of my abilities and circumstances. It’s the same way withtrading. I can’t get caught up with the concept that I’m suddenly“wrong,” and I need to prove myself “right” by holding onto a posi-tion that no longer serves my needs. When it’s time to cut a tradeloose, I have the discipline and the emotional distance to do that.
Retail traders, who aren’t going to be moving in and out of aposition as rapidly or frequently, have to adopt some of the sameattitude. Look at the positions you’re holding. Would you make thesame trade today? Either at that price, or with that market outlook?If not, it’s time for an adjustment.
Again, this is just as important for a “winning” position as it isfor one that has suddenly moved against you. If 1 own a $10 LEAPcall and I sell a $2 option against it, I have 20 percent downside pro-tection. But if that near-term call that I sold erodes due to timedecay to being worth $0.50, it’s not providing much protection formy LEAP, which may be valued at $11 by now. There is no value towait the last three weeks until expiration for the sake of the last$0.50 in that option value. It’s far better, in this scenario, to buyback the calls that I’ve sold for $0.50, and sell some $2 calls that area little further out in time.
But maybe as I’m evaluating my position I discover thatnot only did my opinion of this stock change, my whole opinionof the market shifted. Maybe I don’t want to be exposed to an“Old Economy” stock. Maybe I only want Internet-relatedissues. Maybe I think everyone is running for the relative safety ofwhen to do what—and why! 149
high-dividend stocks, while we decide if the market is in a correc-tion or just resting.
If that’s the case, I don't want to say to myself, “well, I'll getout of this in three months because then I’m dealing with long-termcapital gains instead of short-term trading profits.” That’s a horri-ble way to trade because it undermines your analysis of stocks andthe overall market. The primary driver in any trade that I make ismy risk/reward balance. If a trade suddenly becomes too risky, or ifthe rewards are too small, then it’s time to exit the position.
Similarly, if | put on a trade to make money on volatility—suchas with a spread or a butterfly position—and the volatility sud-denly diminishes, then the reasoning for my trade no longer exists.Chances are the risk/reward scenario also has to be altered.Granted, if I have a spread such as an iron butterfly trade on—lock-ing in my upside and downside range—the stock or index mightvery well hang in there within the range I’ve targeted. But if my pri-mary purpose was to capture a volatility edge that no longer ex-ists, then the backdrop has changed.
The question ultimately becomes one of judgment, which onlyyou—the professional trader or the customer at the brokeragefirm—can answer. How much is enough? If you’ve sold a straddle, astrangle, or an iron butterfly, and you've reaped half the profits—taking half of your money off the table—and the position still has amonth-and-a-half to go, do you want to stay in? Do you know thereis a risk that you could give back what you've made if the stock sud-denly starts to move, or the index that you’ve pegged to be in rangesuddenly breaks out of those parameters? That’s a question thatevery trader and speculator has to address.
Here’s an example, say you've sold a straddle at $3, and thevalue has collapsed down to $1. There is a month-and-a-half left togo. Or you’ve sold an iron butterfly for $5, and you only have $1 leftto make on it. If the market explodes out of your range, you couldlose $4. It’s your $4. You are not playing with the house’s money;it’s your money! Better to get out of the trade once you’ve made areasonable profit (and only you can determine what that is basedon your risk/reward goals) than to hang in there too long. Remem-ber, pigs get fat, hogs get slaughtered.
This is especially true for beginning traders and speculators.It’s better to sell “too soon” as you get your feet wet than to make150 how I trade options
the mistake of staying in a trade too long and risking more than youshould—or losing it all.
Among all the options strategies, there are others that, bytheir very nature, require ongoing analysis and maintenance. Afterall, that’s what they are designed for. One example is the collar,which is a defensive or protective strategy to guard a large, single-stock position.
