In this book, Dave briefly explained what are Options and even show you the procedures to place orders. What is interesting and very different from most trading books, is that he advocated the selling of Options. Instead of being a buyer of Options, you actually assume the role of a financial institution when you sell Options. No other instruments are able to let you be the house, where the odds of winning is on your side.
Why sell Options?
Options consists of time value and at the expiry, it becomes worthless. Statistically, 80% of the Options expire worthless and hence, you win most of the time as an Options seller. Time is on the side of Options seller. If you look at the time decay of the Options in the figure below, you would notice that the rate of decrease in the Options price increases as it gets closer to expiry.
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He termed Options selling as non-directional trading. Simply because you do not need to get the direction of the price to win. The price can move up a little, move down a little or stay stagnant, and you can still win as an Options seller. This further increased your probability of winning.
He uses a method called “short strangle” where he sells a pair of Options (one out-of-money put Option and one out-of-money call Option). He would sell the put Option at a lower price and a call Option at a higher price. This create an upper and lower boundaries and as long as the price stays within this zone until expiry, the Options seller would win. Using a probability calculator (available at his website), he would calculate the probability that the price will stay within the zone and he would only sell the Options when the probability is 90% or higher.
Even though the probability can be very high, the price may still move out of the range in a very bullish or bearish market. Hence, he would need to adjust the trade accordingly. If the trend is bullish and the call Options that he sold becomes a losing position, he would close it at a loss and sell another call Option at a higher price. On the other hand, his put Option will be making money and he will sell another put Option to collect more premium. In other words, he is basically shifting the price boundaries to capture the price within the zone. He may just decide to take the loss and not adjust the trades if the trend is really strong.
I really see Options selling as the only way for you to be the house or “bookie” as Dave put it in his book. In SGX, only the banks and financial institutions can sell Warrants to you. You can only buy call and put Warrants but you cannot sell them. Why are the banks doing this? There is only one reason – they continue to earn money from the retail investors by taking the other side of the trade. As long as they manage the risk at the system level, it is a profitable business.
I would also expect the profits to be very consistent. Unlike directional trading, especially at a longer time frame, your account fluctuates up and down with the market. There is no consistency. Selling Options would allow you to earn cash flow slowly. You would not get fantastic results in one trade, like 100% in one trade. You probably can make 5% consistently. But that is how casinos win money. They take your $1 bets consistently to build their empire.