I'm no quant, but I have a friend who is one. A quant is a quantitative analyst. In the trading world, a quant is a trader who employs quantitative analysis to develop algorithms that govern her trading. I want to have personal input into making my trading decisions: a quant wants to remove all emotional bias. I think each type of trader might have something to learn from each other. I certainly do have something to learn from quants.

That's why I quickly downloaded Philip Reschke's Stock Market Edges: A quantitative guide to developing winning trading strategies when its price was temporarily dropped on Amazon. I'll let you know how I feel about the book when I finish it, but even in the first chapters I've read, Reschke reminds traders of something that we all need to remember.

Our trades need to have both a setup and an entry trigger. For example, my primary trade is a personalized version of a trade developed by trader John Locke. My personal version is 10-15 contracts of a bearish butterfly hedged to the upside with either DITM long calls or call credit spreads and hedged to the downside with an Armageddon put. The setup for that trade includes several factors, most of which I've discussed in various articles. Primary is the time frame. Right now, I'm tending to enter the trade 30-38 days before expiration. My choice whether to hedge with DITM call or call debit spreads depends on the composite implied volatilities for the RUT options for the expiration cycle I'm entering. If the composite IV's are low, that means that options are cheap, and there's usually not much extrinsic value in the DITM calls I like to buy. Therefore, I hedge with long DITM calls. If the composite IV's are above 17 percent or so, however, those DITM options tend to have more extrinsic value. If the RUT then takes off to the upside and IV's start dropping, that extrinsic value is going to bleed away, and my DITM long call position won't gain value as fast as it would if it had very little extrinsic value. Therefore, if the composite IV's are over about 17 percent, I would typically hedge with call debit spreads or a combination of a DITM call and some call debit spreads. Call debit spreads are impacted a little less by IV changes. That's the setup: a preferred and back-tested time frame and a choice of upside hedges that is dependent on implied volatilities. The trade is a complex one because it involves several moving parts, but the setup is actually simple.

What's the entry or the trigger? The entry or trigger depends a bit on my personal schedule but mostly the pricing for the butterflies. Several days before entry, I set up the simulated trade and begin watching prices.

Simulated Trade 45 DTE, graph from Think-or-Swim:

With commissions two ways, this trade will cost $33,562.50. I of course have an idea what I paid in previous months, but conditions will not be exactly the same from month to month. I want to know a good price for current conditions, too. Note: my articles are roughed out and visuals are snapped a week or two before publication. Prices shown are not current.

I also separate out the butterfly portion and watch butterfly prices.

Market Depth from Think-or-Swim for 1140/1090/1040 June14 Put Butterfly:

I also watch on TOS's Spread Book to determine if anyone else is trying to buy this butterfly, checking the price they want to pay. I determine if the trade disappears when the midprice or mark is at that offer. That's not a failproof system, but that study provides me with some sense of whether the butterflies appear to be going near the midprice. I check volume to the best of my ability, to determine whether there will be enough volume to get relatively timely fills if I should decide to start entering the trade. I don't want to get caught with the butterflies filled but not be able to get timely fills on call debit spreads, for example.

It's worth noting that the RUT's price might be moving around in the days while I'm watching prices. I keep moving the simulated flies so that they stay centered about 20-25 points below the then-current price. I wouldn't want to know the best price for a butterfly centered at 1090 if the RUT had jumped to 1150 before I actually entered, for example. I would want to know what constitutes a good price for my butterfly setup with the butterfly initially 20-25 points below the RUT's real-time price, wherever the RUT might be at the time I enter. Note: when I actually entered my JUN14 trade a few days before publication of this article, I entered with butterflies centered at 1070, with the RUT right at 1090 at the time.

If at all possible, I want to have some idea of how the RUT's prices are most likely to be moving over the 30 minutes or so it might take to get all the parts of the position filled. I don't want to fill the butterflies only to find the RUT's price immediately shooting higher, and call debit spreads difficult to fill at a decent price.

When I'm within that setup's time window, and my own entry parameters have been met (good price on the setup and the butterfly itself, my availability to tend the trade long enough to get the fills), I enter.

That setup and entry would make a quant shudder. There are too many points when personal judgment comes in. It is, nevertheless, a two-part system for entering a trade. If prices were good but way outside my tested DTE for entries, I would not enter. If setup parameters were met but the prices for the setup were much higher than I typically pay or than the most recent prices have been, I wouldn't enter. If the setup requirements have been fulfilled, and the price is cheap, but I have appointments all afternoon that might keep me from completing my fills after I had begun them, I won't enter.

The setup and entry might be completely different for another type of trade. I occasionally trade speculative debit spreads with the risk/reward roughly equal. I scan for these trades the night before I enter them. The setup requires that the stock saw unusually high volume the day before, is not a pharma, has average daily volume of 1,000,000 or more and a price of $5.00 or more, does not have an earnings report due during the course of the trade, and is optionable, of course.

On May 7, 2014, NYCB met those parameters. My entry requirements included the requirement that the stock's daily candle left either a long upper shadow or long lower shadow on that day of higher-than-typical volume. The larger-than-normal volume would show that someone other than mom-and-pop retail trader was getting involved. A long upper shadow would show that sellers were overwhelming buyers, and a long lower shadow would show that buyers were overcoming sellers. That would determine whether I would be buying a call or put debit spread for my speculative trade. NYCB met that requirement, too, leaving an upper candle shadow or wick the day of the higher-than-normal volume, although perhaps it might be arguable whether that could be considered a "long" upper shadow. Ideally, that candle would have been produced at the top of a climb, but that's not an iron-clad requirement for me in these entries.

NYCB Daily Chart as of May 7, 2014:

My trade, then, would be a put debit spread, if my other entry parameters were met. However, the next step showed me that those requirements were not going to be met. I said at the beginning that I liked the risk/reward to be about equal on these trade. For this price underlying, I would normally have bought a JUN14 16 put and sold a JUN14 15 put, and I would want to pay somewhere around $0.50 or perhaps slightly more for the put debit spread. However, that spread was instead $0.70. Too much. That didn't give me the roughly equal risk/reward parameters I like for these occasional speculative trades. The most it would be possible to make would be $0.30 minus the commissions paid, and I wasn't realistically going to be able to make quite that. Therefore, although my setup parameters were met and some of my entry parameters were met, not all were. FWIW, I also checked a JUN14 15/14 put debit spread, but the cost was only $0.20, suggesting that market makers weren't pricing in much of a likelihood of a drop to $14.00. Therefore, no trade!

Note: As I edit this article at about 1:13 pm on May 16, 2014, NYCB currently is at $14.77. The JUN14 16/15 put debit spread is priced at $0.85. The JUN14 15/14 put debit spread is priced at $0.30. Both would have been profitable but not very profitable after commissions were deducted. Still, the setup still proves itself workable: the entry requirements just weren't met.

Quant or not, Reschke's point is well taken. I like my current trade enough that it's unlikely I'll ever plunge into developing algorithms for my trading. I'm not ruling out that possibility. Whether or not I ever do, I can still learn from quants and their regimented approach to trading. Perhaps you can benefit, too, from thinking just a bit more like a quant.

Linda Piazza