Trade Options Like a Casino: Step-by-Step Guide & Transcript

[00:02] SMB Capital's options trading desk here in Manhattan. And today, I'm going to be showing you how options traders at prop firms make money as professional traders. And you know, when I tell people that I'm a professional trader

[00:15] and that the way I generate income and build wealth is by trading options, people give me this look like this kind of polite hesitancy. And I know that they're thinking, "Hey, this guy is just gambling. He's just depending on luck

[00:28] and he's just been lucky so far. And when his luck changes, he's in for a world of hurt." And you know, it'll probably shock you to hear me say this, but in a way, that statement's true. Trading is, in a way, gambling.

[00:42] And the market is, in a way, a giant legal casino. Why would I say that? After all, I am a professional trader myself, and I make a living trading. So, Well, let me ask you this very simple

[00:56] question. At a casino, who are the participants that always lose money? And the answer is, the players, the gamblers who come to the casino. The customers of that casino. You see, the gamblers, the customers, sometimes they'll win,

[01:12] they'll go on a sustained winning streak, and that, of course, is all based on pure luck. But luck doesn't last forever. It eventually runs out, and 99 times out of 100, they will end up losing everything they

[01:26] made during the lucky winning streak. And if they're lucky, they'll break So, then you ask yourself, "Well, who always makes money in a casino?" There is one party that always wins at a casino, and the answer is that the

[01:41] casino, and the answer is that the casino itself always wins in the end. house always wins." In other words, the casino always wins because, no matter what happens, they will be the winners in the end. Why do you think the casinos

[01:55] give away free food, free entertainment, free drinks just to attract people to gamble because the more that people gamble, the longer they gamble, the more money they gamble, the more money the casino makes. And why is that? How can

[02:09] this casino assure itself that in a game of chance that they're making available to you that they are guaranteed to win no matter what? And so today we're going to share with you the secrets of the casino business model. We're going to

[02:22] show you how as a professional trader you can set yourself up as a casino because that's how professional options traders set themselves up to make money in the end. And so if that's of interest, stick around because I think

[02:36] you're going to find this eye-opening. How do casinos guarantee that they will always make money in the end? Well, what they do is that they rig the game in such a way that they have a statistical edge over the player. In other words,

[02:50] have what's called a positive expectancy. While the player, the gambler, the casino's customer has a negative expectancy. So here's how it So for example, on this roulette wheel as you can see, the ball has landed on

[03:05] as you can see, the ball has landed on number 23 which is a red number. Come on. Or if it had landed on 35, it would have landed on a black number and so on and so forth. So here's how it works. Let's

[03:22] take a typical game like roulette. And in roulette what happens is that you've got this giant roulette wheel, right? And this wheel is made up of numbers. And you've got this spinning device, okay? And when the croupier, the

[03:35] guy who operates the roulette wheel, when he throws the little ball onto the wheel, the ball will spin around and around and it eventually lands on one of the numbers. So it's either an odd or even number or alternatively you can

[03:50] play the red or black numbers, whichever you like. bet. In other words, you double your money, and if you lose, you lose the full amount of your bet. And so, let's

[04:02] say that you decided to bet on black or red. So, for example, 23 is a red number, 35 is a black number, and so on and so forth. Okay? And so, people think, "Hey, this isn't bad. We can make a bet with the

[04:14] casino, and I've got a 50/50 chance of being right." But unfortunately, they're wrong. It's not a 50/50 chance, and that's because the casino has rigged the game in such a way that there are 18 red numbers and 18

[04:29] black numbers, or for that matter, 18 even numbers and 18 odd numbers. But regardless of whether you're playing the red black or the odd and even, there are two green numbers, which are the zero and the double zero. And these slots are

[04:43] and the double zero. And these slots are neither black nor red, nor even or odd. And so, therefore, that is the secret. So, for example, if you bet on black, you think your chance of winning is 50/50 because there are an even number

[04:56] of red and black numbers on the wheel. But that's not a 50/50 proposition because the equation isn't 18 out of 36, it's 18 out of 38 because there are 36 black and red numbers, or alternatively 36 odd and even numbers, plus two green

[05:13] numbers. So, the casino's chance of winning is 20 out of 38 because if, for instance, you bet on black and the ball lands on one of the 18 reds or one of lands on one of the 18 reds or one of the two greens, the casino wins as well.

