Trade Options with an Edge

Copyright © 2017 by Dr. Russell Richards.

Library of Congress Control Number:   2016914061

ISBN:      Hardcover      978-1-5245-3819-4

                Softcover        978-1-5245-3818-7

                eBook             978-1-5245-3817-0

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Rev. date: 02/15/2017

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CONTENTS

Chapter 1 Is This Book for You?

The Growth of Small Consistent Gains

Why Options?

Who Can Benefit from This Book?

Probability-Based Approach

Why Most Option Traders Lose Money

How Is My Approach Different?

Executing the Strategies Described in This Book

Next

Chapter 2 My Investment Journey

Why You Should Follow My Options Investing Approach

Mutual Fund Investor

Buy-and-Hold Investor

Fundamental Analysis Phase

Technical Analysis Phase

Managed Account

Trading Options

The Typical Investment Book

Next

Chapter 3 Option Basics

Definitions

Leverage

Buy or Sell / Long or Short?

Breakeven Prices

Risk Profile

Intrinsic and Extrinsic Value

Moneyness

The Option Chain

Exiting Option Positions

Option Price Terminology

Next

Chapter 4 Option Pricing

The Probability Distribution of Future Stock Prices

Lognormal Distribution for Stock Prices

Probability of Profit and Probability of Being In the Money

Standard Deviation of Stock Prices

Black-Scholes Option Pricing Model

Implied Volatility

The Option Greeks

Delta

Theta

Vega

Gamma

Basic Facts about the Greeks

Screenshot from Book Software

Conclusion

Next

Chapter 5 The Core Option Strategies

Introduction

Buying Power Reduction

The Six Core Strategies

Buy or Sell Calls and Puts

Vertical Spreads

Risk Profiles and Breakeven Prices for Vertical Spreads

Long or Short?

Probability of Profit

Vertical Spread Terminology

Calendar Spreads

Covered Writes

Synthetic Equivalences

Summary

Next

Chapter 6 Named Option Strategies

Straddle

Strangle

Butterfly

Put Ratio Spread

Call Ratio Spread

Iron Condor

Jade Lizard

Diagonal

Married Put

Protective Collar

Super Bull

Super Bear

Sunny Side Up

Balanced vs Unbalanced Option Positions

Stock Price Regions

Double Calendar/Double Diagonal

How Should You Begin?

Option Wheel

Conclusion

Next

Chapter 7 What Is Our Edge?

Selling Premium

Collecting Time Decay

Expected Profit

Efficient Markets

Expected Return of an Option Trade

Impact of Overestimation of Standard Deviation on Profitability

What about Actual Results?

Implied Volatility Reversion to the Mean

Probability of Touch

Manage Winners

Doing the Smart Things and Sweating the Small Stuff

The Casino Analogy

Translating the Edge into Profits

Putting Less than 100% of One’s Portfolio at Risk

Conclusion

Next

Chapter 8 Select Underlyings for Trading

Schools of Thought

Fundamental Analysis

Technical Analysis

Contrarian Investing

Reversion to the Mean

Momentum Investing

Blended Approach

Liquidity

Implied Volatility and Implied Volatility Rank

Implied Volatility Reversion to the Mean

IV Percentile

Watchlist

Using Your Watchlist

Correlation

Diversification and Modern Portfolio Theory

Other Forms of Diversification

The Advantages of Exchange-Traded Funds (ETFs)

Summary

Checklist for Placing a Trade

Next

Chapter 9 Select Candidate Strategies

Formulating Your Assumptions

Match Option Strategies to the Assumptions

Impact of Type of Account on Option Strategies

Trading a Restricted Account

Risk Tolerance

Use IV and IVR to Determine If the Position Should be Long or Short

Commissions

Conclusion

Pulling It All Together

Next

Chapter 10 Evaluate Candidate Strategies

Evaluation Metrics

Maximum Profit

Maximum Loss (or Risk)

Buying Power Reduction

Breakeven (B/E) Values

Probability of Profit (POP)

