Casinos And The Stock Market – How To Trade Stocks and Options Using Odds

January 17, 2012

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Casinos are built on odds and probabilities and to a certain extent, so should your trading system when it comes to the stock market. As traders, we know that we are never going to be right in picking the direction or magnitude of a stock market move all the time. So why don't we take a page out of the casino's book and focus more on the odds and risk management?

How Casino's Make Money

In very simple and easy to understand terms casinos make money by slightly tilting the odds and chances in their favor. Every game you gamble on in a casino has a built-in statistical advantage in favor of the house. That edge can be extremely small (as low as 2% sometimes), but millions of bets with that edge started to add up.

The casino owners could care less about any but getting as many people through the doors as possible to gamble. Hence why they offer free drinks, food, great shows and amazing hotels. The more people gamble, the more the casino makes.

Casinos know the odds and stick to a very strict risk management plan.

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Probabilities and Odds When Trading

It's fairly easy to find odds data on a particular stock, ETF or index that can transform your trading. By knowing how to analyze historical probabilities you can quickly narrow down your strategy list and choose option strategies that are more likely to make you money over time.

Just like the casino, the concept of trading professionally is knowing up front that you are going to have both winning and losing trades. The key to success is to make sure that the winners outperform the losers on a consistent basis - not just once in a while. Tilt the odds in your favor by making smarter decisions up front and managing risk along the way.

In this video, I'll show you how to find, analyze and choose an options trading strategy using think or swim's desktop platform tools.

[youtube]http://www.youtube.com/watch?v=hIoIZRJQiMI[/youtube]

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.

Henrik

Nice, thanks Kirk!
Joe

Nicely done video and a good introduction to the idea of trading with probability on your side, BUT…you’re overlooking a critical point. The TOS probability analysis is based on an index of *implied* volatility, not historical. That means you’re placing your trades around what the market *expects*, not actual past range of the stock–and the market is often wrong. Regardless, because the probability curve you show is based on market expectations, the odds are already priced in to your trade. Getting a real edge is a lot harder than you make it look.
- Kirk
  
  Your right and I realized I said historical probability when I shouldn’t have as much. In the top left corner of the chart the implied volatility figure is show on the chart. Even still, I think there is opportunity to get an edge based on your analysis and different probability levels. Stocks “price in” expectations much better than options and thus there is still ample room for us as traders to make money.
  - Joe
    
    @Kirk,
    
    If by “Stocks ‘price in’ expectations much better than options,” you mean that the options market typically commands a premium over historical volatility, I would agree. But execution is important, especially for options that aren’t as liquid as, say, SPY options. You take the bid, and you might not get the odds you think you’re getting.
    
    I don’t mean to be critical–just don’t want your readers to learn the hard way (like I did) that options-trading is a much more subtle art than most newsletters and webinars (and software like TOS) make it seem. I’m sure you’d agree. :-)
  - Kirk
    
    Oh I completely agree… illiquid options throw a lot of the stats and odds in different directions. Big bid/ask spreads can kill you alone.
JETWAKE GLOBAL

Very well done. This video gets real at the 7:50 mark to 9:00
john neale

Kirk and Joe, – – Thanks for the insight and clarifications.
Bill Place

Very well done Kirk
Tek Lentine

I use the TOS platform to calculate odds off stock movement in relation to vertical credit spreads. I enter this data into a proprietary spreadsheet that I created that calculates the area under the price curve at expiration for the spread.

The credit spread is set up with an ATM long option and a deep ITM short option. Changing the strike price of the ITM option has very little effect on the margin requirement of the trade, and has no effect on the downside risk of the trade. This means that the trader is free to pick a strike price that has acceptable open interest to provide maximum liquidity. I try to place the ITM short option outside of the 90% probability range.

Probabilities are extremely important to the trade as they are used to determine the % of times one can expect the underlying stock price to land within a given range. The expected profit can then be calculated using the difference between the area under the price curves on the winning and losing sides of the trade.

It is important that the options be held to expiration as this eliminates the effect of volatility on the options price and produces the most random results (random is what you want). This strategy will work with options using any expiration but is particularly effective with short term options. I personally focus on weekly options.

This strategy will lose money about 50% of the time depending on premiums and market spreads, but the losers are choked off early and the winners are allowed to run. This means that on the average the trader will break even or make a little money, but an average of 1 in 10 trades will make profits that obliterate any down side and leave handsome profits.

I know this strategy sounds complicated, and quite frankly, it is. This is the culmination of a lot of research and hard lessons learned through both theory and hands-on investing with the TOS platform. If anybody has suggestions for ways to improve this strategy, I’d be glad to hear your input.
Canyon6

Hi Kirk,
I loved this video because I never did understand this tool of TOS. Now I do and it will make it more interesting to use TOS in a different way. Thank you for making this video.