How do you come up with options trading system/plan?

Martinsos

Martinsos

While learning about options I talked with experienced options traders, and what I have learned is that they have well defined “trading systems” (sets of entry, exit and maintenance rules) that they execute. This allows them to keep emotions out of the equation (emotions being a very dangerous factor when trading).

Of course, the hard part is coming up with a (hopefully) profitable trading system, creating it from the initial idea.
I would like to learn more about this process of creating trading system/plan, so I would be thankful if anybody is willing to share his methodology. I expect that some of them will be similar, so some best practices may emerge!
 
There of course many ways to make money on option trading, but I find there are two general categories for "customers." Those that do the same thing every day, week or month and those that react to an expectation of market movement.

An example of the first one is a typical index option naked seller or credit seller. They mostly sell OTM options as often as they can and hedge or cover when they have to.

An example of the second one, which requires more skill, is to have an opinion as to where a stock will or won't trade over a set time period, then look for the best way using current market option prices to profit from that.

Option market makers tend to trade current volatility vs what they think it should be and compare option skew looking to make small profits. They will also trade vol from one symbol vs another. This type of trading requires an automated platform and is not for smaller accounts.
 
Do you like trend following or counter trend? You can make money with short options if the market does not trend or counter trend.
 
Like I just spent 3.5 years developing the system I am now trading options, granted I been trading very long time, so I am already experienced in charting and TA, I have developed many systems for myself through the years for stocks and futures trading short and long term, have thirteen automated. Options are so way different for me, there is the "worth" of an option and there is direction of an option. Many concentrate on worth and sell premium and try to keep Delta Neutral, they use the "Greeks" a great deal. I can spot direction fairly well and what underlying should go in certain direction and when I see possible signal, find optimum options to sell or buy at Discounts. The longer you back test options (Options data is ungodly expensive), the better the feel you can get if you are looking in that direction.

I have found this past three plus years the toughest but can see options has to promise of doing well than just straight out long term commodities for me.

As far as sharing, no can do, took way too long to just understand. Sometimes trading has to be learned by reading books, then paper trading, then back testing etc...To do it right, it is expensive to backtest, maybe that is good to keep many away from backtesting, LOL.

But I am learning something new each week.
 
Thank you all for your responses!
Maybe I was not clear enough in my question, but I am not looking for concrete advice on how to trade, nor I think that I will suddenly learn how to come up with a profitable strategy. Instead I am interested in how you guys come up with and validate your strategies - maybe that question is harder to answer then I assumed at the beginning, so I will try to make it more specific:
- how do you choose your trading approach / system - do you take existing one and modify it, or you come up with your own? Do you have one that you stick with all the time, or you have multiple systems / approaches? What do you do when it stops working (market changes), how do you make it work again?
- how do you validate your approach / system? Do you use backtesting, and how useful do you find it? Do you paper trade it first?

@Handle123 If I understood correctly, you have one system that you use and it took you years to develop it - you tested it using paper trading and backtesting. Did I get that right?
 
Martinsos said:
Thank you all for your responses!
Maybe I was not clear enough in my question, but I am not looking for concrete advice on how to trade, nor I think that I will suddenly learn how to come up with a profitable strategy. Instead I am interested in how you guys come up with and validate your strategies - maybe that question is harder to answer then I assumed at the beginning, so I will try to make it more specific:
- how do you choose your trading approach / system - do you take existing one and modify it, or you come up with your own? Do you have one that you stick with all the time, or you have multiple systems / approaches? What do you do when it stops working (market changes), how do you make it work again?
- how do you validate your approach / system? Do you use backtesting, and how useful do you find it? Do you paper trade it first?

@Handle123 If I understood correctly, you have one system that you use and it took you years to develop it - you tested it using paper trading and backtesting. Did I get that right?
More...

It is like I get an idea of what I want to do for direction, define trend-what is trend for you Martinsos? Ok, so now you have trend, now I know that for me best way in option trading is decay of options, so like 90%? of them expire worthless, more experienced traders might have better percentages of worthless, stock markets tend to rise 2/3rds the time, so if rising, trend is up, I want to do something with Puts. But going back to trend, you need to develop ideas on entry, chart patterns breakouts, or failures, TA(Only if you have excellent charting skills), trendlines, volume, a great deal to learn first, so you develop entry signal, so you start papertrading to see if it be worthy to spend ton of time back testing based on the underlying, if trading the stock is not worse than 50%, you might have something viable. Then you learn about options, this is going to take awhile to ready study, you learn when or where you might sell options or credit spreads or debit spreads. So for me trading options it is like twice the work, except I already knows what works for trading systems for underlying, so I spent like five minutes there, but options don't decay like I thought, then you have to papertrade them to get a feel of what it takes to decay, you will find all kinds of little nuances that will give you 30 minutes or longer of where the market is going before t even starts going that direction, very cool. I am working now to get this automated cause it is a bear to look over so much info.