Theta Efficiency

Delta Efficiency

Risk Profile

Return on Capital (ROC) and ROC/Day

Using the Excel Software to Evaluate a Position

Using the Metrics

Synthetic Equivalences and Substitutions

Next

Chapter 11 Placing the Trade

Getting on the Board

Select the Expiration Cycle

Option Chain

Select the Strikes

An Iterative Process for Strike Selection

Enter the Strategy

Decide on the Entry Price Target

Position Sizing

Avoiding Large Drawdowns

Type of Order

The Duration of the Order

The Final Step: Submit the Order, Confirm, and Send

Next

Chapter 12 Directional Bias of Your Portfolio

Correlation

Beta

Revisiting Delta

Beta-Weighted Deltas

Beta-Weighted Gamma

Monitoring the Portfolio Risk

Exploring Portfolio Delta Changes

A Personal Experience

Next

Chapter 13 Monitoring Your Portfolio

What Portfolio Information Should You Have?

Overall Portfolio Metrics

Individual Stock Positions

Evaluating Individual Positions

Options Expiring ITM

Binary Events

Hedging a Portfolio

Next

Chapter 14 Managing Winning Trades

Alternatives for Managing Your Trades

Exiting Winning Trades

Defining the Profit Target

Exiting Covered Write Trades

Studies on Exiting Winning Trades

Probability of Reaching a Profit Target

Distribution of Time to Reach a Profit Target

Exiting Winning Trades Separately or as a Package

Managing Trades That Don’t Become Winners Until Close to Expiration

Summary

Next

Chapter 15 Managing Losing Trades

Responding When Trades Go Bad

Debunking Common Wisdom (Stop Losses)

Managing Your Losing Trade

Defined Risk and Undefined Risk Trades

Capital Reduction Trades

Managing Losing Undefined-Risk Trades

Estimating the Risk of an Undefined-Risk Trade

What Actions Can Be Taken?

Understanding the Evolution of Losing Trades

Consider Pr(Touch PR) before Exiting a Losing Trade

Rolling Losing Trades

Going Inverted on Rolls

Adjusting Profit Exits When Rolling

Other Adjustments

Managing Losing Defined-Risk Trades

To Adjust or Not to Adjust? That Is the Question!

