The Casino's Edge & Options Trading

A casino's edge ranges from 0.5% for blackjack to as high as 17% for some slot machine games. Now, of course, this edge may or may not play out on the first, second, or tenth roll of the dice. But they are not in it for the short-term game. You see, the casino doesn't have to beat every player every time. They just know that they'll win their mathematical edge so long as enough bets are placed each year.

It's precisely why casinos offer huge incentives to get you to come back with free show tickets, free meals or even free hotel rooms. It's why the force table limits on how much you can bet on each hand and why they give you free drinks for playing. While you might think it's just them being nice, it's not. It's an investment they know pays huge dividends. In fact, on average casinos spend up to $45 each hour to keep you sitting in your seat and betting money.

Now, I frankly don't care if you like or hate casinos because the reality is that it's an insanely profitable business model based on simple math and expected outcomes. As options traders, we can learn a lot about how we should run our own trading business from casinos. In today's show, I want to walk through some of the most important takeaways that you can apply right now to your trading system and invite you to open your mind and try to see the big picture strategy.

Key Points from Today's Show:

All businesses have an edge, and it is a game of patience over time.
When it comes to casinos, over half their rooms are given away for free because they know that the longer you stay, the longer you will play.
Most casinos will actually give you money to start gambling to get you into your seat and keep you playing.

A Casino's Edge

Casinos know and realize that they do not have to beat every player every time.
However, they also know that it is just a matter of playing their edge over time and over many different players.
Ex: with roulette, there is a 5.5% edge, 17% edge with slot machines, 0.5% for Blackjack, etc.
There are all small edges, but yet they know that it will play out in their favor over time.

Trading Options Like a Casino

Using their edge, casino's do not care about one player at a time — they focus on the long-term game.
This strategy should similarly be applied to options trading. Single losing trades should not make a big impact on your overall trading position and outlook.
In casinos, there are often table limits set up in a game. They know their edge is long-term so one large bet carries much greater risk than many small bets over time.
This is similar to an options trading portfolio — keeping a small position, and position sizes.

Understanding the Trading System

Between your first trade and your 100th trade, anything can happen.
You could be profitable 90% of the time or only 40% of the time.
That does not mean the system is broken or that probabilities and options trading does not work. It just means that you have not played it enough.
You have to let the numbers work out over time.

The Edge in Options Trading

Implied volatility is a great trading vehicle even when it is really low. You can still make money selling options, even when implied volatility is low.
However, the edge is smaller when implied volatility is low. The amount of money you can generate when implied volatility is low is less than when implied volatility is high.
Therefore, when implied volatility is low you will do smaller positions and a lower allocation of your portfolio.

Using Your Edge to Your Advantage

Casinos deliberately lay out their casinos so that the most amount of opportunities for people to bet are in the games that have the highest edge.
For casinos, their edge is smallest in Blackjack -- 0.5%
In 2016, 74% of casino revenue came from slot machine, which have an edge of up to 17%.
In most casinos, their floor space is more than 85% allocated to slot machines because their edge is greatest.
The same concept should be applied to options trading.

— when the edge is greatest, allocate more to that type of position.

— when the edge is small, allocate less to these positions to create low-level, steady income streams.

The Fallacy of Doubling Down

You cannot get the market back. Portfolio drawdowns are part of the options trading game [see episode 75].
People falsely assume that if you have had 9 losing trades in a row, then the 10th must be a winner.
However, the first 9 trades have no impact on whether the 10th trade will be a winner or not.
You have to treat each trade as independently as you possibly can.

Example

You could make 10 trades with 70% chance of success, and 9 of those trades end up being losers. Then you believe that the next trade has to be a winner because the probability of having 10 losers in a row is really high. The problem with this reasoning is that you are not looking at the chances of getting 10 losing trades in a row. You are looking at the chance of the next trade being a winner, or not. The previous 9 trades have already happened and you are basing this investment off of blocks of 10 trades in a row, which is NOT how you trade. This is the fallacy of doubling down. So if you double down on the last trade, there is still a 30% chance that it will also be a loser.