will still remain essential—on and off the floor—especiallydiscipline. That's one of the reasons I like athletes, because mosthad to have discipline to survive. And, I like to hire traders whohave played a team sport, whether it’s football, basketball, orhockey. Because on a team, you have to make sacrifices and act inconcert with others. You have to give up the personal flourish,sometimes, for the sake of the team victory. In a trading room,that’s vital. You can’t have one player taking on too much risk in thepursuit of personal glory.
If you’re backing a trader, meaning you’re putting up the capi-tal they trade in return for a share of the profits they make, youmust have confidence in your trader’s ability to execute trades ac-cording to a plan (especially your plan). You have to know that yourtraders will do what they say they'll do, that they'll trade withinspecified parameters of risk and position size. They have to be self-starters, always looking for opportunities in the market. They haveto want to read or surf the Web, looking for information on a partic-ular company, industry, or sector of the market. Information is dis-seminated immediately, thanks to the Internet, narrowing the timeadvantage. If you can learn something a few seconds before the restof the crowd, you may have an edge.
In the old days, some of the traditional brokerage firms toutedan edge of having the best information, analysis, and so forth onthe stocks that they traded. They knew about earnings, special div-idends, conference calls, and special events. Today, even the whis-per numbers on a company’s projected earnings—which differfrom the widely published earnings estimates—can be found on theWeb (WhisperNumber.com). What used to be so incredibly secreton Wall Street is now incredibly public, and that’s a very goodthing. If there is any advantage to be gained, it will go to theswiftest and the most aggressive.
But the challenge to the upstairs, professional trader (and byextension to the aggressive retail speculator) is to gather informa-tion as quickly as the so-called insiders. You can find the latest162 how I trade options
stock upgrades and downgrades by analysts. And, you might beable to do well trading on that information. But the people who un-doubtedly make the bigger killings are those special customerswhom the broker told yesterday that he was going to make a stockrecommendation, or upgrade today. (Early dissemination of thatinformation is legal since it’s not considered inside information be-cause the firm making the upgrade or downgrade is just an inter-ested third party, not the stock itself.)
the information edge
Information dominates this market. If you want to trade profession-ally or invest aggressively you must have an overriding passion forthe market. Do you read the Wall Street Journal for fun, or is it work?Do you jump past the business pages of your newspaper and diveinto sports? If you don’t read the financial pages then this is notyour business, it’s as simple as that. When I look for traders, | mustsee that intense interest in the market. (Unfortunately, some of thebest traders can be some of the biggest bores because they turnevery dinner conversation into a market discussion. Personally, Ican’t even plan for a vacation without looking at airfares, seeing ifthey’re rising or falling, figuring in fuel costs, and then wonderingif my market position ought to be in airlines or the energy sector. Ifthey don’t have a similar obsession with news, they probably won'tmake it as a trader.)
I should draw a clear distinction between a professional trad-ing firm like The Mercury Trading Group, which backs traders whotrade the house account, and day-trading firms that let virtuallyanyone with enough capital trade. Those retail day-trading firmshave come under a lot of scrutiny lately, particularly from the Secu-rities and Exchange Commission (SEC). (SEC Chairman ArthurLevitt, in recent testimony before a U.S. Senate subcommittee, hasstated: “I am concerned that some day traders don’t fully under-stand the level of risk they are assuming. I am concerned that somepeople may be lured into the false belief that day trading is a sure-fire strategy to make them rich.”) There is even continued debateover whether or not day-trading firms should be subject to stricterregulation, especially when it comes to trading on margin, whichwould allow an unsophisticated trader to put on larger trades withbigger risk than is prudent.building a team—the day-trading firm 163
Luckily, we’re not in that category. Our traders are profession-als who are hired by the firm to trade the house’s money. Ourtraders didn’t quit their day jobs, take their life’s savings, and spintrades at a computer like it was a video poker machine. Our tradersare employees, members of a team I’ve put together. Because weday-trade options, we’re already heavily scrutinized. As a specialistfirm, we are audited every year by our self-regulated organizationand the CBOE, to ensure, among other things, that we have the ade-quate capital minimum and that we are adhering to our responsibil-ities as an options specialist. Our first line of defense is always theclearing firm, which watches both our risk exposure and our capi-tal, then the exchange and, ultimately, the SEC.
