a speculative opportunity in case a stockprice does, indeed, move your way. And in function, options (atleast when they’re bought and not sold) act as a kind of insurancepolicy potentially to limit risk.
Within this marketplace, there are key players, each of whomplays a vital role in making an efficient and liquid market. There isthe market maker, who provides a constant, continuous marketwith a bid and ask spread. There is the broker who executes cus-tomer orders on the floor, and the local traders who speculate onmarket movements. Behind the scenes, in trading offices aroundthe country, are professional traders who sit at computers off thefloor, as I do the majority of my days. As an owner of four tradingfirms and a partner in a Chicago-based brokerage operation, | amtrading on the floor less and less. But | trade on a regular basis ineither our 15th-floor proprietary trading office adjacent to the Op-tions Exchange or help manage our option fund, across the street inaroom filled with computer screens.
To understand options, I believe you must understand the roleof each of those players, and where you—as a professional traderor a retail speculator—fit into the game.
market makers
First there is the market maker who is obliged to make a two-sidedmarket—meaning he or she may have to sell an option that, asspeculators, they’d rather buy. In return for the obligation quotingthe marketplace 23
both bids and offers on options, the market maker is exempt fromReg T, meaning we can buy or sell stock without margin require-ments. (If an investor or speculator wants to buy a stock, they mustbuy the shares outright or put up a margin equivalent to 50 percentof the value of the transaction.) All we have to have is enough capi-tal in our accounts to cover the risk, which is called—inexplica-bly—a “haircut.”
For each stock, there is a designated primary market maker(DPM), a kind of overseer market maker whose job it is to makesure there is a liquid and orderly market for individual options. TheDPMs are analogous to the specialists who oversee trading of astock on the New York Stock Exchange. The American Stock Ex-change (AMEX) and Philadelphia Stock Exchange (PHLX) callthose people responsible for smooth and orderly trading of theiroption classes “specialists,” and the Pacific Stock Exchange (PCX)calls them Lead Market Makers (LMMs).
There are a few other advantages that come with the responsi-bility of being a market maker, namely leverage and the absence ofReg T, which allows us to buy and sell stock and options for a rela-tively small, up-front investment. For example, if a retail customerwants to buy 10 options that have a $6 premium, he or she musthave $6,000 in their account. (Each option represents 100 shares;thus 10 options are equivalent to 1,000 shares. With a $6 premiumfor 1,000 shares, the total value of the transaction is $6,000.) A mar-ket maker, on the other hand, could purchase the same 10 optionsfor as little as $150, thanks to leverage we receive for the obliga-tions we take on.
Leverage and the opportunities that come from being a marketmaker (and, at the risk of sounding boastful, being experienced inoptions trading) can bring some very big rewards. Neither the Ex-changes I trade on nor my fellow market makers, specialists, DPMs,and LMMs would appreciate it if | touted my performance, but I cansuggest a range of returns that is representative of the sort of num-bers we are capable of achieving. First, let me say there is no aver-age. Average doesn’t cut it on the trading floor. Boarding housesare full of average traders. The reason for that is simple: Overheadwill take all the profits of a so-called average trader.
Consider that the seat you need to trade on the Exchangescosts from $5,000 to $16,000 per month, depending on which ex-change you intend to trade on. The seats are in demand because24 ~=ihow I trade options
people are making money down on the trading floors. Most Ex-changes have a fixed number of seats. But the CBOE, which wasstarted by the Chicago Board of Trade (CBOT) in 1973, has an elas-tic membership since every full member of the CBOT can trade onthe CBOE. Even so, the demand for seats on the CBOE is intense.Each month, anywhere from 30 to 60 new members plunk downabout $2,500 to take the test for membership. Even with the elastic-ity created by the unique CBOE/CBOT structure, those new mem-bers mean that about the same number of CBOE members had toleave the business. When you do the math, you see that nearly one-third of our floor, which averages about 1,400 members, turns overevery year!
I think there are two primary catalysts for the surge in demandfor seats on our exchanges: (1) the rapid growth of retail optionbusiness and (2) the groups that have proliferated as computeriza-tion enabled them to link multiple floor traders with upstairs riskmanagers. When I started in 1981, there was really just one suchgroup on the CBOE—O’Connor, which was purchased by SBC War-burg Dillon Read in the late 1980s. Today, there are 15 such groups,each employing as many as 100 traders and, thus, pressuring asmany Exchange memberships (seats).