[05:27] So, if you work it out, the player's chances of making money is about 47.3% and the casino's chances of making money is 52.7%. So, the casino's edge over the player is 52.7

[05:41] 52.7 - 47.3, which is 5.4% - 47.3, which is 5.4% So, the casino has a 5.4% edge over the money at the end of the day. So, what does that 5.4% represent? Well,

[05:56] it means that in the long run, over many, many, many bets, billions of bets even, for every $1 that people bet in the long run, the casino will make 5.4% of that. 5.4 cents for every dollar bet. And so, if a million dollars are bet on

[06:12] the roulette wheel every day, the casino will make on average $54,000. 5.4%. So, the more people that play, the more people that bet, the more money the casino makes. That's the simple reality.

[06:27] example, if the casino's got a thousand bets, and each bet is a thousand dollars, and you bet on red, statistically out of a thousand bets, the casino is going to win 52.7%

[06:40] the casino is going to win 52.7% of the time, player's going to win 47.3% of the time, right? Which means that the casino will win 527 bets, and they'll lose 473 bets, right? Now, each time there's a bet at the casino, if the

[06:54] player loses, the casino wins a thousand, and if the player wins, the casino loses a thousand. So, statistically after 1,000 bets, they'll statistically after 1,000 bets, they'll win 527, they'll lose 473. So, if you do

[07:07] the math, they'll make $527,000 after a thousand bets, and they'll pay out $473,000 on the losing bets, meaning they'll make $54,000.

[07:20] So, that's how it works. So, what we're saying here is that as professional options traders, what we're actually doing is replicating the business model of the casinos. And we're going to show you exactly how we

[07:33] do that in a minute, but first of all, let me focus on a very important topic. And that is that most options traders lose money. 90% of people who trade options or even stocks or currencies, 90% of them lose

[07:49] And the reason most people will lose money is that they don't have a plan. They don't have a strategy. Right? They trade based on rumors, based on emotions, based on opinions that they can't back up with any real logic or

[08:04] proof. Because the reality is that most people who buy options lose money at the end of the day on those options. And the reason that they do is they do not understand the statistical basis of how options work.

[08:17] So for example, let's take Hasbro stock. Hasbro the toy maker was trading on December 1st at 82.69, it's high for the year as a matter of fact. And so this trader heard that Hasbro was going to rally. And he's

[08:31] heard that the cheap way to take advantage of a rally is to buy call options on a stock. So he heads over to an options chain which expires on January 16th, which is 46 days later. And he buys an 87 and a half call, which

[08:45] was trading for a dollar 40 that day. And so because the stock option represents 100 shares of stock, you pay a cash price actually of a $140 for the call that day. And that seems pretty reasonable because we think the stock's

[08:59] going to go up in a rally to 87 and a half would only be a rally of $4.81 a share. So that's not much of a move for a stock like that. So hey, if this thing is going to rally, I could make big bucks for only having to shell out $140

[09:14] for the right to buy 100 shares at 87 and a half in 46 days. That's plenty of time for this stock to take off and go way past 87 and a half and then I'd be But you'll notice

[09:28] for that options chain, which is a column you'll see on your broker platform. And if you look at the column, you'll notice that the 87 and a half you'll notice that the 87 and a half call has a delta of 29.47,

[09:40] which basically means that the stock statistically actually has only a 29.47% chance of closing above 87 and a half by January 16th. Which means that there is

[09:52] a 70.53% chance that the stock will not close above 87 and a half that day. And if you know anything about options, you'll realize that call options that are higher than the stock's closing price on

[10:05] the day that those call options expire, they expire worthless, meaning you lose 100% of your investment in that option. So, you'd lose $140 if that happened. frustrating part? The most frustrating part is that Hasbro actually did rally.

[10:21] part is that Hasbro actually did rally. And by January 16th, it closed at 86.2. But the call strike price was higher than that, up at 87.5. And so, that option expired completely worthless, and you lost $140.