There is also another key issue between traders at my firmand aggressive speculators out there. It comes down to a clear andstrict definition of the term day trader. Some people say that ifyou’re in and out of a position within one day, you're a day trader. Inarrow that definition further. I say that if you rarely hold a posi-tion for longer than a few seconds, then you’re a day trader. Other-wise, you're an investor. That’s a clear-cut distinction that anyonein this business—whether you’re a professional trader or an activespeculator—must ponder. Regardless of what you might want tobe, you must know what you are. And if you’re an investor, youmust trade like one, and have realistic expectations of what yourperformance can be.
If you’re going to be an investor and generate returns of 40percent, 60 percent, or 100 percent, you must be very aggressive.You have to be picking a lot of stocks that are performing just asyou have projected, to manage a four-fold increase from the aver-age performance of the stock market. [According to Chicago-basedIbbotson (www.ibbotson.com) the stock market has averaged a re-turn of 10.8 percent annually since 1929.] But if you’re going to be aday trader and make 40 percent, you are setting your sights waytoo low. Your goal must be to make 100 percent or 200 percent,otherwise you’re kidding yourself. First of all, most day traders arenot opening an account with $200,000 or $500,000. They open with$25,000 to $50,000 and use guts and leverage to make it trade like$100,000. But people frequently ask me, is it possible to open aday-trading account with $50,000 and make 100 percent? The an-swer is yes, but you've got to be lucky, good, and have discipline.But it’s imperative that you cut your losses fast and move on with164 how | trade options
the profitable trades. You have to be glued to the screen to do this.There are those who can and make it—taking that $50,000 all theway up to $1 million.
That requires a 100 percent return day trading, turning$50,000 into $100,000, then $100,000 into $200,000, and so forth. Asanyone who has done it can tell you, it’s easier to turn that $50,000into $1 million, than $1 million into $2 million. To make $50,000, youonly need a profit of $200 a day, which is not unreasonable. To turn$500,000 into $1 million, however, you have to make $2,000 a day.That’s a lot of trading, both more often and bigger size. Eventuallythe returns begin to drop as the market impact created by mullti-thousand share stock scalps, or multihundred option trades beginsto become an issue.
Whether you're an aggressive day trader or a cautious in-vestor, you must know yourself and your pain threshold. There willbe days when, mentally, you're carrying that day’s market actionhome with you—and into the night when you're lying awake withgritted teeth. If that happens too often, I’d say you're in the wrongposition. It may be the first sign that instead of being an aggressivetrader, you’re really an investor. And for an investor, 40 percent is agood, healthy return, which is entirely possible. But as an investor,you must have many of the same attributes as the most aggressivetraders at my firm. You must have a passion for the market, youmust do your homework and you must have discipline. An investorcan suffer big losses, too, if you get in a stock for the wrong reasonsor without an adequate plan.
At Mercury Trading, that “plan” will depend largely uponwhether a trader is on the floor or at the screen. The guys on thefloor are really more like the catcher on the baseball team. They arevery defensive, reacting to retail and institutional buyers and sell-ers who are willing to trade on our posted markets. They are re-quired to make a market, which means they may be buying whenthey'd rather sell, and vice versa. But the people upstairs are moreoffensive and strategic. They are plotting their market moves like achess player, knowing when and where they'll make a play—and forwhat reason. They’re studying the various catalysts in the mar-ket—earnings, new products, lawsuits settlements, sector rotation.Then they plan their moves in the various stocks that they trade.The market maker on the floor understands those same dynamics,building a team—the day-trading firm 165
but has to trade in this defensive manor to justify our preferentialmargins.
