Beat the Dealer, Edward Thorpe, and Option Trading

Written on April 9, 2008 by OptionsRopeaDope

I saw the movie 21 Monday night, the story of how a group of wiz kids from MIT practice card counting and work as a team to fleece casinos in Las Vegas.  It’s a fun movie.

It also made me remember the book “Beat the Dealer”, a classic about how to card count at blackjack, and know when you have an edge so you can increase you bet. It is a reliable strategy if you follow the rules. Casinos try to nullify the advantages by dealing from 6 or 8 shuffled decks at a time and reshuffling long before the end of the deck is reached (where your odds improve dramitically), but you can still get a small edge if you pay attention.

Beyond that, there are also some definite rules around money management, and for good reason. From Poker to Craps, all gambling benefits from wise bet and money management, as does investing… so I decided to do a little math exercise to see how those lessons might be applied to your option portfolio.

The number one money management rule is to not bet more than 2% of your bankroll at a time. On an option trade I would equate that with a max loss. So, your max loss on a single trade should never bemore than 2% of your bankroll. As a general rule of thumb, Alot of income strategies set a max loss around 20% of the at-risk capital. That means the total capital used to make a single trade shouldn’t be more than 10% of your total bankroll… got that? So, along with all the other guidelines (balancing price risk, volatility risk, etc) your trades should be spread out AT A MINIMUM over 8+ different trades, assuming 20% kept in cash for adjustments. By initiating fewer trades (say, putting half your nut on a single iron condor) you increase your risk significantly…

There is also a corallary to this rule. If you were like me, and ever geeked out by writing a computer program to simulate black jack bets (this was nearly 15 years ago..I think I used qbasic) you find out quickly that the more bets you make, the bigger your payroll gets. You spread the risk out more, plain and simple. So, according to probability theory, if you spread your capital across 20 trades, your retrns would be smoother, and more predictable. Over 50, even more so, and so on. This applies even if it is on the same underlying, on different days or prices of course. So, scaling into a position fits right into this… using the half-of-capital-on-a-single-trade example I mentioned earlier, Scaling in over 4 days would qualify.

So, some things to think about. Theres always more to the story (such as, diversification across strategies and underlyings helps very much too) but as a general guideline, I think there’s much wisdom to be learned from studying how to Beat the Dealer for the option trader.

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