I’m an Accountant by trade and, as a result, I love trying to make sense of numbers.  One of the reasons trend following trading is very appealing to me is that the philosophy is based entirely on numbers.  Specifically, trend following works because profitable systems have a positive expected outcome despite having a very low winning percentage.  In some cases, trend following systems have a 40% win rate and still make money (I know because I trade one of those).While I think of my options trading as trend following in nature, there are some significant differences between trend following with options and pure vanilla trend following systems.  The two biggest differences between trend following with options and pure vanilla trend following are that the maximum win is capped (because I’m short premium) and the expected win rate is higher.  Before we get too much further, let’s take a look at the expectancy equation:Expected Outcome = P(winning)*Avg\$Win-P(losing)*Avg\$Loss
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.