We don’t just look at the price of stocks that we're trading. Wealso look closely at volatility, which we treat like a rubber bandthat stretches from one extreme (fear) to the other (greed). Let’ssay that Micron’s volatility is 50 percent normally, but selling pres-sure could take that volatility down to 35 percent. Maybe some in-stitutional trading company thinks the market will be rangeboundand is looking to milk some premium out of what is expected to bea dull market. Or perhaps some concern in the marketplace (thefear factor) has brought droves of buyers into the market seekingprotection, bidding up the volatility to, say, 30 percent. When theseout-of-balance situations occur, there is an opportunity to act, buttiming is everything. And in these times, you need to know thatyour traders are following not only the trading plan for the day, butthe risk parameters that will keep them out of trouble.
For example, we knew that April 14, 2000—the day thatNasdaq closed down 9.7 percent, dropping by 356.74 points—wasgoing to be a tricky kind of a day. There was already a lot of fearin the market, resulting in high premium for issues such as SunMicrosystems, Micron, and AOL. Stocks like these normally havevolatility in the range of 60 percent or 70 percent. But the fear fac-tor had pushed the volatility on these stocks to 150 percent or 200percent. The challenge for us was to determine if this was a goodplace to sell the premium, or would fear push it even higher. Youdon’t want to sell too soon and have to buy your position back in arising market. Or, conversely, you don’t want to buy too soon andhave to sell in a falling market.
back and front spreads
Ideally, you’d like to have a back-spread trade whereby you buymore contracts than you sell. Let’s say you’ve bought 10 $50 at-the-money calls that have about a 50 delta. That delta means that forevery $1 the stock moves, the calls will move by $0.50. Therefore,with 10 call contracts I’m 500 delta long [10 x 100 shares (per op-tion) x .50 = 500] equivalent to being long 500 shares of stock (eventhough, without taking the delta into consideration, 10 options con-tracts are equivalent to 1,000 shares). As a hedge against this call166 how I trade options
position, I would sell 500 shares of stock. That’s a classic backspread, because J own 10 call contracts, which is 5 contracts morethan I’ve sold (500 shares of stock).
If the stock were to move up to $60 a share, you'd face a $10 ashare loss on the 500 shares of stock, or a loss of $5,000. The op-tions, however, have increased both in value and delta, movingfrom a 50-delta to a 70-delta or more (meaning that for every $1move in the stock the option moves about $0.70). The call optionsthat I may have paid $3.50 for when they were at the money at $50have risen by $7 and are now trading at $10.50 a share. That’s aprofit on the call options of some $7,500. On a net basis taking intoaccount the $5,000 loss on the stock position, I’m still up $2,500.
To show how well hedged this position is, if the stock fell to$40 a share, the stock position makes $10 a share for a total profitof $5,000. My call options that I bought for $3.50 are worth about a$1, for a loss of $2,500. My net profit on the overall position is still$2,500. | make money either way, although time decay as expirationapproaches will eat away at the value of the call options.
But there are times when market conditions—particularlyhigh volatility that pushes premium to lofty levels—dictates a dif-ferent, and far riskier, kind of trade—a front spread. In this trade,you’re short more contracts than you’re long, which increases yourexposure to potential losses as market gyrations are not the frontspreader’s ideal situation. At Mercury, when we’re putting on frontspreads, which may involve thousands to millions of shares ofstock and hundreds and even thousands of options contracts, youwant to make sure that everyone is following the same play book.You can't afford to have a trader decide to break rank and go his orher own way. When the risk is high, trust becomes crucial.
Let’s say Sun Microsystems is trading at $90 a share. Withnormal volatility, the stock might trade in a daily range of $87 to$93 a share. But when volatility increases—as we saw in April2000—it’s going to trade in a wider range. Instead of its usual 3-point range, let’s say the price is fluctuating by 15 points. This in-creased volatility also pushes up the premium on options.(Increased volatility, after all, means that the stock is moving in awider range, improving the chances that a particular strike pricewill be hit.)
As I've said, times like these favor the seller since it’s assumedthat abnormally high volatility cannot be sustained. Thus, when thebuilding a team—the day-trading firm 167
volatility is on the high end, we favor front spreads in which yousell more than you buy. In this example, we’d sell 1,000 SunMicrosystems $90 at-the-money calls, which have a delta of 50. Soeven though those 1,000 calls are equivalent to 100,000 shares,with a delta of 50 it’s more like being short 50,000 shares of SunMicrosystems at $90. To hedge the trade, we’d buy 50,000 shares at$90. If the stock price doesn’t move a dime, we're completely neu-tral. But our hope is that volatility will decline and we, as the callsellers, will be able to keep much of the premium we've collected.