Trade Expectations

The P&L Over the Lifetime of a Trade

Summary

Next

Chapter 16 Trading IRAs and Other Restricted Accounts

Introduction

Restrictions

Comparison of Strangles with Iron Condors

Using Synthetic Equivalences

Next

Chapter 17 Pairs Trading

Correlation

Beta

Notional Value and Weighted Notional Value

Beta-Weighted Deltas

Selection of Underlyings for a Pairs Trade

Putting the Pairs Trade Together

Pairs Trades Using Options

Deciding on the Pairs Strategy

Managing the Pairs Trade

Next

Chapter 18 Market Awareness

Broad Market Indices

Bond Activity

Volatility

Commodity Indices

Volume

Bellwether Stocks

Watching the Laggards

Tape Action

Market Breadth Indicators

Currency Indices

Conclusion

Next

Chapter 19 Wrapping It Up

The Edge

Conclusion

Next

Chapter 20 Excel Software

Analysis Software

Directory of Worksheets

Software Conventions

New Entry

Position Metrics

Inventory and Open Transactions

Risk Profile

Mid-Course Analysis

Pairs Trading Assistant

Black-Scholes Calculator

Calendars and Diagonals

Solve for Implied Volatility

Determine BPR

Key ETFs

Expiration Dates

Evaluate IV Change

Strategies

Futures

Retirement Planner

Tax Planner

Explore P&L Surface

Conclusion

Next

Appendix A Attractive Portfolio Returns with Small Allocations

Appendix B Tastytrade

Appendix C Option Position Arithmetic

Appendix D Investing Hardware and Software

Appendix E Summary Metrics for Common Strategies

Appendix F Popular ETFs

Appendix G Implied Volatility Skew

The Put Skew

The Put Skew Trading Opportunity

Appendix H Probability Distributions

Continuous Random Variables

Probability Density for Future Stock Prices

Appendix I Checklist for Entering Trades

Liquidity

Implied Volatility

Your Assumption

Strategy

Duration

Expected Move and Strikes

Position Size

Portfolio Fit

Awareness of Binary Events

Evaluation Metrics

Price and Order Type

Appendix J Futures

Appendix K Acronyms

Appendix L Market Indices

Appendix M Buying Power Requirement

Cash Secured or Retirement Account

Margin Account

Portfolio Margin

PREFACE

I HAVE BEEN INVESTING all my adult life. Probably like most of you, I focused initially on mutual funds and stocks. That was fine as long as the market was rising. However, multiple large market declines convinced me that I had to find a way to make money even when the market was not increasing. That led me to explore options trading.

My initial forays into options trading were not successful. I was enticed by the leverage that options trading provided, and I fell into the trap of going for the home run. It was not until 2012 when I somewhat accidently discovered a new Internet site, tastytrade, that was streaming live programs from 8:00 AM to 4:00 PM EST every trading day. All the programs were about trading (stocks, options, or futures), with most focusing on options trading. I was immediately attracted to the site because the presenters all had good credibility—each had been a successful floor trader. Furthermore, the approach they prescribed aligned well with my own analytical background. But most importantly, I made money when I used their approach.

I owe tastytrade a big debt of gratitude. After reading this book, you will too. I strongly recommend that you become a tastytrade subscriber. They are now the largest live streaming financial network with over 100,000 viewers. They are amazingly customer oriented. I frequently send e-mails to the founder, Tom Sosnoff, or his sidekick, Tony Battista; and I have always received responses in twenty-four hours or less. Just go to tastytrade.com or download their Apple app or Android app. Or view them on one of their other streaming video offerings. Tastytrade is free. You will not get a better trading education for thousands of dollars.

My approach to options trading is analytical. I recommend that the user consider several metrics before deciding to place a trade or to exit a trade. The metrics that you need should be generated by the trading platform provided by your brokerage firm. Thus, you need only understand what the metrics mean and know how to use them.

All the metrics that I use are provided by TD Ameritrade’s thinkorswim (TOS) trading platform. I believe TOS is the best and most powerful trading platform available to support trading, and it is available free to anyone with an account at TD Ameritrade. It was the main reason that I transferred all my trading accounts to TD Ameritrade. If the trading platform provided by your broker does not provide the information described in this book, you should seriously consider switching to TD Ameritrade. Trading on an inferior platform is like working with one hand tied behind your back. Tastytrade also provides a very nice trading platform called dough, but since it works in conjunction with TOS, you will still need an account at TD Ameritrade to take advantage of it.

I have developed a software package to support my own trading. It requires any version of Microsoft Excel 2007 to present. It provides all the metrics that I discuss in this book, along with several other useful functions including retirement planning and tax estimation. I am providing that software with this book. I believe you will find it useful. Download instructions are provided later in this book so that readers can access the software.

I am not a professional trader. I have a PhD in mathematical sciences. In my professional career, I have been a tenured professor of operations research, a consultant, a cofounder of three businesses, an entrepreneur, an inventor, a manager of operations research and systems analysts, a systems engineer, and a research and technology manager. I am now retired, but I am registered with the IRS as a securities trader. I spend most of every weekday trading options, futures, and stocks. I consider it a labor of love.

When I seized upon the tastytrade approach, I realized that my background in probability, optimization, decision analysis, systems analysis, modeling, and simulation was perfect for their approach to trading. Then, when I realized the parallel the approach had to the way gambling casinos grind out consistent profits day after day, I was sold. Give me a small edge, give me an opportunity to place lots of small trades, give me good mechanics, provide me with a good trading platform; and I will produce consistent profits. You can do this also. You will learn that it doesn’t matter if the market is going up, down, or nowhere. You will have the tools to make money in any kind of market.

You do not have to have an analytical background, but you do need to have an appreciation of probabilities and be systematic in your approach. Since my approach recommends active management of your positions, you should plan to devote at least one hour trading three days every week. This book will teach you the mechanics for successful trading. You need to just grind out results like the casino.

