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4 Considerations When Designing a System

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by Gavin in Blog, Guest Posts
December 8, 2013 2 comments

This is a guest post from Dan at ThetaTrend.com, a blog focused on Trend Following with Options.  He aims to develop and share simple rules based systems for trading ETF’s and Options.

When I first started trading options, I was afraid to trade directionally.  I heard that most options expire worthless and I definitely didn’t think I could consistently be one of the lucky people holding options with value at expiration.  As a result, I spent my time learning to trade non-directional spreads like Iron Condors and Butterflys because they focused on selling options that expire worthless.

Around the same time, I began experimenting with Trend Following trading systems.  I really liked that I could backtest a system and prove to myself that the rules were valid.  Additionally, I didn’t need to attempt to predict what the market would do and I could just follow signals.  After trading Trend Following systems for a while, I realized that there might be some benefits to combining an options selling strategy with Trend Following.  Because I was already used to trading Iron Condors, I focused on out of the money credit spreads.

The challenge many traders encounter with credit spreads is that the position implies that you have some sort of directional bias.  The degree of the bias is open to interpretation, but with a credit spread there is a clearly defined place that you do not want price to travel.  In order to build a successful credit spread system, I believe the rules should be totally systematic.  In other words, if we’re both looking at the same market with the same indicators, we should come up with the same trade or at least the same direction (long or short).

The steps below outline some considerations when designing a credit spread trading system.

1).  Objectively Identify Trend:

If you’re trading a directional system, there needs to be some consistent way for determining trade direction.  While there are many indicators available for determining direction, Donchian Channels and/or an Average True Range Trailing Stop work well.  Donchian channels are very popular in trend following systems and a little Google research on the “Turtle Trading Rules” should yield a complete trading system using Donchian channels.

Donchian Channels plot the N-Day high over some look back period.  Breakouts above the N-Day high are a signal to go long and breakdowns below the channel low are signals to go flat or get short.  There are numerous technical indicators available to determine trend and the specific indicator matters less than consistently using the same indicator with the same settings.

2). Entries:

There are two main types of Trend Following systems:  systems that are always long or short and systems that are long, short and flat.  Similarly, you can build a credit spread trading system that trades all months or waits for signals.  My original credit spread system traded the same markets every month and was almost always in a trade.  However, Donchian Channels can be a powerful trade filter for a trend following credit spread system.

When price breaks out to the upside in a Donchian channel, we can infer a few things about the market:  a) price may be starting a new uptrend, b) price may be starting a strong uptrend, or c) price might chop around and fall back.  However, when a new Donchian breakout takes place, price is unlikely to reverse and break out in the opposite direction.  Depending on the period you use for your Donchian channel, price can reverse, but with a 50 day channel it doesn’t happen very often.  If we know that price is unlikely to reverse, it makes sense to sell options in the area the price is unlikely to travel and wait for those options to decay.

3). Exits:

An Average True Range trailing stop is my preferred exit for options trend following because the average daily price movement is reflected in the stop distance.  Additionally, using an ATR trailing stop gives you an objective level that is not open to interpretation.  One of the biggest challenges as a discretionary trader is knowing when to get out of a trade and an ATR trailing stop both identifies the trend direction and provides a price based exit point.

In addition to using an ATR trailing stop, a credit spread system might want to employ a risk based exit point.  For example, if a spread is sold for a .50 credit, the most we might want to risk is .50.  If price moves against the position shortly after entering the trade, we might be sitting down at our maximum loss.  Because the credit spread system is directional and based on the principles of trend following, I exit positions whenever my maximum loss is hit.

Rolling and Other Adjustments:

I realize that some credit spread traders like to roll positions down and out, but my personal preference is to close trades and move on.  I feel that rolling trades generally involves selling additional spreads to make up for the lost credit, which has the effect of adding risk to the trade.  My personal preference is to only use adjustments when they decrease risk, but other options traders have been successful with rolling.  I’d recommend knowing what you prefer and testing your strategy in advance.

4). Risk:

In addition to the Average True Range Trailing stop discussed above, positions need to be sized appropriately for the system and your risk tolerances.  Underestimating your own risk tolerances is very likely to result in you overriding the system.  Many trend following systems use a risk size of less than 2% per trade.  For example, if the market is at 100 and the stop needs to be placed at 97, a trend following system will size the position so that getting stopped out at 97 will not result in a greater than 2% loss.

Knowing where you are planning to take a loss and also knowing the loss amount in advance is an essential part of trading.  If you go into a trade without a clearly defined exit point, you’re likely to take a loss greater than you should.  Additionally, “should” really relates to trading a system with positive expectancy or one that makes money over time.  See the note below for the envelope calculation.  My rule of thumb for trading is that if you trade with a roughly 50% winning percentage and you never lose more than you make on a winning trade, you should come out ahead over time.  However, if you win on 80% of your trades and lose 2-3 times the amount you make, your success is much less assured.

Note, you can compute your expected outcome using the equation:

EO = P(winning)*Avg. Winning Trade – P(Losing)*Avg. Losing Trade

Where P(winning) means probability of winning and P(Losing) is probability of losing

Combing the Steps and Building a System:

I realize that the discussion above is a little foreign in the options trading space, but the principles on risk apply across all types of trading.  Having a clearly defined trading plan with risk management rules is incredibly helpful regardless of whether you’re trading Iron Condors, Credit spreads, Forex, or exotic cats (probably an illiquid market).  The interesting part of building an options trading system is focusing on the entries and exits, however, risk management can take a system with 40% winning trades and make it profitable.

While Options backtesting software is fairly limited, Thinkorswim has a great “Think Back” feature that enables you to look at historical options data.  I don’t receive any benefit from you using Thinkorswim; I just really like them.  Thanks for reading and let me know if you have any questions.

2 Comments
  1. agnnis says:

    Really appreciative article regarding trading system thanks it will help me at avapartner.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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