Let’s say that the stock falls from $90 to $80 a share. We lose$10 a share on our 50,000 shares of stock;-for a loss of $500,000.(Remember, as a proprietary trading firm we have the advantage ofno Reg. T requirement which exempts us from the 50 percent mar-gin customers must pay.) The options we sold decline somewhat,but volatility remains high. So the premium on those call optionsis now $8, down from $10, and at this point, as the seller ofthe calls, we have pocketed the $2 difference. We make $2 times the1,000 calls, or a $200,000 profit. But taking into consideration the$500,000 we lost on the stock, we're out $300,000. The only hope isfor the volatility to decline further to more than make up for the de-cline in the stock holding.
When market conditions dictate, we may do dozens of tradeslike that—some winners and some losers (and, of course, we hopefor more profitable ones than unprofitable positions). So as we re-view the trades on the books, we want to see that the traders haveexecuted according to our plan, based on our analysis of volatilityand pricing models. You don’t want to find out, at the end of an ad-verse move, that you suddenly have a negative surprise to dealwith, which you weren’t anticipating.
As we tell our traders, both on and off the floor (and retailspeculators could learn a lesson from this), you can’t let the markettell you what to do. You have to have a plan and stick to it. Ofcourse, conditions that affect that plan may change. But you mustfollow the plan to keep from getting sidetracked. For example, youmay be a buyer—whether of stock or options. Then a massive sell-off hits, and everything around you indicates that you should bea seller.
Maybe Nasdaq is down 400 points and you're long stock. Tocut your losses, maybe you'd sel! the stock. If you were a floortrader, you could easily become swept-up in the emotional panic 
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selling on a day like that. In such circumstances, you need to bracenot just for the continued selling, but in the back of your mind, youmust anticipate some profit taking, which may lead to a rebound.This anticipation causes you to ask yourself: Could the Nasdaq sus-tain being down 400 points? Or would it likely recover. Conversely,if the market is up 200 or 300 points and you're short, everything inthe market says that you need to buy. But can you afford to buyknowing that the market could come back down just as quickly inthe afternoon? This, admittedly, puts a lot of stress on traders whoare handling these big positions, especially on days when an ad-verse market move could cost the firm $1 million or more in losses.It takes discipline to withstand moves like that and keep a clearhead. But that’s exactly what successful traders do every day.
Granted, I monitor the positions of the traders at the firm. Butmostly I rely on them to follow instructions and keep disciplined.That’s so critical in these times when volatility can expand to 120percent at the end of one week and, by the end of the following Mon-day, collapse back to 80 percent and then 60 percent a day later.
The challenge is different for traders on and off the floor. Floortraders often can’t see the forest for the proverbial trees. They areup to their eyes in trading. They’re surrounded by the emotions ofthe pit. In the frenzy, they can’t gauge the shift in sentiment. Theycan’t see that the selling is exhausting itself at some level and themarket has reached a point at which they could buy with some de-gree of confidence.
Traders will tell you that there are many days when they go tothe floor with a very bullish bias. And even if you disagree with (ordespise) every other trader in that pit, it’s hard to keep your per-spective when you hold a view that’s opposite of the prevailingemotion on the floor. So even if you’re bullish and you want to buythis stock, you can easily become swept up in the sentiment andturn seller.
