Where P(winning) is the probability of winning and P(Losing) is the probability of losing
Going forward I’ll refer to Expected Outcome as “EO”If we break down the equation, we see that it is made up of five components: EO, P(winning), P(losing), the average winning trade amount, and the average losing trade amount. In order to improve our trading, we need to focus on changing the things we can control in the markets. Assuming the direction of the market is something we can’t control, we’re left with three things we can control: the probabilities of our system (through system design) and the average loss. In general, we have no ability to control the average win, however, you can estimate it based on your historical results.
Now that we theoretically know where we’re coming from, here is how we can directly apply that knowledge to our options trading:
#1 and #2 – Improve the Probability of Winning or decrease the probability of losing: There are a few ways to influence the probabilities in your trading, but they don’t always have positive outcomes. The probability of winning can be increased simply by taking profits more quickly. Unfortunately, quick profits sometimes barely cover commissions and don’t cover up the losses as well (especially when the losses get out of hand). Another way to influence probabilities is to increase the duration of your trend filter. Theta Trend recommends using an ATR trailing stop equal to roughly 3.5 ATR. If you use a longer time period (say 5 ATR), you end up with a system that has fewer whipsaws and may result in a higher winning percentage.
#3 This is the easiest way to improve your EO: Control your losses, control your losses, control your losses.
#4 Bonus Idea: Improve the average winning trade. I realize that this seems impossible to do at time, however, it can be done. There are a few ways to improve the average winning trade including selling a wider spread with more premium, selling naked options for more premium, selling closer to the money for more premium, and holding the spreads longer to capture a higher percentage of the premium.
Hopefully that gives you a few ideas to improve your trend following options trading. Be sure to check out the full Theta Trend system for free on the Start Here page. Enjoy.