Last update: July 2021

At some point during a trader’s learning curve, they will undoubtedly encounter the idea of a trading plan. Achieving consistent results requires having a consistent approach. While shooting from the hip or “winging it” may require less effort, it is usually a recipe for disaster in the long run. Each trader should have some type of method to the madness, a rhyme and reason as to their timing, trade, and risk management. A systematic approach has helped me produce more predictable results.

While there are numerous ways to explain your plan and outline the decision-making process, one valuable tool I’ve found particularly useful with adjustment trading is a decision tree, such as the one displayed below.

Decision trees offer the ability to model potential trade adjustments based on changes in the underlying market. Since options trading can involve numerous trade tweaks if your stock rises or falls, this type of schematic helps organize your choices. You can outline the exact modifications you’ll consider to keep things straight in that big ol’ noggin of yours. In the tree highlighted above, I’ve displayed a Risk Rocket trade with various adjustments worth considering. The Risk Rocket involves buying 100 shares of stock and a call option. The idea is to grab a quick profit on the stock and then sell it, leaving the call option on to ride. A typical target is one ATR. If you want to make it easier for the one ATR of profit to pay for the accompanying call, then buy a shorter-term OTM option.

T1 represents the original trade, while T2 and T3 represent secondary and tertiary adjustments. For example, if the stock does, in fact, rise one ATR then we’ll sell it thereby adjusting into a straight long call position. If the stock increases further, then we could consider rolling the long call into a call spread, butterfly, or ratio backspread. Alternatively, if the stock tanks after we deploy the risk rocket, then we might sell an ITM call which rolls the long stock into a covered call position. The premium received from the short call will partially hedge the stock and, hopefully, provides the means for us to recoup our loss due to time decay.

The beauty of the decision tree lies in its flexibility, as it allows users the ability to create very simple or complex models. I’ve also found them quite useful from an educational standpoint. It’s more straightforward to show the potential adjustments traders can make at various points in a trade as opposed to explaining them.

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