To give an example of what it’s like, think of being at a sport-ing event and becoming swept up in the emotion of the crowd. Evenif you’re a tepid fan at best, you find yourself screaming your lungsout or cursing the opposing team, even though, in reality, the gameis not that important to you. Now imagine that the game is the mar-ket, and you’re trying to keep your head while everyone else is los-ing theirs.building a team—the day-trading firm 169
That’s why a lot of trading firms have senior traders on thedesks who call the biggest shots. They direct the other traders onthe desk to buy and sell. By no means am! belittling the talents ofany trader. But there are times when it’s better for someone moresenior and experienced to pick the levels at which a stock or an op-tion should be bought or sold, and then a more junior trader exe-cutes that trade. The senior trader who is calling the shots wants tosee discipline among the ranks, and not some less experiencedtrader trying to “please” by taking initiative when they shouldn't.
the disciplined broker
Discipline is also essential for a broker, who must know when it’smore important to execute a customer’s trade quickly at the prevail-ing market price, rather than to “fight” for a better deal. A good bro-ker will do everything reasonable to make the most money for thecustomer. Sometimes that means that calls were offered at 44, butwe were aggressive and got them at 44. It’s great when that happens,and you can brag to the customer that you fight for every “teeny” ona trade. But brokers need to keep a disciplined mind to know the dan-ger of being the proverbial penny-wise and dollar-foolish. If a cus-tomer needs to buy something, you can’t try to save a teeny or aneighth by trying to get a better deal. The problem is that delay infilling the order, while you try to get a better price, can mean youmiss the opportunity entirely. For example, if a customer needs tobuy 50 options, the difference of an eighth is $625. But if you missthat opportunity to buy at the prevailing price and the stock moves$2, then those 50 options could cost an additional $10,000! Gener-ally speaking, it’s okay to fight for a better price in a static market,but when things are moving—you’d better be alert and agile.Here’s an example: On April 19, 2000, Bristol-Myers Squibb Co.announced it was withdrawing its request for U.S. marketing ap-proval of the hypertension drug Vanlev (Reuters, April 19, 2000,“Bristol-Myers Says Vanlev Users Needed Breathing Help”). Tradingin the stock was halted on the New York Stock Exchange, but sharesplummeted in third-market trading. In cases like this, you knowthere is going to be a strong reaction when the stock does resumetrading. You have to make your decision fast. In this case, I wantedto be a buyer and it was more important for me to get in at what I 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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expected to be a dramatically lower quote when the stock resumedtrading. I wasn’t going to worry about a quarter or an eighth. Iwanted to take advantage of the opportunity created by the panic.
I] knew the stock was going to open under $50 a share, so Iput in a market order even if that meant I didn’t get the “best”price. Why? Because I wanted in. I knew that if I hesitated andsaid, “Let’s see where it opens,” then I could very well miss theopportunity. I didn’t want to commit the sin of being “penny-wiseand dollar-foolish.” By that time, Bristol-Myers had lost some $30billion in market capitalization. The drug was allegedly a $1 bil-lion loss. So didn’t that $30 billion drop in capitalization seemlike an over-reaction? I thought so. I was a buyer at what I ex-pected to be bargain prices. I wasn’t going to quibble about aquarter or an eighth. In the end, when the stock reopened, Ibought the stock at 484.
The point I want to make is I wasn’t worried about an eighth—which is equivalent to 12.5 cents per share. I wasn’t scalping forquarters and eighths in this scenario like a typical day trader. I wasbuying the stock because it was down $12, which I considered to bean extreme move, on bad, but not earth-shattering news.
The same goes for our customers when the market is movingand they say, “Buy this.” It doesn’t serve our customers if they missa buying opportunity and the stock is $2 higher, because a brokerwas trying to do better than the prevailing offer. There are timeswhen a broker wants to impress a customer by doing better on anorder, by showing their skill as a trader. What the market demands,however, is for brokers to execute. That takes a kind of ego-less dis-cipline, to put the customer’s need to get a fill over the sense toprove yourself. But as we say in football, you don’t want a playertrying to be his own quarterback on the field, instead of followingthe coach’s game plan.
Luckily for my partner, Tom Haugh, and me, all of our brokersare former floor traders. They have experience on the frontlinesand now they don’t mind getting out of the trenches. At the risk ofpainting with too broad a brush, perhaps they came upstairs to thebrokerage firm because their backs were shot from standing ortheir voice gave out from yelling bids and offers. They could stillgrind it out in the pits, but why pound their knee cartilage to mushand further ruin their vocal cords? Being brokers doesn’t meanthey’re out to pasture. They’re still part of the market, but in theirbuilding a team—the day-trading firm 171
present roles they are the liaison between the customer and thefloor broker who will execute the trade. As trading becomes moreelectronic and ECNs—including iTradem.com, which we’re develop-ing—become more dominant, our brokers will work in conjunctionwith an electronic order-routing system.