Given the cut-throat competition for seats and position in thetrading pits, you can understand why average doesn’t cut it. A rea-sonable amount that a good options trader takes home after ex-penses is $150,000 per year. With some seasoning, proper discipline,and sufficient capital, the numbers probably average between$200,000 and $800,000 per year. Exceptional traders, maybe the top 5percent, push into the strong seven figures.
Other than the lack of proper discipline, the greatest obstaclefacing the trader is access to satisfactory capital. For that reason,the majority of traders do as I did and find a financial backer to helpinsure their success. Profit splits range from straight salaries tosliding scales of profit-sharing. Some traders must sign noncom-pete agreements that obligate them to a certain number of years ofservice for the backing, while others gets 50 percent, 60 percent, oreven 75 percent of the profits they generate from their tradingactivities.
When you look at these kind of returns, you might say to your-self, gee, if ] had two or three winning trades and the kind of lever-age that a professional has, I’d really make a killing in this market.the marketplace 25
But you have to remember that the same kind of leverage that cancompound a reward will also compound the risk. Leverage puts riskon steroids. As a professional trader, when a trade goes against meI’m losing from 20 to 100 times as much as a retail investor wouldlose on the same dollar-amount of investment.
Another consideration is my cost, starting with a seat at theCBOE. The Chicago Board of Trade, where commodities such ascorn, soybeans, and wheat and financial instruments such as fu-tures on 30-Year U.S. Bonds are traded, founded the CBOE in 1973.At that time, every full member of the Board of Trade—about 931members—had a right to a seat at the optioas exchange. The seatswere originally priced at $10,000. The ail-time high was about$750,000. Today, the seats are valued at about $600,000. To lease aseat, the cost is about 1.75 percent per month, roughly $10,000 permonth. To be a trader on the floor, that $10,000 per month lease isquite an up-front cost.
Once you have a seat and pass the membership test, you needa clearing firm, such as the one I use—First Options of Chicago, aDivision of Speer Leads & Kellogg—to clear your trades. As a traderor broker on the floor, who buys or sells puts and calls on nothingmore than a verbal agreement, there must be a firm that stands be-hind your trades. You can usually tell by the color of the jacket thata trader wears—black is Bear Stearns; red is Schwab; steel blue isMerrill Lynch; and black jackets with planets on them are for Mer-cury Trading, my firm.
Traders’ connections with a clearing firm and trading firm pro-vide the assurance that any trade they make is good. Anothertrader doesn’t need to know your financial situation. All they needto know is that your clearing firm backs any trade you make, andalong with that there is the Options Clearing Corporation (OCC),which is the only AAA-rated clearing facility in the world. All listed
 
Here’s an aside on the naming of my firm: One day | was sitting in myoffice, which overlooks the CBOT, and found myself staring at thestatue of Ceres, the goddess of the harvest, that stands atop theCBOT. That gave me a little inspiration for the naming of my own firm,in this case for Mercury, the god of markets and commerce and theprotector of traders.
 
 
 26 how I trade options
options in the United States clear through the OCC, which standsbehind every trade with the full faith and credit of all its members,which include the likes of Goldman Sachs, Merrill Lynch, and Mor-gan Stanley Dean Witter. When you're trading on the floor, you'reidentified by your trading badge. On the CBOE and CBOT, we havefrom one to three letters that create our acronyms. Mine is “DRJ.” Ifirst sought out “JON,” but that was taken. So I opted for DRJ tohonor my Dad, because he, too, is known as “Doctor J.” Traders onthe Chicago Mercantile Exchange can choose up to four letters fortheir badges, while traders at the AMEX, PHLX, and PCX get num-bers on their badges.
As a professional trader, I pay miniscule commissions—10cents or less to trade an option and only a fraction of a penny ashare to trade a stock. That’s one reason why I’m not in competi-tion with the general public. As a professional trader on the floor, Ihave a time and place advantage that no retail investor can repli-cate. If you try to compete against someone who has one-tenth orone-hundredth of your costs in any business, you are going to loseno matter what and no matter how good you are. Additionally, floortraders, with our time and place advantage, can buy and sell infractions of a second, while the fastest cyber-trader still has topoint and click his or her trade into a brokerage, which then routesthe order to the trading floor.
