. You need to wait till the situation improves. Personally I don’t enter the market if the potential profit is not twice as big as the potential loss. If I expect the market to move in a certain direction, I decide on reasonable price objective (the price where I will take my profit) and stop loss. If the profit is not twice as big as the loss, I wait. This means that some ideas don’t develop into good trading opportunities and I end up not taking a position.
There might be reasons for exit before your price objective or stop loss are reached. This is either if your reasons for entering the market are proven wrong or the market simply don’t behave like you expected it to. Let’s say you’ve entered the USD/EURO exchange rate expecting the USD to loose in value due to a long and costly war in Iraq. If the war comes to an end, you have been proven wrong and you need to get out of the market. This is an example of your trading idea in itself was wrong. It might also be that your idea is still valid but your general analysis is wrong. Imagine your bet is that the USD will weaken due to increasing budget and trade deficits. You expect these deficits to grow as the president increases spending and cuts taxes. After you’ve entered into a position, the president announces new tax cuts and new spending increases. This is all in accordance with your expectation. But, on these announcements the USD strengthens. This goes against your analysis. The market interprets these new differently than you thought it would. That proves your general analysis wrong and you need to close your position even if your stop loss is not reached. If you have a position in a market that has proven to you that you don’t understand it, you’re gambling.
Conclusions
Under this heading I write down what I learned. Remember that the diary is part of your option trading education. This learning doesn’t have to be very profound conclusions. It can also be small observations that are good to keep in mind. I’ve for example noticed that if I follow the markets constantly, I tend to trade more often than I should. As the trading platforms I use let’s me put in automatic profit taking and stop loss orders I really only need to follow the news and check the market from time to time. If I do take a position I write down the results and try to identify the reasons I made/lost money.