My interest in trading systems grew in tandem with my interest for options. At various points throughout the years, I've focused on one more than another, but I've always kept the two in my mind. While developing trading systems, I'd keep in mind how options could be applied. And the same goes for looking at option strategies and how they might be applied to trading systems. Allow for two quick examples. If one were developing a trading system for thinly traded stocks or penny stocks, there is likely no possibility that this could be used with options. If one is studying 4+ leg option strategies, there is likely no possibility that this could be used within a trading system since fills and spreads would probably kill a lot of your trading system's edge. The good news is, trading systems like options typically do better in a high liquidity environment. If you're getting bad fills in either options or within your trading system, it's very likely that your backtested results are not going to be anywhere near your trading account results.
There are a number of criteria I use when filtering for option candidates within my trading system. The two biggest are volume and whether or not they have penny spreads. This is mostly a manual process, I'm afraid. The CBOE web site contains a list of the highest option volumes from month to month. That page can be found by
clicking here. This is a good starting point, however, my trading system parameters can also interfere with my option volume parameters. A lot of my trading systems operate in a low volatility environment. In other words, one of my watchlist screening techniques is to find stocks with relatively low beta. So I have to take the list from CBOE and trim out the high volatility stocks. The second problem here is that CBOE doesn't trade all of the options in the world. My second and more arduous task is to take a list of high volume equities and manually lookup the option volume. Fortunately, these usually don't take more than an evening or maybe weekend afternoon. It would be nice if I had a list of high volume options from all of the exchanges.
The final and most crucial step is introducing the watchlist changes into my trading system. My watchlist changes should feel more or less random to my trading system. I'm not really basing the selections on performance, so it should have little change on my system's P/L. However, I will run a number of tests against the old watchlist and compare it to the new watchlist to confirm or deny this. If there are significant changes (i.e. my profit doubles over the same measured time between the new and old watchlist), I will attempt to isolate why. I may or may not throw the symbol or symbols out all together, but the most important aspect here is that you understand why something is. If I go ahead and put that solar energy stock into my watchlist with it's 400% gain in the last 2 years and then wonder why it drops 50% in a day, shame on me.
This is just an introduction and not a recommendation to begin using options in your trading systems. There are a whole host of other complexities to be concerned with, especially with options. The two biggest are theta and vega. I'll get into these later. I'll also discuss how to use various option strategies depending on the type of trading system you're developing.
Disclaimer: This is all my own opinion based on my experience. I don't pretend these are the best ways and I certainly don't recommend you follow any of my advice. These are meant to be points of discussion and idea sharing.
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