No, my competition is not the public, but rather the other1,399 traders on the floor of the CBOE. With the time and place ad-vantage of being on the floor, and trading within shouting distanceof the institutional and retail brokers, I can trade repeatedly. Thatsheer volume of trades means that even if] make a profit on only 50percent of my trades (keep in mind that a market maker is obligedto quote bids and asks that may result in losing trades as obliga-tions are fulfilled) I can make money overall. How? Because | hedgemyself against risk, cut my losses short, and let my profits run.
Within this realm of professional traders, there are the mar-ket makers who are drawn by opportunity. Where there is thegreatest perceived opportunity—whether it’s Dell, IBM, or the lat-est dot-com stock—there will be the greatest number of marketmakers, all vying with each other for the brokers’ bids and offers.
When a new stock options out such as eBay or Broadcast.com |(which premiered briefly on the CBOE before the company wasthe marketplace 27
taken over by Yahoo) players compete to be the DPM. It’s not a bid-ding war with money involved. Rather, it comes down to who willmake the best market. First, you need to show you are an experi-enced market maker. In the case of Mercury Trading’s Chicago of-fice, we handle 30,000 options and several million shares of stockeach day. Then you propose your specifications to create a deep,liquid, and tight market that will encourage people to trade. Basedon the various proposals, the Exchange’s committee chooses whowill be the DPM for the new issue.
The first time Mercury Trading was given DPM status was forCapital Cities Broadcasting. That was a great one. At that time, themanagement of Capital Cities went to Warren Buffett with whatturned out to be a valuable discovery about New York propertiesthat ABC’s owned: They thought ABC’s New York City propertieswere not properly accounted for on the balance sheet. These hid-den assets meant, in effect, that ABC’s stock was grossly under-valued. So when Capital Cities’ made its bid to buy ABC back in theearly 1980s, both stocks went up. (Normally, the buyer’s stockgoes down because of added debt to pay for the transaction or dilu-tion due to additional shares being issued to finance the deal.Shares of the firm to be acquired usually rise to near the buyer’sbid price, with a slight gap in case the transaction should fallapart.) As you may recall, takeovers like this and others engineeredby people such as Carl Icahn and T. Boone Pickens were the rage asso-called vulture capitalists sought value from the stocks thatmanagement was unable or unwilling to emancipate. (It’s strangeto imagine that now in early 2000, the government may unintention-ally take on the same roll in the Microsoft case, as they negotiatewhether to split the software giant into two or more companies.)
The CBOE didn’t always have DPMs. In the beginning, Chicago,being fiercely entrepreneurial and very competitive, wanted todraw a distinction between itself and the New York Stock Exchange,which has the specialist system for trading stocks. Instead, theCBOE set up its marketplace as a very egalitarian arena where any-one who was fast and aggressive could get the trade. Remember,anyone on the floor of the Exchange has to perform one of two func-tions: they’re either a broker executing customer trades or they'remarket makers who make a two-sided market. That made for a veryindependent environment.28 how I trade options
Then in 1987, the CBOE created DPMs. We needed a specialist-like entity to compete in the newly competitive battle for multiple-listed stocks. Until 1987 there was a lottery for stock options. Eachtime a new stock was eligible for an option, it was offered toPhiladelphia, Chicago, the Pacific Exchange, American Stock Ex-change, or the New York Stock Exchange. (In 1997, the CBOEbought the New York Stock Exchange business.) Under a Securitiesand Exchange Commission mandate, options could only be listed onone Exchange.
What ensued prior to 1987 was a little like an NFL-draft. TheExchanges acted like the team management, accepting the stockoptions they wanted when it was their turn to pick or passing it onto the next Exchange. With options, it’s completely up to the Ex-change to choose which options it will list. The company doesn’t re-ceive any compensation for its options to be listed, nor do theyhave to pay the Exchange to list its options.
