Big Trader, Small Trades: Formula for a Bite-Size Trading Strategy

Trading success doesn't mean "going for broke," or searching for the next big thing. It's more like pacing yourself at the hippest restaurant in town.

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What does grilled chicken breast with red onions and spinach in a feta-cheese béchamel have to do with an options spread? When you dine fancy, you pick a place with great food. You choose the best stuff on the menu and most importantly, you pace yourself in honor of all the treats to come.

Investing is also about digestion. And pacing. Have you ever spent days—weeks, even—researching a stock? Analyzing the financial data, the reports, the charts, searching for news, looking for the next Apple or Google before it hits $600 a share? Maybe you’re so convinced you’ve found a winner, so confident it’s a superior opportunity, that you sink a lot of dollars into it. And should the stock price rise, great. But what if it goes south?

So, maybe you can pick winning stocks consistently. Most people can’t. Part of the reason is that efficient markets incorporate any new data into a stock price nearly instantaneously. The other reason is that most stocks are correlated with other stocks in their industry, and with larger indices. So if all stocks are dropping, your stock is probably dropping, too. With most of your money now tied up, there isn’t much you can do if you spot another potential opportunity that might offset the loss of that larger investment. Just like filling up on your first course, you can invest a lot of emotion and lose too much money and time when you make one large investment. During your 5-star meal, it’s small bites and careful slow going. And with investing, it’s trade small, trade small, trade small.

A BIG FORMULA

The idea is that one big trade does not a big trader make. “Big” can simply mean someone who makes money trading. It could be $500 a month or $50,000 a year. But if trying to make a big chunk of profit in one big trade isn’t smart, what is?

One potential path is placing a lot of small trades in liquid products that have a better than 50/50 chance of making money, and using a trading strategy that doesn’t require days or weeks of analysis. The goal is to create enough small profits, and manage them smartly to create a profitable portfolio over time.

Baby steps for potentially big results:

1. Find liquidity
2. Use high-probability strategies
3. Keep it small
4. Manage winners
5. Don’t be afraid to lose

Find Liquidity

Using our food analogy, let’s start by finding the trading equivalent of a great restaurant. That would be a list of actively traded stocks and options, hopefully with narrow bid/ask spreads. With these, it’s more likely to execute limit orders at a price that keeps slippage at a minimum. The less a stock or option is actively traded, the harder it is to get a good execution price.

Where to find these possible opportunities? Look at the “Penny Increment Options” list on the MarketWatch/Watch tab on TD Ameritrade’s thinkorswim® platform. (See Figure 1.)

FIGURE 1: To get a list of stocks with penny-increment options on thinkorswim go to the MarketWatch tab > Watch > Show Arrows > Penny Increment Options from the submenu. For illustrative purposes only.

Not every stock and index on the list has options with tight bid/ask spreads. But looking at options whose prices trade in 0.01 increments is a good place to start. Doing this gives you an idea of some of the range of stocks whose options you might consider trading.

Use High-Probability Strategies

Now, on to the expensive menu. Just like you can scan a great menu and find just the dishes you love, you want to quickly identify strategies that have a higher probability of making money. Whether your outlook on a stock is bullish, bearish, or neutral, there’s usually a strategy that might be a tastier trade than just buying or shorting the stock. That usually means options strategies like short puts, covered calls, short verticals, and iron condors that have greater than 50% probability of success. You can use the tools on the thinkorswim platform like the Trade page and the Analyze page to explore these approaches. (For more on probability, see “How to find greater than 50/50,” below.)

The probabilities of an option expiring in the money or out of the money are calculated in real time on the Trade page, while the Analyze page lets you calculate the probability that a simple or complex strategy may be profitable at some future point. (Then, to see which strategies may work in which market, check out our Special Feature on spread trading, page 34.)

Keep It Small

Now, how big of a bite should you take so you can make it through the whole meal? This is about position size—i.e., fewer contracts and a strategy with a small capital requirement. When you engage a large number of small-sized trades, each with a probability of profit greater than 50%, over time your portfolio could have a probability of profit that is very close to that of individual trades. No matter how high a single trade’s probability of profit, it could still be a loser. And you don’t want one trade to take you down.

Now that’s not to say you won’t get wiped out with a series of smaller trades as you could with a few larger trades, but smaller potential losses on many trades can keep you at the dinner table longer. Instead of doing 10 contracts each on five trades, for example, do say, two contracts each on 25 trades. And keep the amount of capital used on each trade to a small percentage of your overall account. (Just keep in mind that that many small trades will eat up funds via commissions and fees as well.)

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FIGURE 2: OPTION CHAIN IN THINKORSWIM showing the probability of the calls expiring out of the money ("Prob OTM" column). For illustrative purposes only.

Manage Your Winners

Just like enjoying every bite of a nice dinner, manage your winning trades strategically. Consider taking smaller, more frequent profits when they present themselves, rather than waiting for bigger profits that might not ever come. A very broad target may be taking 50% of the max possible profit if and when it’s available. Of course you have to factor in the additional transaction costs. But by potentially realizing more and smaller profits, you may sometimes reduce the number of times a winning trade turns into a loser.

Don’t Be Afraid to Lose

Finally, if you want to have a fantastic meal, you can’t be afraid to try something new and run the risk you might not like it. The same is true for trading. You can’t be afraid of losses. Every trader has them. Don’t feel bad if a logical trade loses money. It’s part of the experience. If you keep your position size small, two things happen with losing trades. First, the loss is smaller than with a larger trade. Second, you may decide to hold a smaller losing trade longer to see if the stock eventually turns into a winner. Bon Appétit!

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The probability projections in the thinkorswim Analyze page assume the underlying stocks follow a lognormal distribution. The results are derived using the Black-Scholes formula for delta, consisting of the current stock price, number of days in the future, current volatility of the stock, and the risk-free rate of return. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. Be aware that assignment on short option strategies discussed in this article could lead to unwanted long or short positions on the underlying security.

Security symbols displayed for informational purposes only. This is not a recommendation to trade any specific security.

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Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.

TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.

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