Curiously, collar trades are probably one of the most popularand in-demand strategies out there, but most of the investing publicnever hears about them. Undoubtedly, that’s because collars areused to protect large, single-stock holdings that we may associatewith being a top executive of a Fortune 500 company. But in truth,there could be lots of reasons why you could end up with a largeholding of a single stock that, due to its weight in your portfolio,you want to take extra measures to protect. Perhaps you werelucky enough to be part of a dot.com start-up, which made you apaper millionaire after the company went public. But you don’twant to sell and with such a large portion of your net worth tied upin a single stock, you don’t have a diversified portfolio. Or perhaps,as a long-time company employee, you’ve amassed $100,000 or$200,000 in company stock, which you want to hang onto to avoidthe capital gains and because you are ultimately sold on the growthprospects of your employer.
A collar trade basically involves the purchase of a protectiveput, to insure the down side, which is financed (at least partially)with the sale of a covered call.
Here’s how a collar trade works: Say a stock that you hold istrading at $70 a share. But since you were a long-time company em-ployee (or a company co-founder) you were lucky enough to havegotten in at $1 a share. You don’t want to sell the stock. But youknow that the fortune you’ve amassed in this single share is vulner-able to the whims of the market. To protect your treasure, you pur-chase a 65 put and finance the put purchase by selling the 80 call.
So, on 1,000 shares, you’d be obligated to sell the stock at $80a share (which you could conceivably buy on the open market ordeliver from your shares, whichever suits your situation). The $65put that you bought protects you on the downside. If the stock fallsto $55, the $65 put is worth $10, which helps to offset the $15 losson the value of the stock.when to do what—and why! = 151
The protective put that you purchase can have a strike pricebased on whatever comfort level you need. You can put it fartherdown and pay less of a premium. And you can design a collar strat-egy that not only pays for itself (the difference between the callyou sell and the put you buy), but also actually makes money, inand of itself.
Granted, a lot of these collar trades are done off the exchangefloor because of the huge size involved. Perhaps you’re looking toprotect 200,000 shares. As a single stock millionaire, you can dothis trade to protect your holdings and sleep at night. You can de-sign a trade that gives you only $5 a share of downside risk even ifthe stock drops as much as $20 a share. Through my brokeragefirm, PTI Securities & Futures, we have dozens of high net worth in-vestors that have employed the collar strategy.
There’s another financial trick that single-stock millionairescan take advantage of, which—even if it doesn’t apply to you rightnow—is good to know about. You have all this money tied up in astock and, on paper, you’ve amassed a small or large fortune. Butthat’s on paper. You're still living in the house or apartment you’vehad since before your ship came in. You want to upgrade, say, to a$2 million property, but everything you have is tied up in yourstock, and you don’t want to face the capital gains if you liquidatepart of your position. Many brokerage firms and investment bankswill loan you up to 95 percent of the value of your stock at compet-itive rates (usually tied to prime or broker loan), which is usuallyfar less than you’d pay for a mortgage. While you face interestcharges, it’s one way you can enjoy the fruits of your stock hold-ings without having to sell what you hope will continue to appreci-ate in value.
When it comes to collar trades, this doesn’t apply only to theultra-wealthy. As a long-term employee, you could have 1,000 sharesof a stock, such as Hewlett-Packard (which as of this writing wastrading around $146 a share). That’s $146,000 in one stock thatyou’d undoubtedly want to protect, and a collar trade is one way ofaccomplishing that.
Here’s how it might work: You could sell the $155 call, usingthe $3 premium to help purchase a $140 put for $4. If the stockmakes a large downside move, you're protected from 140 down tozero. And if it spikes suddenly in one month, the worse that could152 how I trade options
happen is you have to sell some stock at $155, locking in a niceprofit. You could adjust the parameters of that collar—by rollingyour short 155 calls up to the 160 or 165 calls if you thought thestock was poised for an upward run or a lower put to keep more ofthe premium profit in return for a bit more downward risk.
Now, as time goes by, let’s say it’s two weeks to expiration,and Hewlett-Packard is trading at $150 a share, having bouncedaround to both the upside and the downside. The $150 call that yousold has slipped in value to $0.75, but you’ve pocketed the other$2.25. The put that you purchased for $4 is trading down to $0.50.It’s time to re-establish another position, out one month or maybethree into the future. So you buy back the call and sell another onefurther out, and you sell the put and buy another one, again adjust-ing the strike prices to fit your needs. Maybe I want to buy the July$150 puts and sell the July $160 calls. This is a position that mustbe managed going forward. The purpose is to protect a large stockasset, whether it’s 1,000-plus shares of a high-priced issue in your401(k) or the founder stock you have from the latest dot.com IPO. Ifyou wouldn’t drive a Ferrari off the showroom without insurance,why would you let $140,000 in stock go unprotected?