But that practice changed in 1987. Now, when a new option isavailable, it is more than likely to be listed by all four Exchanges.When this happened, the CBOE found its lack of a “specialist,” oneindividual who centralized all trading and brokerage, was a detri-ment. Large institutions such as Salomon or Merrill Lynch wantedto deal with one person in the options market who was in charge ofthat stock. Thus, to compete and survive, the CBOE gave birth tothe DPM.
The DPM must always have a presence in the pit to ensure anefficient and orderly market. In return for that responsibility, theDPM gets a minimum of 30 percent of the trades. That means if 100lots are traded, at least 30 of them go to the DPM. If there are 1,000options, at least 300 go to the DPM—regardless of price. But thatdoesn’t mean a DPM can set any price. Options are usually multiplelisted so even if you tried to quote a price that was too high or toolow, the other Exchanges wouldn’t move. When the market re-turned to equilibrium, you’d be eating the price difference all theway up or all the way down.
Now, with 20 new stocks eligible for options every month (andbearing in mind that these options are likely to be multiple-listed),firms must bid to become the DPM. Their proposals must show thatthey will not only create the best possible market to attract volumeto this option, but also win a majority of the business away fromother Exchanges that may list the same security.the marketplace 29
My firm, Mercury Trading, specialized in biotechnology firmsin the 1980s (a reflection, perhaps, of my own interest in the bio-technology field, given my father’s specialty as an organ-transplantsurgeon) and in high-technology stocks in the 1990s. Whatever thestock, it’s important to remember that customers want volatility. Ifthe underlying stock price doesn’t rock and roll, there will be feweropportunities to buy or sell the option.
At the same time, the DPM must be aware of the dynamics ofthe options marketplace. For example, when a big order comes in,the effect will extend beyond the option to the underlying stock aswell. So if there is a big seller of Micron options, say 5,000 optionsor so, that’s equivalent to 500,000 shares of stock. If someone sellsthat much stock to hedge an options position, you know the stockprice is going down. Although options are a derivative of the under-lying, there are times when the catalyst for the market movementbegins with the options, sort of a tail-wagging-the-dog scenario.
In most situations in options, the only player bigger than theDPM is going to be a large mutual fund or, in the case of an NYSElisting, the stock specialist. For example, on the occasions whenFidelity is getting into the options market, they’re going to dwarfeveryone else. It’s like in the movie, Jurassic Park, when the T-Rexis approaching. You can hear and feel the ground shaking asbig funds trade 200,000 shares the way customers trade oddlots. But as the DPM, entitled to 30 percent of the volume of a bigstock such as Sun Microsystems (SUNW), I’m going to make somenoise, too.
At the same time, it’s the responsibility of the DPM to createan orderly marketplace to facilitate both large orders and small. Forexample, say a broker has 5,000 options to sell, although he won'ttip his hand in the beginning regarding the size of the transaction orwhether he’s buying or selling. He has to begin this ritual with ashout to the pit, for anyone within earshot to hear. Even with all ourelectronics, we’re still an open-outcry auction marketplace. And soit begins like this:
“What’s the market on Jan double [meaning, in this instance,55—get it? Double 5s] calls?” the broker yells out.
“Four to a quarter, a thousand up,” the DPM replies. [This re-sponse lets the broker know the bid is 4 and the offer is 4%, both for1,000 contracts. ]
“T’ve got 5,000 to go,” the broker adds.30 = how I trade options
Now, the DPM, specialist or LMM has to estimate how muchimpact that half-million shares is going to have on the price of theunderlying security. To buy or sell a large order, a market maker isgoing to want to build in a little price protection for himself.
“For 5,000 my best bid is 3%,” the DPM shouts, estimating heneeds another % point to get the majority of his hedge in the under-lying stock. If you do the math, a quarter-point price adjustment ona 1,000 lot is worth $25,000, or $125,000 for a 5,000-lot. But beforeyou begin to think trades like this are free money, consider the factthat if the DPM misjudges the impact of his hedging, the stockcould fall by %, %, or more, thus locking in a loss of $125,000,$250,000, or more! That’s why I spend so little time at the tables inLas Vegas. I get plenty of action every day, and I think my odds arebetter on Wall Street.
