Rules vs. Discretion — Where the Journal Lets the Trader Decide

The journal's playbook is built around the principle that mechanical rules produce more consistent outcomes than discretionary judgment. The principle is not original to the journal; it is the same principle that underlies the algorithmic trading literature, the checklist movement in medicine, and the playbook approach in sports. The journal's playbook is the trader's equivalent of a checklist: the rules are the steps that the trader follows on every entry, and the discretionary judgment is reserved for the situations where the rules do not apply.

The rules in the playbook

The playbook's rules are mechanical. The rules are designed to be applied to every position without exception, and the rules are designed to produce the same outcome every time they are applied. The journal's most important rules are:

1. Position sizing. Every position is sized to 2% of NLV (or 1% for the iron butterfly, the diagonal, and the risk reversal). The sizing is mechanical: the structure's max-loss divided by 0.02 × NLV.

2. Strike selection. Every position's strikes are chosen based on the playbook's rules for the specific structure. The playbook's strike selection rules are mechanical: the long strike is at-the-money, the short strike is at the price target, and the wing width is chosen based on the expected move.

3. Expiration selection. Every position's expiration is chosen based on the playbook's rules for the specific structure. The playbook's expiration rules are mechanical: 30-45 DTE for short-premium structures, 60-90 DTE for long-premium structures, and 30-90 days of spread for diagonal structures.

4. Target and stop. Every position's target and stop are chosen based on the playbook's rules for the specific structure. The playbook's target rules are mechanical: 50% of max-profit for short-premium structures, 50-100% of max-profit for long-premium structures, and the 50% of max-loss stop for debit spreads.

5. Adjustment rules. Every position's adjustment rules are based on the playbook's rules for the specific structure. The playbook's adjustment rules are mechanical: roll forward when the underlying is moving toward the short strike, roll out when the underlying is moving against the short strike, and close the position at the target or stop.

The rules are the foundation of the playbook. The rules are applied to every position, and the rules are designed to produce the same outcome every time.

The discretion in the playbook

The playbook's discretion is reserved for the situations where the rules do not apply. The discretion is the trader's judgment about the specific situation, and the discretion is documented in the trade log entry. The journal's most common discretionary decisions are:

1. The probability adjustment. The journal's expected value calculation includes a probability adjustment based on the directional bias. The adjustment is discretionary: the journal's rule is that the adjustment is at most 10% in either direction, but the actual adjustment is based on the trader's judgment about the strength of the directional bias.

2. The size exception. The journal's sizing rule is 2% of NLV for most structures, but the journal has the discretion to size a position smaller if the structure's risk profile is more complex than usual. The discretion is documented in the trade log entry.

3. The strike selection for unusual markets. The journal's strike selection rules are mechanical, but the rules do not cover every market condition. The journal has the discretion to choose strikes that are not in the playbook's rules if the market is unusual (e.g., a major event, a sharp volatility spike, a sector-specific move).

4. The adjustment decision. The journal's adjustment rules are mechanical, but the rules do not cover every adjustment scenario. The journal has the discretion to choose an adjustment that is not in the playbook's rules if the position's situation is unusual (e.g., a wide bid/ask spread, a low-volume option, a significant gap in the underlying).

The discretion is the trader's judgment about the specific situation, and the discretion is documented in the trade log entry. The journal's rule for discretion is that the discretion is reserved for the situations where the rules do not apply, and the discretion is not used to override the rules.

Why the discretion is reserved

The discretion is reserved for the situations where the rules do not apply because the rules are the foundation of the playbook's consistency. A trader who uses discretion to override the rules on every position is a trader who is not following the playbook, and the trade log is not a record of the playbook's outcomes.

The journal's view is that the rules and the discretion are both necessary, but the rules are primary. The rules are the mechanism by which the playbook's edges are exploited consistently, and the discretion is the mechanism by which the playbook is adapted to unusual situations. The journal's process discipline is the mechanism by which the rules and the discretion are separated: the rules are applied to every position, and the discretion is reserved for the unusual situations.

The journal's rule for the discretion is that the discretion is documented in the trade log entry. The journal does not tolerate undisclosed discretion: every discretionary decision is recorded in the trade log, and the position-level review identifies the discretionary decisions. The journal's process discipline is the mechanism by which the discretionary decisions are reviewed and the playbook's rules are revised.

The line between rules and discretion

The line between rules and discretion is not always clear. The journal's experience is that the line moves over time as the methodology is refined: a decision that was discretionary becomes a rule as the pattern emerges, and a rule that is not producing the expected outcomes becomes a discretionary decision pending revision.

The journal's rule for the line is: any decision that is made consistently across multiple positions is a candidate for a rule. The mechanization of the decision is not the goal; the consistency of the decision is the goal. The journal's process discipline is the mechanism by which the line is drawn: the position-level review identifies the discretionary decisions, and the monthly methodology audit proposes the revisions.

The journal's most recent rule revision was the probability adjustment. The journal observed that the probability adjustment was being applied consistently across multiple positions, and the journal revised the rules to formalize the adjustment as a range (0-10% in either direction) rather than a discretionary decision. The revision is documented in the lessons-learned article, with the date of the revision and the reason for the revision.

The role of the trader

The trader's role in the playbook is to apply the rules consistently and to exercise the discretion wisely. The rules are the foundation of the playbook's consistency, and the discretion is the foundation of the playbook's adaptability. The trader is not a rule-follower; the trader is a rule-applier with discretion.

The journal's view is that the trader's role is to be the steward of the playbook, not the author of the playbook. The author of the playbook is the methodology audit, which is the synthesis of the realized outcomes and the strategy articles. The stewards of the playbook are the traders who apply the rules consistently and exercise the discretion wisely.

The journal's rule for the trader's role is: the trader is accountable for the trade log, not for the playbook. The trade log is the trader's record of what was done, and the playbook is the methodology's record of what should be done. The trader is responsible for the consistency between the trade log and the playbook; the methodology is responsible for the playbook's quality.