There are other options positions that can, and must, be man-aged going forward to offset a stock holding. These strategies fallunder the umbrella of “stock repair.” Let’s say you received whatyou thought was a hot tip for a stock that was selling at $70 a share.You rushed out to buy 1,000 shares—without doing your home-work—believing this was going to the proverbial moon! Now, thestock has declined to $57 a share, and you're out $13 a share or$13,000 on your position.
What do you do? Options may be the answer. The stock hasample strike prices available, given its recent activity. Here are afew examples: The $55 calls are quoted at 9%, the $60 at 75, the $65at 5% and the $70 at 4%.
Now with the stock at $57, you could sell the $60 calls againstit, collecting 75s. (Remember as a call seller, you'd be obligated todeliver stock if the call is exercised by the buyer.) Now, let’s as-sume the stock finishes above $60 at expiration. The call I sold isexercised and I deliver stock (which | originally purchased for $70 ashare) for 67%, before commissions.
Or, I could have opted to sell the $65 calls, which would obli-gate me to deliver stock at 70% (taking into account the premiumwhen to do what—and whyl =. 153
collected). Or, | could sell the $70 calls, and deliver stock at 7436.Granted, none of these are great solutions. But they do offer somerepair to a damaged stock holding.
repair strategy
My preference would be to establish a stock repair strategy in thefollowing way: I would buy 10 July $55 calls, paying 9%, and sell 20July $70 calls at 4% each, or a total of 834. That means your net coston this position would be $1. On a 10-lot trade, that would involve anet cost of $1,000 in additional cash outlay for this position.
At expiration, if the stock rose from $57 to just $65 a share, mylong calls would be worth a total of $10 or $10,000 on my 10-lot pur-chase. Plus, the stock would have risen $8 a share from its lows, re-covering $8,000 of the $13,000 decline in value. With total gains of$18,000 on the options and stock price recovery, you'd be back inthe black by $5,000 on the overall position—even though the stockwas still trading below the price at which you purchased it! And allit cost to put on this position was $1 a share on a net basis. If thestock rallied to $70, my stock would have recovered 13 points, or$13,000, and my 55 calls would be worth $15 or $15,000 at expira-tion. The short 70 calls would be worthless at $70, but at any priceabove 70, the 20 short 70 calls would max out our potential profitas 10 of the 70s are against my 55s and the other 10 are against mystock. Thus, we get the upside performance of owning 2,000 sharesof stock until we cross the 70 strike, with an additional outlay ofjust $1,000 for 10 contracts.
Note the relatively small percentage move necessary to getback the initial investment versus waiting and hoping and prayingthat the stock rallies back to where I bought it.
I could have picked the 60-70 repair and established it for acredit. For instance: I could buy 10 of the 60 calls for 7% and sell 20of the 70 calls for 444. Again, the extra 10 short 70 calls are notnaked; they are written against the stock we already purchased.This 60-70 1 x 2 spread is established for a credit of % ($875 on a10-lot spread).
If the stock rallied to 60, we recover $3 on the stock, but bothour long and our short option finish worthless at expiration. How-ever, we keep the $875 credit we collected for the spread. As a re-sult, we recovered $3,875 less commissions. At $65, the stock is up154 how I trade options
$8 (from $57), and our 60 calls are worth $5 ($5,000). Our short 70calls finish worthless. Result: We recovered our original investment($13,000), less commissions. We’re back to breakeven!
At $70, the stock is up $13 (from $57) and our 60 calls areworth $10 ($10,000). Our short 70 calls are still worthless. Result:We recovered our investment, and we are now up $10,000 lesscommissions!