I believe that you will be able to generate consistent returns of 1% to 2% per month. That may not sound like a lot, but when you do it month after month, year after year, the power of compounding returns leads to a sizable portfolio. These returns beat most managed accounts, mutual funds, and hedge funds. You will find very few financial advisors who will do better; and believe me, it is a wonderful feeling to know that you can manage your own money better than almost anybody else.

SOFTWARE: TRADE OPTIONS WITH AN EDGE

I HAVE DEVELOPED A powerful software package over the last several years to support my option trading. The software provides the calculation of all of the metrics and probabilities discussed in this book. In addition, it provides useful tools to support the selection of strategies, the decision to exit an existing trade, and the sizing of pairs trades. It also offers assistance with maintaining inventories of positions, retirement planning, and tax estimation.

I believe you will find the software very useful. That software is provided free to all purchasers of this book. I have made that software available for downloading from my cloud server. You need only follow the download instructions at the bottom of this page. I intend to keep an up-to-date version of the software that you can revisit from time to time and download the latest version using the same instructions.

The software is written in Visual Basic for Applications (VBA). You will need Microsoft Excel (any version from 2007 to present) to run the software. It makes extensive use of the macro features of Excel. Therefore, make sure that you have macros enabled in your instantiation of Excel.

Software Updates and Other Supporting Material

I will update the software from time to time and provide other material for corrections to the book, the results of new important studies, or other material that I think will support your trading. It may also include announcements of additional products. You can access this new material by using the same link provided below. I suggest that you visit the site from time to time to make sure you’re working with updated information.

Download Instructions

I have placed the software on my Microsoft OneDrive cloud account and provided sharing privileges to all readers of this book. Enter the link below into your browser to access the software from the cloud:

http://tinyurl.com/j9ja6q4

When you have reached the shared folder, you should see a display like the one below. The actual display that you see will change as files are modified or added. The latest version of the software will be named TOWE Software.xlsm. Other files will be named TOWE yymmdd where yymmdd is the year, month, and day that the file was created. This will help you determine if you already have each file shown. In the display below, the folder has only two files—the latest version of the software and the Word document named TOWE_160420.docx. You can tell the latest date that each file was modified by looking at the Date modified column.

To download a file, you should highlight the file you want by right-clicking once on the name of the file that you want. For example, if you want the latest version of the Excel software, you should right-click on the line showing the name TOWE Software.xlsm. Your screen should then show the following:

If you then left-click on the Download option in the middle of the line above the list of files, the file will be downloaded to your Download folder. You can then execute the file by double clicking on it.

After publication of the book, I plan to post results of simulation studies that I think will be useful to support your trading. Therefore, as I suggested, you should view the site periodically to check for new information.

I suggest that you have the software open when you read the book so that you can follow along actually making the calculation discussed in the book. Also, since the book is in black-and- white only, having the software open will make it easier for you to follow along with the descriptions of the screenshots. I use different colors for the cells in the software to indicate what the user is required to do, and those colors may not be obvious in grayscale.

Chapter 20 provides basic instructions on using the software. Pay careful attention to the various conventions for using the software. For example, the user enters data only into yellow or blue cells, never into green cells. Also, there are very specific requirements for the order in which you will enter the information about the legs of an option position. Chapter 20 discusses each worksheet and provides screenshots for most of the worksheets. Since I am continually updating the software, you may find the latest software version to be somewhat different from what is described in Chapter 20. If that is the case, I will provide instructions with the software download.

ACKNOWLEDGMENTS

I MENTIONED IN THE preface how much I have been influenced by tastytrade. Much of what I discuss in this book is simply a capture in black-and-white of what tastytrade advocates and does each and every day. I want to thank Tom Sosnoff, Tony Battista, and the tastytrade research team for all that they do. As you read this book, you will see that I reference several of the tastytrade studies done by the research team. Unlike most financial organizations, tastytrade actually walks the talk and backs up what they say with studies based on real data. Tastytrade is totally transparent.

Thanks also go to TD Ameritrade for providing the thinkorswim (TOS) trading platform. I have had trading accounts at nine different brokerage firms, and TOS is by far the most powerful trading platform that any provide. TOS generates all the information that a trader needs to support the trading methods that I recommend.

