Trading Systems: Black Box Trading for the Rest of Us (Sort Of)

You may not be wired to build automated trading systems that require endless code. But that doesn’t mean you can’t trade systematically. Yours may be a different kind of system—one with no math—but you can still develop and follow a set of rules to help you decide what and when to trade.

As a trader, you’ve likely come across countless typical trading “rules”: don’t trade based on emotions, make a plan, be disciplined, stick to your plans, and so on. But be honest: do you follow these rules each trading day, or do you still make certain trades based on instinct? Creating a system and a set of rules that works for you is a strong first step. To take it further, you’ll want to be consistent in how you engage your system each trading day. This next step requires more thought.

One idea is to keep it simple and limit the number of rules. Trading involves quick decisions. The more checks and balances you have, and the more complicated your strategy, the more your stress levels can rise. And that’s when things could start to fall apart. So, don’t get fancy. You may want to stick to three important factors when trading options:

• Defined risk
• Positive time decay
• High probability of success

Less Is More

Defined risk. Whether the stock, index, or exchange-traded fund goes up, down, or sideways, you should know what your max potential loss is before you place the trade. For example, if you trade a short call vertical, your max loss would be the difference between the two strikes, minus any premium you may have received, minus transaction costs. If you were to sell a naked short call, you don’t know what your max loss could be because the risk with this strategy is unlimited.

Positive time decay. You may want your options positions to have positive time decay. Meaning: all things being equal, as each day passes, your options position may be worth a little bit more. But don’t all options lose value as each day passes? Yes, but if you put on a spread such as a short vertical, long calendar, or short iron condor, the short option puts time on your side.

High probability. The chance of a stock going up or down is like a coin flip (50/50). But those aren’t good odds. You want better odds of success. One way to increase your probability is to look for an option chain with a shorter-term expiration and a higher probability of expiring out of the money (OTM). Get to know these parameters. They could become your new best friends.

Putting Them to Work

When you consider trading anything, you’re going to have some directional bias. It could be based on technical or fundamental analysis, or maybe something you heard from a friend. This isn’t exactly systematic, but hey, trading is a little bit art and a little bit science. Which means it’s also subjective. And remember—just because you have a directional bias doesn’t mean price is going to move in the direction you expect it to.

Once you’ve figured out what to trade, you’ll need to pick strategies and strikes.

Let’s walk through a short vertical spread, which is a defined-risk trade. If you have a bearish bias for a stock you want to trade, you’d create a short call vertical. If you have a bullish bias, you’d create a short put vertical. As a starting point, you may look for options that have somewhere between 25 to 45 days to expiration, since this gives you enough time to see the effect of time decay on your positions and also if your directional bias works in your favor. If you have a bearish bias, consider an OTM short call with say a 60% to 75% chance of expiring worthless, since that’s what you ideally want your options to do. If you have a bullish bias, consider an OTM short put with a relatively high probability of expiring worth less.

Next, select the options strikes. If you’re going to create a short call vertical, to limit your risk, consider buying the call option that’s at least one strike further OTM than your short call. And if you’re going to create a short put vertical, consider buying the put option that’s at least one strike further OTM than your short put.

Consider these scenarios:

• With the short OTM call vertical, if the stock moves down by expiration, you’ll likely make money.
• If the stock moves up past the short strike of the short call vertical, you’ll probably lose money.
• If the stock goes up some, but not as high as the short strike of the short call vertical, you may still make money.

Now you have the lay of the land. Let’s put a plan into action.

A Day in the Life of a Trade

Naturally, the starting point is to establish a directional bias. And this isn’t based on a coin toss if you make sure there’s some amount of objectivity involved. First, get an idea of overall market performance. Luckily, you have tools available to help. Fire up the thinkorswim® platform from TD Ameritrade and select the MarketWatch tab. Then look to see which S&P 500 sectors are outperforming or underperforming. You can also visualize how each stock within the sectors is performing to help get an understanding of which direction a stock might move. Identify what you may want to trade and add those stocks to your Watchlist.

Then select the Analyze tab. Enter a symbol from your watchlist into the symbol box and review the different option chains (see figure 1). Set up your layout so it displays Probability ITM in one of the columns.

For starters, you might want to look for options with expiration dates that are 25 to 45 days out. On the far right of the row, notice the volatility (vol) and the expected move (the number in parentheses next to vol) for each option. If the stock is volatile and you’re comfortable with the expected move, go to the next step. Otherwise, it’s back to the drawing board.

Say you have a bearish bias and want to sell a short call vertical. Because Prob ITM+ Prob OTM = 100, a lower Prob ITM suggests a higher probability of expiring OTM.

Looking at the option chains, you could pick OTM call strikes that have about a 25% to 40% probability of expiring ITM (see figure 2). So, you’d sell one call, and buy one that’s one strike further OTM. You know what your credit is. Now select Risk Profile to visualize the potential risks and returns associated with this trade. You can go back and try other strikes, keeping that $1 width between the two, and analyze the different risk/return scenarios.

Even if you check off everything on the above list, it doesn’t always mean your system will go as planned, or that you’ll make money. Bottom line? Find and execute trades that make sense instead of shooting from the hip. Still hesitant to jump into a trade? Try placing some trades in your paperMoney® account to see how this “trading system” works.

There’s no guaranteed profit when trading. But creating a system and following a checklist can give you the satisfaction of having made a sensible trade. You’re not going to win them all. But with a method of analysis and a trading system, you’ll have critical data for understanding what happens and why.