At $75, the stock is up $18 (from $57) and our 60 calls areworth $15 ($15,000), and our short 70 are each worth $5, or a loss of$10,000 ($5 x 100 shares x 20 contracts). We recovered the invest-ment plus $10,000. (Any price higher than $75 would be the same re-sult, as the short 70 cap the stock and long 55 call potential.)
Additionally, there are times when this trade (based on strikeprices and premiums) can be executed for a net credit. As a rule ofthumb, these are not quick-turnaround strategies. Normally, youmust go out two or three months for these to be most effective.
Regardless of the strategy that you use, remember that a posi-tion must be managed. With the possible exception of European-style options like SPX, you can’t buy a call and then forget about ituntil expiration. Your market research is an ongoing process. Youmust constantly ask yourself the key question: Would I buy this op-tion today? If the answer is yes, then you can maintain the position.But if the answer is no, then it’s time to rethink the strategy.chapter 8
building a team—the day-trading firm
I always wanted to build something. In college, when I wasn’t con-templating a career in the NFL, | planned to go to architecturalschool. I wanted to design and construct buildings or at least put“something” together. For me, that dream has been fulfilled in put-ting together a trading firm. Even when I was a trader on the floor—a one-man entrepreneur with no one to worry about, or dependupon, but myself—I wanted to have a company with employees. Forsome, that might seem like a nightmare. But for me, that was a won-derful prospect.
When you work only for and by yourself, you may enjoy suc-cess, but in a sort of vacuum. To me, success is all about buildingon your own skills to train, teach, and empower other people. Withthat comes greater success, which is shared by all. (All of ourtraders at Mercury Trading Group share in the profits that we makeas a firm.) My motivation was not just altruistic or socialistic.Building and running a firm makes good business sense. Directingyour energy at the management level can be a far more profitableendeavor than going it alone. With the right people, you can dupli-cate your efforts and thus, your successes. Then you can reap fargreater rewards (even if they are shared) than you could have onyour own.156 how I trade options
Building a company—whether you’re trading puts and calls orputting soles on shoes—has some basic requirements. You have tohave an idea that can be replicated and you have to have the rightpeople. In a business such as trading, having the “right” people isessential. Trading is not for everybody, particularly in the high-stress, emotional, and high-risk world of day-trading options.That’s the bread-and-butter of Mercury Trading, which has tradersboth on the floor and in the upstairs offices at three locations—New York, Chicago, and San Francisco.
When I think about the people I’ve brought into the Mercuryfold over the years, I've had some wonderful successes and somespectacular failures. Overall, it’s been a very interesting adven-ture. For those who contemplate trading professionally, it’s essen-tial to know what it’s like in a firm such as mine, where you’re givenresponsibility and, at the same time, required to follow instructionsfrom a senior trader or principal of the firm. And for those of youwho are retail investors, knowing what it takes to be a professionalcan give you insight into this marketplace. Even if you buy a calland hold it for weeks, you need to know the dynamic of the day-to-day market, in which volatility can shrink or expand the option thatyou’re holding. There are lessons to be gleaned about discipline,about cutting your losers before they eat away your capital, andabout having a plan—always—for the options that you hold.
With the headlines filled with stories about day-trading firms,it’s important to discuss the kind of operation that Mercury is.Ours is a firm in which we employ traders who make a salary andget a discretionary bonus that is based on the profits made tradingour capital. Opportunities for young traders vary from straightsalaried positions to percentage deals. As we discussed in earlierchapters, some firms don’t require much in the way of tradingskills, as they employ a “Fat Brain” concept of an upstairs person(or persons) who determines appropriate hedges and manages theglobal portfolio. Other firms give traders wide latitude in establish-ing and managing their positions. You can probably imagine thatthe more independence the firm gives the trader, the greater thepossibility the trader will not only be salaried, but share in theprofits of his or her account.