I am also now working on 60 minute approach that looks very promising, where I can buy and sell 3 week option durations.

But systems are like your life, they take a great deal of time to learn, program, tweak, and they not something you can do in a year when first starting out, but it be yours and you know how to correct it the longer you work at it.
 
Martinsos said:
Thank you all for your responses!
Maybe I was not clear enough in my question, but I am not looking for concrete advice on how to trade, nor I think that I will suddenly learn how to come up with a profitable strategy. Instead I am interested in how you guys come up with and validate your strategies - maybe that question is harder to answer then I assumed at the beginning, so I will try to make it more specific:
- how do you choose your trading approach / system - do you take existing one and modify it, or you come up with your own? Do you have one that you stick with all the time, or you have multiple systems / approaches? What do you do when it stops working (market changes), how do you make it work again?
- how do you validate your approach / system? Do you use backtesting, and how useful do you find it? Do you paper trade it first?

@Handle123 If I understood correctly, you have one system that you use and it took you years to develop it - you tested it using paper trading and backtesting. Did I get that right?
More...

I have developed countless systems over the last 24 years. I call them systems because I think systematically. At first I started using fundamentals (Picking direction based on a story). I later moved into technical analysis. Today I trade options based on picking a range rather than a direction. It was an evolving process. I only used real money (Paper money couldn't keep my interest). If you can use paper money I strongly recommend it.

I choose a trading system after trying something and failing then trying a variation and failing. When you have failed 100 times you have learned something. Each failure was built upon. The more failures you have the more you understand risk. Risk management is key.

I have found many that work in a back tests then the market does something it hasn't since 1985 or some crazy random thing and its back to the drawing board.

I have a great system that took approximately 23 years to create. Even though I have a great system I'm always looking for new ideas because its challenging and I like it.

I would number your systems. I wish I did from the beginning. I just started numbering them my best is system #8. Even though system #8 is profitable, I have tried to create 7 variations of system #8 and I have I variation a probable system #9 working in one of my real money accounts.

To back test I use TOS analyze tab then think back button. You can place an option trade in the past and move time forward for results. It sounds like a lot of people on this forum have a more sophisticated back testing method but this one works great for me.

Learning options can be a tall order but I have found through trial and error that they are the best vehicle for me.
 
Last edited:
Robert Modd,

I take a different tack on paper trading. Paper trading is great for those not familiar with options and those that want to forward test their system first. Back testing is nice, but since we all know what happened before, we can design a system that worked for the markets we had, but may not work moving forward. With that said, I feel paper trading with options may not be accurate because you don't know when you would have gotten filled. At least with stocks you can make the assumption with MOO and MOC orders that those values are real.

I prefer to test with very small size with real trading. Nothing wrong with 1 lots to see how you do. If you are at a retail broker that charges ticket fees, it can get expensive, but you can back out the ticket charges to see how it would have worked with larger size.

Bob
 
Last year I spent like 3-4 years of a Starbucks full time employee buying one minute options data with all the Greeks on each minute, so my back testing pretty accurate. But my entire life I have always paper trade something first before spending hours/days of programming to be able to do good back testing then the hard part of going over most of the trades with a chart, that takes the greatest amount of time, yes, I could just let the stats speak for themselves, but going back and making comparisons allows me to see why something isn't working or a tweak that might make something better. And no, don't even ask to buy or me to share data.

Yes, risk management is the key, better and more time you spend there instead of signals, better the bottom line.

I remember the good old days when all I did was lose, hmmmm what is the big hype of wasting time back testing..... They were not really good when you making money one day of week and thinking that one day there is nothing to this....
 
Thanks guys, that is some great feedback!
Ok, so few key points I feel are repeating and are therefore probably extra important:
- coming up with system takes a lot of time (years)
- unavoidable part of learning is trying and failing, learning from mistakes
- understanding risk and mastering risk management* is the key
- backtesting is good way to validate strategy, but it can be expensive (both time and money), plus it can be too optimistic because it can not predict all possible moves in the market
- forward testing is also a good way to validate strategy, but paper trading may not be accurate because of unrealistic volume/liquidity

*When you say "risk management is the key", what do you exactly mean? Does it mean that except for being excited about possible profits, I should pay extra attention to possible downsides and think about scenarios to handle those? Or does this involve something more?
 
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