Setting Limits

Last month

Last month I talked about the importance of setting limit orders when trading with our option investing strategies.  Limit orders are the means by which traders strategically lock in profits as soon as the market offers them.  Carefully placed, limit orders put traders in a proactive position and generate the highest probability for producing profit with every trade.  With the virtues of this important tool well established; it is time to turn our attention towards the obvious next question:  How do traders determine where to set limits?

Learning how to set limits

Every time Options-Intelligence recommends a trade the outcome is recorded into a database.  As of this writing our database now has the results of over 2100 option trades spanning just over 8 years of market activity.  With the results filter and statistics box found on the option trading history page, traders can utilize this data to find the historical, statistical probability for any trade to reach the result they are hoping to achieve.  This important metric, referred to as the winning history, helps traders determine where to place their limit orders for any trade they enter.

Finding the winning history for a trade is really quite easy, simply set the parameters in the results filter to match the trade and click the “Apply” button.  For example, if Options-Intelligence issues a Core Options Trading Strategy play for QQQQ, we would need to set the results filter to the following:

  1. Type: Core Strategy
  2. Month: Blank
  3. Year: Blank
  4. Symbol: QQQQ

This will limit the results, removing any trade that does not match the settings provided.  Additionally, the statistics reported in the statistics box, including the winning history, will now be calculated by using this subset of trade data.

By default, the website counts winning trades as those that achieve at least a 1% return, which provides traders with the historical, statistical probability for the trade to return any positive gain.  In this case, the winning history for any QQQQ trade issued from the Core Options Trading Strategy is currently 90.7%.  This means 9 out of every 10 Core Options Trading Strategy trades issued for QQQQ have achieved a positive return and that 1 out of every 10 was a losing trade (failed to achieve a positive return).  While this number serves a strong indicator of the general success of these trades, we still need more data to determine where to set our limit orders.  To get this data, we are going to manipulate how the website determines which plays it counts as winners.

By raising the number in the “Win %” field, the website will reduce the number of winning trades used in calculating the statistics found in the statistics box.  Incrementally raising this number and recording the effect on the winning history indicates the probability for success using different limit levels.  Working with the example of QQQQ trades issued from the Core Option Trading Strategy currently produces the following:

Win %(required gain to count as winning trade) Winning History(historical, statistical probability to achieve win %)
10% 86.05%
15% 83.72%
20% 82.56%
25% 81.40%
30% 80.23%
35% 74.42%
40% 68.60%
45% 67.44%
50% 65.12%

Armed with this data, we can clearly see that the key to determining where to place limit orders is merely a function of finding a comfortable level of risk and reward.  Perhaps the best way to discover the right balance is to consider the risk (winning history) and reward (win %) in a real world manner.  Rather than thinking of the winning history in terms of percentages, consider the effect on 10 trades.  Again, working with our example:

  • For limit orders at or below 30%:  These trades will win 8 out of 10 times
  • For limit orders above 30% and below 40%:  These trades will win 7 out of 10 times
  • For limit orders above 40%:  These trades will win 6 out of 10 times

In my own analysis of QQQQ trades issued from the Core Options Trading Strategy I found that 30% limit orders offered me excellent reward (30% returns) at the right level of risk (2 out of 10 losers).  I found that using 30% limit orders instead of 25% had a marginal effect on reducing the winning history; however, moving to 35% from 30% dropped the winning history dramatically.

There are some important caveats that must be mentioned when using this method:

  1. Make absolutely sure that the number of trades is high after you set the results filter to match your trade. You do not want to base your limit orders on the statistical analysis of fewer than 20 trades as this could cause the data to be skewed.
  2. Although, it continues to work like a charm for me, I am legally obligated to indicate the following words of caution: This method is based on historical data which is not a sound indicator of future performance.
  3. Always use your own judgment when entering trades. Every time I trade QQQQ with the Core Options Trading Strategy I always consider other factors before opening a position and setting my limit orders. Never forget to take a look at the political, economic, and emotional factors that are at play when entering a position.

Next month

With the method behind the madness of setting sound limit orders out of the way I want to sign off with a warning and a preview of my topic for next month:  There is one tool in the trader’s arsenal that can quickly undermine the research and effort spent on placing limit orders.  This over used, over appreciated, oft relied on order is designed to protect traders from loss but more often than not merely prevents them from taking in profits.  I am of course talking about none other than stop orders.  Ready for a shocking reveal?  I don’t trade with stop orders, yet I still manage my risk. Sign in next month and I will spill all the juicy details.

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