Because of the wide divergence between what the traders arerequired to do (buy when the screen turns green, sell when it turnsred, versus employ your judgment to initiate and hedge trades), thebuilding a team—the day-trading firm 157
salary range is also quite varied. Some traders get a job with a trad-ing firm and a salary of, say, $50,000 a year, and 30 percent of theprofits they make the first year, 40 percent the second, and 50 per-cent or 60 percent the third year. Most firms will provide someform of training and that firm will also provide capital for theirtrading. We employ a slight variation on that theme, as we pay ourtraders a salary, back them with capital, and coach them throughthe learning curve, watching how they develop and then put themto work in one of our option specialist trading areas. Our firm actsas a kind of incubator for traders, who will, in time, be fast, deci-sive, and, above all, disciplined. We want our traders to make prof-itable trades for the house. Period.
That’s different from the so-called day-trading firms that cap-ture negative headline attention, the trading rooms that let wanna-be millionaires plunk down their $50,000 nest egg to point and clicktheir way to becoming a stock day-trader. These traders are oftentrading on margin, sometimes excessively. The blow-out stories canbe frighteningly sensational.
swimming with the sharks
In our seminars, we encounter a lot of aggressive retail investors,who want to make options their new vocation. When the bull mar-ket was percolating along and almost any reasonable option (orstock) strategy was working, it may have been tempting to chuckyour job and become a trader. Before you give up your day job, itwould be prudent to remember you have to walk before you run. |hear hundreds, perhaps thousands, of stories about folks that madethat bold move long before they should have. Why not hone yourskills as a customer before you jump into these shark infested wa-ters? (The joke about traders goes something like this: An optionstrader falls into a shark tank, but emerges unscathed. Do you knowwhy the sharks didn’t eat him? Professional courtesy.)
The best way to walk before you run is to get some qualitytrade execution and/or strategy counseling from a knowledgeablebroker. Our firm, PTI Securities & Futures, is staffed with formermarket makers with a wealth of options experience. Thus, I thinkwe offer an attractive, but not the only, solution. I know great bro-kers at both full service and discount brokerages, so it really comesdown to finding someone who will work hard for and with you. 
 
 
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If you are ready to venture into the day-trading arena, youmay consider an Internet-based trading firm such as iTradem.com(see Chapter 10). Trading professionally, to be candid, is a job thatis suitable for only a special kind of individual. There is great op-portunity being a retail investor (and if you hold any positionlonger than about 10 seconds, I consider you to be an investor andnot a trader). Still, there are those whose aggressive nature and de-meanor makes them a natural for a career as a trader, but those in-dividuals are a rare and valuable find.
With the kind of professional trading operation that we have atMercury, the right people are as essential as the right information.We can have every online quote, chart service, and options analysisprogram available. But if we don’t have the kind of traders a firmneeds, we’re doomed to suffer a poor performance, if not worse.
Trust in the traders I have working at my firm is invaluable ondays like we’ve seen through the month of April 2000, when volatil-ity has been greater than normal—or more specifically on a weeklike April 10 to 14 when the Nasdaq lost 25 percent of its value.That’s when you need to know, beyond a doubt, that the traders onstaff will follow your instructions to the letter. You have to knowthey will not exceed risk parameters by taking on positions that aretoo large, or hold onto unhedged positions. That kind of trust cansave a firm from losses that you’d rather not even contemplate.
The Mercury Trading Group, which I founded in 1989 withthree traders, now has three offices and between 60 and 70 employ-ees. Mercury’s traders work primarily on the floor, but we haveabout five traders upstairs. Our ratio tends to average one traderupstairs for every five we have on the floor, but that ratio is likely tochange as all electronic exchanges draw our trading talent upstairs.Mercury’s business is proprietary trading, meaning we are tradingfor the house, and not executing customer orders (which is the jobof the brokers at my brokerage operations, PTI Securities & Futuresand iTradem.com).
When I started Mercury, I looked primarily for traders withsome experience who needed capital to back them. Today, I look forenergetic people with an upbeat attitude. (If you’re a mope, I can’tbe around you! The market throws enough challenges at us eachday without having to deal with people who have a perpetuallynegative attitude.) In fact, the majority of successful traders at ourfirm and our competitors’ on the trading floor(s) are those who arebuilding a team—the day-trading firm 159
the most upbeat and outgoing. Not surprisingly, | find that tradersrecognize this and, even if they are not sociable by nature, theypush themselves to be more gregarious and affable. To that point,we have a trader who, by nature, barely says two words when he’soff the floor. But on the floor, you’d think he’s the most convivialguy around. When he hits that trading floor—where he makes hisliving by shouting out bids and offers and dealing with a host ofbrokers—he turns on his personality.
