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An options trading system, much like any trading system, is composed of individual elements that are combined to achieve a final objective. The objective of an options trading system is simply to create a profit. The elements of a trading system are money management, risk management and the trade itself. The different types of options trading system can be considered twofold: one based on specific rules and analysis and one based on the trader's judgment, which isn't really a system at all.
The trade is composed of an entry and two possible exits. One exit is in the case of a profitable trade or a win. The other exit is in the case of an unprofitable trade or a loss.
An options trading system might involve a combination of buying or selling puts and calls, which is referred to as a complex option trade. The system might include the trading of options combined with the trading of the underlying asset. These underlying assets might include stocks, commodities or currencies.
The options trading system might also include the trading of options combined with the trading of inversely related or non-related options or assets. The configuration of the trade is unlimited. The most commonly traded option systems are related to the stock market.
The opposite of systematic trading is discretionary trading. This is where the trader relies on judgment about future market direction and trade entry and exit points. The advantage of systematic trading is that emotion and poor judgment are no longer factors. The options trading system itself dictates the rules of entry and exit. The elements of money management and risk management are determined before a market position is opened.
Options trading systems begin with the development of money management rules. These rules are based on account size. A common rule of thumb might be to risk no more than 5 percent of the account value on any one trade. Many traders prefer to risk no more than 2-3 percent per trade.
An example of this might be a trader who has an account value of $10,000 US Dollars (USD) of risk capital. In this case, the trader would risk no more than 5 percent, or $500 USD, per trade. Money management rules are followed on every trade. There is no place for discretionary trading within a system.
Options were created as risk-management tools. Risk management is a built-in factor when it comes to an options trading system. Options are complex derivatives. Knowledge and experience are necessary to navigate this complex market.
Entry and exit signals are commonly created through the fundamental or technical analysis of the underlying asset. Many traders use both fundamental and technical analysis. After the underlying asset has been analyzed and a decision has been made on the entry and exit points, the options available on the asset must be analyzed as well.
Option analysis would begin with the options chains. The options chains provide a wealth of information about the current price, volume and open interest of each contract available on the underlying asset. Next might be a study of the option Greeks: delta, gamma, theta and vega. These variables will enhance trading decisions. Finally, an implied volatility study might be necessary to determine whether it is an opportune time to buy or sell options.
All of these factors might be taken into consideration when an options trading system is developed. After the system has been created, back testing and forward testing, also known as paper trading, might be in order. When the elements of the trading system have been compiled, the trader will have a good idea about probability ratio and risk/reward ratio.
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