I want to thank my reviewers, Gordon Johnson, Phil Balma, and Tom Anderson who provided me with encouragement and useful comments that improved this book. In particular, I want to give them credit for two rather substantial changes I made to my original drafts. One, was their suggestion that I soften the mathematical treatment in the book. Being a former graduate school professor, and considering that my options approach is analytical, it was difficult for me to eliminate all the mathematics. I want the reader to know that the approach I recommend indeed has a solid mathematical basis, backed up by testing with actual data. I did, however, tone down the mathematics. Furthermore, I excuse the readers from plowing through all the details, encouraging them, instead, to simply concentrate on understanding what various metrics mean and how to apply the results in their trading. And I provide the important takeaways that simplify, or even totally forgo, all of the mathematics.

I also want to thank my reviewers for recommending that I include my own trading software with the book. Since the software actually does all the calculations, it enables the reader to focus on understanding and using the metrics. In addition to supporting the trading, the software also provides a variety of useful worksheets to support retirement planning and tax preparation. Inclusion of the software enhances the value of the book.

Thanks also go to Miss Emily Needham, my high school mathematics teacher, for instilling in me a love of mathematics and an appreciation of applying analytical methods to solving problems. Trading options is but one application of this.

Finally, I want to thank my wife, Bobbie, who put up with me for a period of a couple of years after my retirement as I spent hours at my computer watching tastytrade, trading, trying out various option strategies, conducting experiments, developing software, and writing this book. She recognized that I was passionate about this effort, and she encouraged me from start to finish. It helped that my trading has been profitable.

CHAPTER 1

Is This Book for You?

Y OU CAN FIND all kinds of advertisements for investing programs that claim to return nearly 100% winners, or that will allow you to double your money in one year with little risk, or that they consistently produce tenfold winners in a single day, or that they will turn $10,000 into $1 million in one year. I think all of these claims are pure bunk. Think about it. Mutual funds return a long-term average of 9% or so (before fees) each year. Highly paid hedge fund managers (supposedly the smartest investors around) produce returns that fall short of the S&P 500 ¹ market index. So how likely is it that someone really has an investment program that will allow you to achieve returns like those stated above?

I will not make such ridiculous claims for this book. However, I do claim that the techniques addressed here will allow you to consistently grind out small gains that will grow your wealth significantly over time. I will show you multiple advantages that my options trading approach will give you. And those advantages will provide you with an edge that you will be able to turn into consistent profits.

Let’s see if the options trading program that I prescribe is appropriate for you.

• Do you have a self-directed brokerage account of at least $10,000?

• Are you willing to trade your own account?

• Are you willing to take a little risk?

• Can you trade online? You should have

o Internet access

o Computer, tablet, or smart phone

o Trading software (This should be provided by your brokerage firm, and this book provides software that will support just about everything that I recommend.)

• Have you tried other investment approaches and been unhappy with the results?

o Mutual funds

o Managed accounts

o Stocks and bonds

o Futures

o Options

• Are you willing to let your investment decisions be driven by the numbers?

o Probabilities

o Risk/reward ratio

o Return on capital

• Are you willing to spend some time at least 3 days a week to actively manage your portfolio?

o Make a large number of small trades

o Monitor and take action as needed

• Are you willing to forgo the home run trades to grind out small consistent gains (1%–2%) each month?

If you answered yes to all these questions, then this book is for you.

The Growth of Small Consistent Gains

Before I go farther, let me show you how small consistent gains each month can add up over time. You may not believe that one can get rich on small gains like 1% to 2% per month. I think you will change your mind after seeing the examples below. Table 1.1 displays the investment results for several different scenarios depending on the starting age of the investor, the starting amount of money available to invest, the monthly returns, and the annual contributions to the account. The annual contribution amount of $5,500 corresponds to the maximum IRA contribution. The last column of the table shows what the accumulated account value would be at age 65.