Another case in point is my brother, Peter, who is a very suc-cessful trader. By nature he is a comedian and has a very imposingphysical presence (6’3” and 235 lbs.), having been a pro footballplayer for seven years. When he stands on the trading floor, hedoesn’t look like anybody else in that pit. I'd say his commandingpresence and outgoing personality are definite assets when he’scompeting to get the best bids and offers on the floor. His successis evident from the $20 million of stock he buys and sells every day,working in the AOL pit—one of the most active in the world.
Peter, like other good traders, can turn that presence on andoff. You have to. When you trade, you want a presence that’s largerthan life, but you better check your ego at the door. You don’twant your ego to dictate your trading position. When you’re wrongand you’re holding a losing position, you have to be able to get out.If the blinders go on and you can’t see clearly, you won't last asa trader.
The traders who do well on the floor have what I consider to bethe three big attributes: discipline, aggressiveness, and some so-ciability. You need the balance that comes with all three. You maybe personable. You may be extremely aggressive. But if you lack thediscipline, then chances are you'll blow out after the first year. Atthe same time, you also must be aggressive enough to be the first torespond when a broker wants to know the market for whatever op-tions you’re trading. Traders on the floor are competing with eachother, not colluding to make a market. When options are bid at 4%and offered at 4% and nobody’s buying, you have to be the first tolower your selling price to 4%, or 4%. Then you get that trade. Youcan’t just sit back and raise your hand. To quote J. Paul Getty, “Themeek shall inherit the earth, but not the mineral rights.”
Over the years of hiring and training traders, I’ve encounteredmany who are enchanted by the market, who believe they will makethis their “life.” But the problem is after a month or so, too many 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
160 how I trade options
begin to give up. Perhaps they succumb to the feeling that this is allover their heads and they’ll never “get it.” Or else they came in a lit-tle too cocky, believing they were just that much smarter than ev-eryone else and, therefore, immune to the rules that govern the restof us. The market can be a humbling experience. Just when youthink you cannot only outsmart your fellow traders but also out-smart The Market, you're in for a lesson—and most likely a painfuland costly one.
fire in the belly
Whether someone is an experienced trader or a college-studentintern, those who are successful in the business have one com-mon trait: They have fire in their bellies. They have the passionand the commitment to go the distance, to weather the inevitablestormy times, and to stay disciplined. As someone who has tradedon and off the floor for 20 years, I know that the only way to sur-vive is to have a passion for this business. Money, alone, won’t doit. You can only water ski behind one boat at a time, only drive onePorsche, or Ferrari at a time. And if you don’t love this business,there aren’t enough zeros on the check to make up for the pres-sure and headaches.
Given the changes in the options industry, those who want tobecome traders must be comfortable at the computer. As I statedearlier, those who have gone on to trade on the floor over the yearshad certain qualities, including a physical presence; you have to beboth visible and audible in a crowded, noisy trading pit. And youhave to have a high energy level. At The Mercury Trading Group,we're not recruiting floor traders. Those whom we bring onboardmay initially assist our floor operations, but they will ultimately betrading upstairs, where the market is increasingly moving.
Today, we are building for a future that will be determined byelectronic trading. I hope the trading floor and open outcry tradingsurvives, but I believe the jury is still out on this issue. As I discussin Chapter 10, I believe that the trading floor will become increas-ingly electronic, with the expanded presence of and roles forelectronic communications networks (ECNs) that handle tradeselectronically. True, the traditional exchanges have the advantageof liquidity at the moment. But that edge could be taken awayrather quickly if—or when—volume builds to a critical mass onbuilding a team—the day-trading firm 161
these alternative, electronic exchanges. Without a brick-and-mortarpresence and related overhead, ECNs and other electronic com-petitors can operate at slim margins.
These electronic competitors will challenge traders to becomeincreasingly technologically savvy and at-home on the computer,pointing and clicking rather than waving and shouting. But certaintraits