Or perhaps the deal is best done in increments. That scenariogoes like this:
“What’s the market for Jan double calls?” the broker begins.
“Four to a quarter,” the market maker replies.
“I’m a seller,” the broker tells him. “How many are you buy-ing?”
“Five hundred on that bid,” the market maker says.
“Sold!” Thus the first 500 options are purchased by the marketmaker for a $4 premium.
“Where can I move some size,” the broker continues.
“3% bid for 2,000,” the market maker responds.
If the broker is still selling, then it could be a large order. Thatmeans the options and the underlying stock price are likely to godown.
“Sold you two thousand,” the broker adds.
“Done,” the market maker agrees.
Perhaps the next 1,000 lot is down at 3’, and then at 3% andthen at 3 and so on. The market maker is protected from what is ex-pected to be a drop in the stock price, and the broker has staggeredthe selling price on the way down. For the market maker, this riskprotection is crucial, because when he or she must hedge their riskby selling 500,000 shares of stock to offset those 5,000 options thatwere purchased, the specialist at the New York Stock Exchange isgoing to go through a similar price discovery ritual. And, there’s noguarantee that the market maker will be able to purchase all thethe marketplace 31
stock that is needed to offset the options position—particularly ifit’s late in the day. It’s not that there is a right or wrong way for thebroker to execute the order, but as the scaled price example aboveillustrates, a single price execution is often the better route forsuch large-block option trades.
The conundrum the broker faces is just how much informationcan be disclosed to get the trade done at the best price for the cus-tomer. The broker-customer understands that a 5,000 lot in-the-money (ITM) option trade will necessitate a hedge of up to 500,000shares of the underlying security. But if after opening up to the spe-cialist, DPM, or LMM, the broker sees blocks of stock hit the mar-ket, or option prices dropping like crazy, that would be the last timethat broker would open up to that crowd. These are the times whenthe market maker must forget about trading the market, and con-centrate only on making one.
There are times when trading a customer’s order goes againstyour own best interest, including if you get stuck in a position thatgoes against you. I remember vividly the biggest loss my firm everhad in one day. We lost $1 million on my birthday, September 29,1991. Here’s what happened:
One of our traders was trading options for SciMed LifeSystems, a med-ical device company that has since been acquired, and we were theDPM for this stock. SciMed (SMLS) was very active in those days, andthe stock was up sharply that year based on a strong performance todate. On September 29, late in the session, the stock was around $94a share.
It was two minutes to the close. Goldman Sachs came into the mar-ket to buy 2,000 put options with a strike price of $70 a share. In otherwords, that customer was either betting that the stock was going to godown sharply, or looking to hedge some downside exposure after thebig run up. We knew that earnings would be announced after the mar-ket closed, and thus, volatility was trading near its zenith.
So the trader made a bet against Goldman Sachs, which is never awise gamble, as they clear a number of very well-informed, fast-moneyhedge funds. Our trader figured those puts were only disaster insur-ance. The chance of the stock actually going down $23 a share, in hismind, was very slim. So he sold those puts, which meant he was obli-gated to be long the stock at $70 a share, and did not hedge the expo-sure by selling the physical stock. For one thing, it was two minutes tothe close, and it would have been difficult to hedge 2,000 options—thehow I trade options
equivalent of 200,000 shares of stock—in two minutes. Besides, thetrader was convinced that we'd make a small fortune selling those puts,anticipating the volatility would zoom out of the options after the earn-ings, and he’d be able to buy them back and make a big profit.
Keep in mind that our policy has always been to be flat overnight.We massage all our long and short positions until everything is hedged,even if that means carrying millions in stocks to offset our long andshort options positions. The goal is always to be hedged, so that we arejess than one percent long or short.
The SciMed Life options scenario was a deviation from that policy.And it turned out to be the worse-case scenario. SciMed Life came outwith earnings that were, on the surface, quite good. Then one of the ex-ecutives dropped what turned out to be a bombshell. The companywas involved in patent litigation that potentially affected a large partof its product line. This was widely known by the Street, but that exec-utive for SciMed then did the Wall Street equivalent of screaming,“Fire!” in a crowded theater. He said the litigation may force the com-pany to drop its most-profitable product.