Table 1.1. Accumulation of fortune with small consistent returns

Yes, these values are correct. Compounding returns over a long period of time produces remarkable results. Note the advantage of starting early. But even if you start at forty-five, fifty-five, or even later, you can still build up your account size to a level that should support you for the rest of your life (I did not start investing with options as described in this book until I was sixty-eight). For example, suppose you are able to accumulate an amount of $1 million at age sixty-five. You continue to invest the account earning 1.5% per month, and you draw $150,000 out of the account the first year in retirement and increase the draw by 3% each year. At age 85, you will be drawing $270,917 per year (that should easily keep up with inflation), and your account balance will have grown to $5,702,447! At that rate, you should be able to live comfortably and leave a nice estate for your heirs. Note the huge difference between earning 1% per month and earning 2% per month.

The software provided with this book includes a worksheet that produces the results shown in Table 1.1. Input your own data and see what the future may hold for you. It is very useful for retirement planning.

Why Options?

This book is for the retail investor who wants to make money in both up and down markets and consistently outperform the market. I believe that trading options offers the best chance of accomplishing this goal, so that is the focus of this book. There are several reasons why I focus on trading options. Unless you are a great stock picker, your chances of having a winning trade are just slightly better than 50/50.

However, if you can reduce the cost basis of the securities you trade, the odds that you will be successful increase. Probably the most popular use of options is in covered call positions. In a traditional covered call position, the investor buys shares of a stock and then sells calls against that position. The credit received from selling the calls, in effect, reduces the cost of the underlying security. The more one reduces the cost of the underlying security, the more likely the position will result in a positive profit. Reducing cost basis is one of the main advantages of trading options. There are others. Let me list what I believe are the main advantages of trading options:

• Reduced cost basis

• Increased leverage

• Reduced buying power required

• Increased profit probability

• Increased ability to take advantage of volatility changes

• Flexibility in constructing positions to take advantage of any type of market (up, down or sideways)

This book will show you how to enjoy all these advantages.

Who Can Benefit from This Book?

You may be experienced at investing, but have not yet achieved the results that you seek. Or, you may be a beginning investor. I assume the reader has little prior knowledge about trading options. I start with the very basic information. My goal is to convince you that trading options offers the best chance of success and to provide you with the confidence and know-how to successfully execute. This book will show that option trading need not be risky and can be very conservative. It will show you how to trade with an edge. It will show you how to construct option strategies that completely define risks and match your assumptions about the prospects of an underlying stock or ETF. It will show you how to construct trades that can be profitable even if your assumptions about the market (direction, magnitude, or volatility) are wrong. How great is that—make money even when your assumptions are wrong! You can’t do that by buying stock or mutual funds.

When properly informed about the various option strategies—their advantages and disadvantages, their risk profiles and breakeven points, their probabilities of success, and returns on capital—I believe you will want to experiment with option trading. And if you follow the trading philosophy laid out in this book, I believe that you will consistently outperform the indices, mutual funds, and even most managed accounts. When you have experience in actually executing the various option strategies, it is reasonable to expect consistent returns of 1% to 2%, or more, each month in both up and down markets.

Probability-Based Approach

The approach that this book recommends relies heavily on probabilities. It advocates making a large number of relatively small high probability trades and to actively manage those trades. You do not need to be a math whiz, but you will need to devote time and effort each week to your trading. All the calculations you need are handled by the software provided with this book. And some of the brokerage trading platforms provide the information that you will need. I trade through TD Ameritrade largely because their thinkorswim (TOS) trading platform is the best available. TOS provides almost all the information I need.

The law of large numbers states that if the number of trials of a random event is large, then the fraction of successes will converge to the probability of success. This is why we want to have a large number of high probability trades. The approach manages risk largely at trade entry by properly sizing the trade. It recommends that the risk of each trade be no larger than 2% to 4% of your overall portfolio value. In addition, it recommends active management of your trades. Active management of a large number of trades will require that you devote time each week. I recommend at least an hour three days a week. If you cannot afford that much time, then my approach is probably not for you.

However, if you work your way through this book and you can devote adequate time to your trading, I’m confident that you will be able to generate generous returns month after month. You will become more knowledgeable about options trading than 90 percent of all options traders, and that knowledge, combined with experience, will translate into confidence and profits. You will enjoy the thrill of managing your own money. Few mutual funds or money managers achieve consistent returns of 1% to 2% per month. I believe you will be able to do so.