[10:36] And so, you heard a bullish rumor, you were right, you bought a call option, the stock went up, and you still lost money on the trade. You lost all of your money on the trade. And you know why? Because you were basically just

[10:51] dynamics of options. You didn't understand their probabilities. You just ran out and based on a rumor, bought a cheap call option when you honestly didn't know what you were doing or the math behind options. And so, what you

[11:05] would have realized is that what was a likely winning trade was in reality rigged against you from the beginning. Like the casino, the options market had Like the casino, the options market had rigged the game so that you had a 70.53%

[11:19] chance that you'd walk away with nothing, and you didn't even know it. And that's one of the major reasons that people lose money trading options, even if they are right and a stock goes up in many cases like this example of Hasbro.

[11:34] You see as professional traders, we make money at the end of the day by replicating the business model of the casino and not by replicating the foolishness of the gamblers. Do you remember that we explained how

[11:46] casinos rig the game in order to have a statistical edge over the player? Well, professional options traders rig their trades, legally of course, through professional options trading strategies. Okay, so most amateur options traders

[12:02] act like the guy we just mentioned who entered into Hasbro options trade with no real understanding of his probabilities uh of or how he would win that trade. Well, professional options traders don't fall into that trap.

[12:15] Instead, what we do is we study options strategies and we're keeping an eye out for repeatable strategies. Strategies we can trade the same way every time that a

[12:27] trade is triggered by our indicator or whatever we're using to determine bullishness or bearishness. And the key is that we will only adopt a strategy if we we've been able to rigorously test it using years of data

[12:40] that this options trading technique has significant edge, just like the significant edge of the casino has, and we need to determine that that edge has been consistent and sustainable for many years. And if a particular option

[12:54] strategy does not prove to have that historical edge, then we simply won't trade that strategy. We won't take a random untested shot and risk our capital without proof that this trade, over the long haul, has edge. That would

[13:09] be irresponsible. In fact, that would be gambling. And we're not gamblers. We're traders. So, let me give you an example of what I mean. We have a trader on our trade desk who, after hundreds of hours of backtesting, had found a strategy

[13:22] that was consistently profitable over many, many years. Now, this is a fair to the trader on our desk who did all that work to disclose the exact, you know, details of the strategy. But, what I'm going to be doing is the next best

[13:36] thing, and that is to show you the way his strategy works. The only thing you trade, which only goes off if the market is very likely to make a pretty strong move in one direction or the other. And

[13:49] the trigger will tell him whether it's likely to be a big bullish move or a big bearish move. So, through the example of what this trader developed, we're going to show you the principles of how professional traders work very hard to

[14:04] develop systems that allow them to trade like a casino and give themselves a sustainable edge. And so, to give you an example, let's move back to March 29th, 2018. And as you can see, the S&P 500 index,

[14:18] which trades under the symbol of SPX, had closed that day at 2640.87. that next trading day, which was April 2nd, 2018, the index opened at 2634.27.

[14:33] Down a little bit from the previous close, and the trader's trigger for a bearish trade, well, that went off. And so, he pulled up an SPX index options chain expiring 11 days later, which is part of his protocol, and he moves down

[14:48] to the put side, and he scans down that column called delta, which you'll find on any options platform, and he looks for a put option with a delta of at least 75. So, he picks that 2700 put,

[15:02] which has a delta of 76.61, which is close, and he buys that one at a price close, and he buys that one at a price of $77.25. And simultaneously, he heads down to the closest delta to the 25 deltas, which is

[15:16] the 2565 call, and he goes ahead and sells that one at a price of 1640. Now, when you do this, buying a put higher up on an option chain and selling a put lower down on that same options chain, when you do that, you are

[15:31] entering into what options traders refer to as a put debit spread, which is the option strategy this trader uses for this system when he gets a bear signal. Now, first of all, let's take a look at the cash needed to enter this trade.

[15:45] You see, he paid a price of 7725 for that 2700 put option. And index options have a payout of $100 per point, and so you multiply that by 100, and so the you multiply that by 100, and so the cash cost of that 2700 put was 7,725,

[16:01] cash cost of that 2700 put was 7,725, but he also sold that 2565 put. And for that, as you can see, he received cash in the amount of 1640. And so, the net in the amount of 1640. And so, the net cost of the trade was 6,085.