During the course of a conference call with analysts, the stock inthird-market trading fell from $93 a share to $68! By that time, thoseputs we sold were $2 in the money instead of $18 out of the money. Inplain words, a stock price target of $70 a share was already a done dealinstead of a long shot. The next day, the stock traded down to $50 ashare, and keep in mind those puts we were short obligated us to buythe stock $20 higher at $70.
I'd say we lost about $1 million on our stock exposure in about twominutes. The pain was horrendous, but at least it was administered allat once. Ultimately, there was a good conclusion to this financialbloodletting. We made back all the money we lost over the next month,in part because we got back to our knitting and didn’t let the orderflow make us come in long or short. In other words, we can’t end upwith a net long or net short position simply because a customer wantsto do a trade that, because of circumstances, we can’t cover. If youcan’t sell 2,000 options and cover with stock with only two minutes togo, then you'd better build some massive edge into the trade, becausewith no minutes to trade, my money is on the customer who wants tobuy 2,000! You do the trade and get it hedged, or you don’t do thetrade, Simple as that. And while exercising your duty to create a fairand orderly market, you also protect yourself on a large order by see-ing how much the customer is willing to pay for those last-minute,large-volume options trades.
Luckily about a third of the volume that we handle on the floor
involves 200 contracts or more. That level is generally assumed tobe the minimum size an institution will play. The vast majority isthe marketplace 33
comprised of smaller-volume transactions. Most of our day is spenttrading 10, 20, or 30 contracts.
But that may be changing. For years there was an “anti-churning” rule imposed on mutual funds that prohibited themfrom making too many short-term trades, which although theycould be profitable, would absolutely generate significant feeswhich would impact the return to investors. If the fund made toolarge a percentage of its profits from short-term trades, thepenalty would be tax imposed on the fund before the distributionto investors. That put the brakes on churning, but it also hurt op-tions trading by the funds, since most cptions plays are short-term (90 days or less) transactions.
A change in the tax law some two years ago has resulted in anincrease in short-term trading by mutual funds, which has beenpart of an overall rise in options trading volume. According to theOptions Clearing Corp. Web site (www.optionsclearing.com), sincethe start of the bull market in 1990, cleared contract value in-creased 142 percent, yielding an average daily volume of 2,015,442contracts. The options industry also achieved a milestone whencleared contract volume surpassed 5 billion in mid-October 1999,underscoring the momentum of the market. Total options volumeacross OCC’s participant Exchanges amounted to 507,891,483contracts cleared, marking the first year options trading at over ahalf-billion:
OCC Annual StatisticsYear Ended December 31, 1999
AMEX Total Contracts 129,662,442Equity 126,821,529Index 2,840,913CBOE Total Contracts 254,331,851Equity 198,086,825Index 56,202,720Interest rate 42,556PCX Total Contracts 75,801,209Equity © 75,770,940Index 30,269PHL Total Contracts 48,095,981Equity 44,085,930
Index 3,189,58734 = how I trade options
I expect that increase will become more dramatic, in the op-tions traded to help hedge and manage the trillions of dollars worthof stock positions that they manage. I addressed a buy-side confer-ence in Washington in November 1999, with an audience that in-cluded many mutual funds and hedge funds. I was not surprised tohear how they plan to expand their trading of listed options—suchas the stock and index options listed by the CBOE.
Many of these funds have been trading over-the-counter(OTC) derivatives, which are subject to pending legislation thatwould limit their use. Many funds have opted to buy OTC deriva-tives because they’ve been told there is not the necessary liquidityto buy and sell options on a listed Exchange. Think about it. Ifyou’re trading a $1 billion stock fund, you need to make some verylarge trades to make a difference to your bottom line.
Instead, a growing number of investment banks and large bro-kerage firms—who shall remain nameless—do OTC transactionsfor mutual funds and large institutional and private clients. Thereare no commissions. Just the net transaction. The brokerage firmwill devise an option product with the size that the fund needs forspeculation or to hedge existing positions. The only time wetraders on the floor get a glimpse of the deal is when the brokeragehouses then come to the floor to buy or sell listed options to lock ina profit or lessen their risk on a big OTC trade.
As a market maker and professional options trader, I'd like tosee more funds