When I started PTI with Tom, his brother Dan, and a handful ofbrokers, we had a great idea of offering quality trade executionsand great customer service. But we had one problem: We didn’thave any customers. We knew there were customers out there whowanted to trade options, retail clients whose stock brokers didn’tunderstand options. Whenever we'd lecture at a seminar, we'dheard countless times from retail customers that their broker actu-ally tried to discourage them from speculating with options or evenuse options as an insurance against a stock portfolio. We knewthere was an opportunity, we just had to build it. It took two yearsfor PTI to be profitable, but we knew it was worth the wait.
Looking back, | suppose we should have built the firm withbrokers who had existing clients. Instead, we built the firm fromscratch, believing that excellent service and word-of-mouth wouldprovide us with a loyal customer base. That’s paying off. We've gotexperienced, former traders on staff, who wanted to come off thefloor to have somewhat of a slower pace. Granted, options can helpyou limit your risk. But then you add in the leverage that profes-sional traders have, the kind that can take $50,000 and turn it into$100,000 or $250,000. That can get pretty exhausting.
To get away from that hyperactive risk, some traders wouldgladly become brokers, working in more of an investing atmo-sphere. They’re still part of the game, and in fact are integral play-ers in a market that is seeing increased retail participation. Theskills they bring upstairs—how to read the tape, how to listen towhat the market is telling you at earnings time, when the market isworried and when it is complacent—are valuable to a brokeragefirm and its clients. And as we'll discuss in the next chapter, thereare times when you want a broker who will do more than pass alongyour buy and sell order, and give you advice on a trade. Addition-ally, the trade off for the freedom of independent market makers isthat they don’t build anything permanent. Specialists and DPMsbuild businesses that can be sold for millions of dollars, but inde-pendent market makers don’t have such hard assets as a book ofgreat stocks. This was a factor that compelled us to build our 
 
 
 
 
 
 
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brokerage and helps us attract former market makers to staff ourtrading desk.
At the risk of sounding too self-satisfied, I’m pleased with thefirms I helped to build, both Mercury Trading and PTI Securities &Futures. Looking back, I remember what it was like to step on thattrading floor for the first time, to be so clueless about what wasgoing on that I never thought I would catch on. Now, I’m trainingothers to trade, both the traders who come onboard at Mercuryand the retail customers who come to our seminars. Trading is away of life, which is not for everyone. But investing is an activitythat can be adopted by a far wider population, from the cautious orcasual player to the super-aggressive speculator. Regardless ofwhat group you fall in, there is a commonalty among them—disci-pline. You have to devise and stick to a plan, and not let fear andgreed sway you from your resolve.
That’s easier said (or written) than done, sometimes, but theprofits to be reaped are their own reward.chapter 9
getting the right tools
In options trading, as in many endeavors, you must have the righttools. if you’re not equipped you will severely handicap yourself ormake it virtually impossible to be able to do the job. For optionstrading, we divide these tools into five categories: quotes, software,advisors, brokers, education. We'll discuss them one at a time.
quotes
How can you trade if you don’t know the price of whatever you wantto buy or seli? While that may seem oversimplistic, it really is theessence of this issue. When it comes to price quotes for options, theinformation you’re receiving must be timely and accurate. For abuy-and-hold stock investor, it might be adequate to look at yester-day’s New York Stock Exchange or Nasdaq settlement prices in thismorning’s newspaper. That newspaper won’t tell you where thestock opened this morning or where it’s currently trading. But if aday-old settlement price lets you keep track of your holdings, that’sprobably adequate. Generally speaking, the longer your investmenttimeframe, the more “dated” the information you can use.
If you are a little more active, or the next notch up on the vigi-lance scale, you might tune into the radio for market updates orwatch CNBC, which has streaming quotes on the screen. Thoseup-to-date prices on the television screen may