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Stickin' It to the Nerds: Building a High-Frequency Trading System

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October 1, 2011
building high-frequency trading system
Fredrik Broden

As a kid, did you ever dream of becoming a nerd? I didn’t think so. But over the past couple of years, how many grinning people did you see in the financial news who looked like, well, nerds? Schooled in computer theory, math, physics, whatever, these nerds were in the headlines for making a lot of money with computerized trading: high-volume, split-second, machine-driven buys and sells that netted maybe $0.05 per 100 shares. That doesn’t sound like a lot of money, but multiply that by hundreds of thousands of shares across thousands of trades a day, and it starts to add up. In fact, it accounts for the majority of today’s stock trading volume. And as you switch on your underpowered laptop, you might wonder, is that what I have to do to make money trading?

Short answer: No.

Longer answer: Absolutely no.

Nerd Repellent

What those stories haven’t told you is that the recent sharp swings in volatility have forced many who develop computerized trading to rethink their strategies. The short-term, back-and-forth price movements that computerized trading is supposed to capture have been more uni-directional, and have left some traders with large losing positions.

Okay then, you ask, if not high-frequency, computerized trading, then what? You need a strategy-based approach to trading, so that regardless of the stock or index, regardless of the market environment, you have an approach to finding and executing trades that makes sense. In other words, a system. This means you need to create a set of rules that you follow for getting in and out of trades every time, rather than simply shooting from the hip. Your system may not always turn out as you expected, or always make money, but you’ll have a plan for placing trades. You may not get your picture in the financial news, but maybe you’ll pay your bills and still have time to be a normal person.

Build a 1-2-3 System

So, how do you do it? Well, for starters, if you already have the thinkorswim® platform loaded on your laptop, you have tools at your disposal that are designed to offer more than what most of the Wall Street nerds have. Seriously. And you’re going to use those tools to find trades that meet the following three criteria:

1. Defined risk

2. Positive time decay

3. Favorable odds

Let’s break each one down.

1. Defined Risk

This means no matter what the stock or index does, whether it goes up big, down big or nowhere at all, your maximum potential loss is known before you even do the trade. For example, a short call vertical has defined risk. A short naked call does not. With the short vertical, the max loss is the difference between the strike prices minus the credit received. That’s it. With a naked short call, you don’t really know what your maximum loss might be. Even if you think you’ll use a stop order to buy the short call back if the loss gets too great, what if the stock gaps up overnight when you can’t trade? Stick with defined-risk trades.

2. Positive Time Decay

Besides death and taxes, the only other thing you can count on is time passing. And if it doesn’t, we’ve all got bigger problems. Because of that inevitability, you want time passing on your side. That means you want your positions to have positive time decay so that all other things being equal, one day passing means your position is worth a little bit more. Positive time decay generally comes from having a short option somewhere in the position. It doesn’t have to be a naked short (see criterion #1), but as part of a spread like a short vertical, long calendar, or iron condor, a short option will put time on your side.

3. Favorable odds

No matter how much research you do, the probability of a stock or index moving up or down is 50 %. But you don’t want your trading to depend on the flip of a coin. The way to tip the odds in your favor is with smarter strategy selection. That begins by searching the option chain for a shorter-term expiration and a high probability of expiring worthless. This will let you create spreads that depend less on being right on direction and more on premium decay.

Okay, Now What?

Not too nerdy, is it? Let's turn the theoretical into practical with a couple of real-life examples for both the stock and options trader. 

The Stock Trader

You’re a stock trader. Maybe you’re not quite ready for all the option spread stuff. So how do the three criteria work for you? If you’re long stock, you already know your maximum potential loss if the stock goes to zero. Even though that risk might be a very large number, I’ll argue that it is defined in its own way. That’s criterion #1.

For #2, you look to create a short covered call against that long stock to give you some positive time decay. When you’re short a call against your long stock, for each day that the stock price doesn’t move, that short call is going to get cheaper and cheaper and make you a little bit of money.

For #3, getting the odds on your side means selling an out-of-the-money call that has a probability of expiring worthless of about 60 %, which you can do from TD Ameritrade's thinkorswim® trading platform (Figure 1, below). The stock can rise up to the strike price of the short call by expiration, and the call will still expire worthless. That reduces the cost basis of your long stock, which also lowers its breakeven point. That means the stock can make a larger move down, and you still might not lose money.

probability of option expiring in-the-money

FIGURE 1:

In thinkorswim, view the probability of an option expiring in-the-money (ITM). Here, a call with a 34% probability of

expiring ITM is the same as saying it has a 66% probability of expiring worthless. For illustrative purposes only. 

The Options Trader

You’re raring to get going with options, but you’re not sure whether you should be bullish or bearish on a particular stock or index. Don’t sweat the direction of the stock. Using the three criteria, you can find a strategy that may still make money even if you’re wrong on your directional bet. Let’s see how.

First, start with some directional bias for the stock or index. Maybe it’s based on technical or fundamental analysis, or maybe your favorite talking head on TV suggested it. We’re going to create a short vertical spread (criteria #1 and #2)—a short call vertical if you have a bearish bias, or a short put vertical if you have a bullish bias. Start by finding the expiration ranging from 25 to 45 days.

For criteria #3, if you’re bearish, find the out-of-the-money short call that has a 60 % to 70 % probability of expiring worthless. If you’re bullish, consider finding the out-of-the-money short put that has a probability of expiring worthless of between 60 % and 70 %. To create a short call vertical, consider buying the call option that’s one strike further out-of-the-money than your short call. To create a short put vertical, consider buying the put option that’s one strike further out-of-the-money than your short put.

Now, here’s what can happen. With the short out-of-the-money call vertical, if the stock moves down by expiration, you make money. If the stock stays the same by expiration, you make money. If the stock moves up past the short strike of the short call vertical, you’ll probably lose money. But if it only goes up a little, not as high as the short strike of the short call vertical, you can still make money. The short put option works the same way but loses money if the stock moves down past the short strike of the short put vertical.

This is not a fool-proof, guaranteed way of making money trading. But it is better than sitting on the sidelines, frustrated and confused by not being able to trade the way you think the Wall Street pros do it. Each trade you make based on these criteria will have reasoning behind it. And even if the trade loses money, you’ll know exactly how much and why. That’s being an educated trader. Instead of a nerd.

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