[16:13] And so, if we move to the end of the day, we can see that the index did sell day, we can see that the index did sell off that day, closing at 2581.88. Now, let's say that the trader's protocol is to close the trade if it

[16:26] reaches a profit equal to 15% of the cost of the debit spread. And conversely, he'll close the trade at a loss if the spread loses value such that it's lost 7 and 1/2% of its value. So, in other words, his target profit is 15%

[16:41] of the capital he put into the trade, and his max loss is stop is 7 and 1/2%. And so, on this day, it so happens that 15% of the cost of the trade comes to $912.75. So, that's our profit target that day.

[16:57] And so, as it happens at 10:15 a.m. that day, the 2700 put had rallied to price of 9150, and the 2565 put had also rallied to a price of 2060 because both

[17:11] puts are going to go up when the index is selling off. And so, the way that you close a debit spread is to sell off the put you bought and buy back the put you sold. So, if you had done that at 10:15 a.m. that day, as you could see from the

[17:25] calculation, you'll see that the proceeds from closing the trade is $7,090, which as you can see results in a profit which as you can see results in a profit of over 16%, which slightly exceeds the

[17:37] 15% target profit. Okay, and so assuming that the trade used about $6,000 in capital every time it was triggered. What he found was that if he put this trade on every time his indicator

[17:50] triggers, there was a high probability historically, not a guarantee, but a indicator tells him that it's going to be a bullish day, that then a bullish debit spread would be used, what's known as a call debit spread. Um the move

[18:05] would happen and that it will be a big enough move that he's going to hit his 15% profit target that day before the end of the day in all probability. Or, we just gave you, there's a good probability that the put debit spread

[18:21] will achieve a profit of 15%. Now, there's by no means a 100% chance of become a losing trade, but the probability is definitely greater than 50/50 that it will be won. And in fact, he found from backtesting uh many years

[18:37] that there was actually a 60% chance of it hitting its target profit before the end of the day and only a 40% chance that the trade would not make that move and instead go the opposite way. And so, if this happens, which it will 40% of

[18:52] the time, he'll simply take a stop and close the trade when it gets drawn down to a loss of 7 and 1/2%. So, to reiterate, his target is 15%, which on an average trade of $6,000 comes to $900, and his max loss is stop is 7 and

[19:08] $900, and his max loss is stop is 7 and 1/2% or $450. Okay, so let's say that as 1/2% or $450. Okay, so let's say that as we said 60% of the time you win and 40% of the time you lose. Well, for one thing you'll notice right away that this

[19:20] is way better than the casino edge we described earlier where the casino only had 52.7% as its edge and there are numerous option strategies with win rates well above 60%. So you could argue that based

[19:34] just on the probabilities that his system is better off than a casino's roulette system. But it gets better. You see what makes this strategy special is the next part and you could argue the most important part. You see when the

[19:48] casino offers a roulette game, the bet is that when you win, you win one to one thousand dollars at a roulette wheel and you win, you get a thousand. But if you

[20:00] lose, you lose a thousand. But with this option strategy and many others actually, when you win, you get double what you lose. And specifically as we said when the trader hits his target profit, he makes a profit of 15% of his

[20:14] capital that day or $900. And on losing days, which of course are going to happen, he only loses 7 and 1/2%, which is $450. In other words, when his trade gets drawn down to the point where it's down 7 and 1/2% of the capital he put

[20:28] then he's going to pull out and with discipline close that trade. And so in other words, his target profit, which is 15% of the capital he has in the trade, 15% of the capital he has in the trade, is double his stop or his max loss of 7

[20:42] and 1/2%. Or putting it another way, he has intentionally set his stop at half of his profit target. So on each winning trade, he wins double what he loses on losing trades. In other words, we're risking a dollar to make two dollars.

[20:57] you do this consistently, in other words, for example, if the trigger over time went off a hundred times and therefore we entered 100 trades, you should win about 60 trades and you'll lose 40 trades. But the crucial point is

[21:12] that each time I lose, I lose a dollar, while each time I win, I win $2. Why? Because like we mentioned, we fixed our stop loss and our target profit so that my risk reward is 1 to 2. So if on my first trade that requires $6,000 in

[21:28] capital, I'll be risking 7 and 1/2% if you think about it, or $450. I win the next trade, which my historical stats show me will happen six

[21:40] out of 10 times or 60%, then that next day when I win, I'll make $900. And so for the first two days, I'm up $450 having won $900 and only lost $450.