History shows that the vast majority of retail investors either lose money or make gains that lag behind the returns of common indices like the S&P 500. Most of these are long-term investors who trade mutual funds, stocks, or bonds. Furthermore, most are buy-and-hold investors. Some are very disciplined using techniques like dollar-cost averaging (DCA)² to periodically add funds to their investment portfolios. They take advice from stock advisory services or work diligently on their own using approaches like fundamental analysis or technical analysis to try to pick just the right underlying³ and the right time to place trades. Then, in monitoring their portfolio, they focus on managing their losing trades. They use such techniques as stop-losses to make sure that their losses are not large. If they correctly pick the direction that the underlying moves, and if they manage the position effectively, they make money; if not, they lose money.

Most retail investors are long investors. They count on the market going higher. If the market is in a prolonged downturn, they either wait it out and lose money or get out. They don’t have the wherewithal to make money when the market declines. I was that type of retail investor until only a few years ago.

I have been a retail investor for over forty-five years, concentrating mostly on managing my retirement accounts. During that time, I transitioned through many phases. I eventually largely rejected the basic tenets of each phase, but learned valuable lessons from each. In 2012, I was exposed to an online financial network, tastytrade,⁴ and their investing philosophy that focuses on a probabilistic approach to investing with options.

The remainder of this book will explain the probabilistic approach and guide you through its execution. For the first time in forty-five years, I am confident that I can make investment gains in any type of market (up, down, or sideways) that significantly exceed what can be gained by investing in common stock, common market indices, or mutual funds. And I believe I can outperform hedge funds or other managed accounts.

Why Most Option Traders Lose Money

The vast majority of retail investors that trade options lose money. Since options provide tremendous flexibility and leverage, why is this the case? I believe there are ten main reasons:

1. They do not properly consider the probabilities.

2. They do not properly consider the impact of implied volatility.

3. They fail to select strategies that best fit their assumptions, volatility, and risk tolerance.

4. They make investments on underlyings that do not have adequate liquidity.

5. They lack consistency.

6. They trade too large.

7. They do not have enough trades.

8. They do not properly diversify their portfolio.

9. They focus on the home run trades that seek big gains.

10. They pay more attention to managing losers than managing winners.

Too many option traders are intrigued by leverage. They look for the home run. Or they risk much too large a fraction of their portfolio on a single trade. Or they have bought into the saying Manage your losers and let your winners run. Or they do not understand how volatility impacts their positions. Or they consistently place trades that give them a low probability of success (50% or less). Or they trade options with wide bid/ask spreads, giving up too much money on entry.

How Is My Approach Different?

In this book, I will show an approach that is pretty much the exact opposite of what most options traders do. The philosophy advocated in this book is similar to that used by gambling casinos to consistently make money day after day. The essence of the casino strategy is as follows:

• Take on lots of small bets.

• Take only bets that provide a probabilistic edge to the casino (their edge ranges from less than 1% to as much as 20%—but is always positive).

• Manage risks on entry (the casino does this by limiting the size of any customer bet).

With casinos, it is all about having a probability advantage, even if that advantage is small. They just need to persevere—take on lots of bets over a long period of time. Given enough time, the law of large numbers guarantees that the casino edge will result in a nice profit. Isn’t it interesting that casinos provide gamblers with the opportunity to make the home run, but there is no bet for which the casino collects more than the gambler’s wager.

For example, slot machines sometimes (but very rarely) return payoffs 10 times or more than what the gambler bet. Roulette and craps offer bets for which the winning payoff could be up to 20–35 times the size of the amount wagered. But the gambler’s loss is never more than the amount wagered. Furthermore, the casino limits the size of the bets that the gamblers can place.

In spite of this, the casinos win consistently. They just grind it out. They know that they have a positive expected return on each bet, and over time and a large number of occurrences, they will achieve that expected return. The laws of probability guarantee their results. Wouldn’t it be nice if a retail investor could