[21:54] And of course, I know that whenever I make a trade, I've got no certainty as loss. And in fact, in the short term, I may have a losing streak. Or for that matter, I I might have a winning streak, but either of those outcomes, well,

[22:07] that's what they call luck. And it's basically just noise. But over many trades, say 100 in this example, in other words, over a statistically significant number of trades, I know that the statistics are in my favor.

[22:21] That I'll make 900 bucks hitting my target profit of 15% more than half the time, and the other times I'm only losing $450, which is my 7 and 1/2% stop. And so let's suppose that I want to try to figure out how much this

[22:35] system should make me for over 100 trades. Well, that's the final part of this lesson, which pulls the whole thing together. You see, every trading strategy has a win rate and a loss rate, and those are percentages, of course,

[22:49] which is the amount of money you win when you win, and the amount of money you lose when you lose. And so what professional traders do is they have a formula called the expectancy formula, and it tells you how much you expect to

[23:04] make on each trade over time, and then you just multiply that expectancy per trade times the number of trades, and the answer is how much you should make on the strategy over, say, 100 trades. And so, the expectancy formula works

[23:18] like this. You take the percentage probability of winning, and you multiply that by the profit you make on the winning trades, and you subtract from that the probability of losing the trade times the amount you lose when you lose.

[23:31] And so, when you do that subtraction, the result is what is called the average outcome of the trade. And if this is a positive number, then it's known as a positive expectancy strategy. And if it's a negative number, it's known as a

[23:45] negative expectancy strategy. And so, for instance, with this trade, if you multiply the 60% probability of winning times the dollar amount you win, as you can see from the calculation, you get a result of $540. And if you multiply the

[24:00] 40% probability of losing by the amount you lose, you get a figure of $180. So then, by subtracting those two, you get what traders refer to as the average outcome of the trade, or for short, the expectancy per trade. And so, therefore,

[24:16] over 100 trades, the result should be a profit of $36,000. that you're going to win 60% of the time. For instance, suppose that for whatever reason, you go through a rough patch, and your win rate drops down to

[24:31] even as low as 50%, which shouldn't happen, but if it somehow did, then it means that out of 100 trades, you win 50, but you also lose 50, right? Because of the way that we have set our risk to return ratio, we would still win $2 for

[24:46] every $1 we lose, so we'd simply recalculate our expectancy calculation, assigning a 50% probability to both the winning and the losing. In which case, winning and the losing. In which case, we still make $225 per trade on average,

[25:01] and as you can see, even though each trade has only been a 50/50 proposition, which means that our 100 trade expectancy would be a profit of 22.5, it's still a solid profit. So, in other words, if our win rate dips, we have a

[25:15] strong margin of error for an excellent outcome in either case. And so, what I'd like you to take away from today's video is that professional options traders develop trading systems that not only have a high probability of

[25:29] winning a trade, but also have a superior ratio of risk to reward, which acts as a kind of fail-safe. So, that if the probability of the trade starts to drop somehow, then the strategy should still be very profitable on the strength

[25:43] of the tight risk management, where we risk $1 to make $2, meaning your risk to reward can actually drop to one to one, and you'll still have a solid system. This is how professional options traders discipline themselves to design systems

[25:59] that are safe and effective, and now you've got the tools to begin taking a look at your own trading approach, and fine-tuning them to the standards we've described in this video. If you could put that work in and achieve that, you

[26:12] may well have what it takes to be a professional options trader. So, thanks time. Now, if you'd like to learn three more options strategies that our pro traders use, including a unique options trick that allows you to make money

[26:28] while you wait to buy stocks or ETFs at the price you want, and the options income strategy that allows you to make consistent money whether the market goes consistent money whether the market goes up or down or sideways, and how to make

[26:41] money on a stock or index trade even if you're wrong on the direction, then click the link that's appearing right now at the top right-hand corner of your screen. That will open up the free workshop registration page in a new

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