the computer. This transition in floor trading, Ibelieve, isn’t completed yet. The final outcome, I believe, will be anelectronic market place, ultimately replacing or at least replicatingthe trading floor as we now know it. That will demand some majorchanges at a brick-and-mortar exchange such as the CBOE.
Before that transition is complete, however, there will be othermoves toward electronic trading. One is a new exchange, the Inter-national Securities Exchange (ISE) which, as I'll discuss later inthis chapter, may present enough of a competitive challenge toprompt a change in the CBOE’s own structure. Additionally, thereis a rise of electronic communications networks, which act like anelectronic order-matching system. That’s where I hope my latestproduct—a computerized trading tool known as iTradem—fits in.
Phil Barnett, Craig Hellman, Tom Haugh, and I initially cre-ated the handheld iTradem to make the floor trader's job easier. Onthe floor, it acts as a robotic assistant, keeping track of positionsand movements of other options, reporting trades to the exchange,and even facilitating automatic hedging. iTradem processes eachoption trade and, if the trader has set the device on auto-hedge®,iTradem will generate a marketable buy or sell order to the NYSE orNasdaq market to hedge the delta exposure the trader just took on.On the Internet, iTradem.com offers electronic access to the op-tions market.
Here’s how iTradem works on the floor. Let’s say I’m tradingSun MicroSystems (SUNW), AOL, and CMGI—very active issuesthat might trade 100,000 or 120,000 contracts a day. At the sametime, I’m trading another technology issue, say, Spyglass, whichmight trade only 1,000 contracts a day. Stocks that are tradingsmaller volume may be more difficult to keep track of because ofthe attention commanded by the more active issues.
As I’m trading these active issues, | can use iTradem to reportmy trades to the CBOE, calculate my hedging position, and execute a 
 
 
 
 
 
198 how I trade options
stock order on the New York Stock Exchange or the Nasdaq. Fur-ther, this device, which has been used on the CBOE sinceApril 1999, also acts as my “eyes” in markets that I’m not activelymonitoring.
Say, while I’m busy trading AOL or CMGI, unbeknownst to meSpyglass rises $3. Even though my attention is elsewhere, I don’thave to miss out on that move. Rather, iTradem, acting as a robotictrading assistant, can be programmed to keep track of movementsin a particular stock. So, for example, if Spyglass $60 calls move toa target of 3%, iTradem could generate a sell signal and in manualmode, send an alert to the screen to alert the trader, or in auto-hedge® generate a hedge in the underlying security.
The iTradem device allows you to preprogram your trading pa-rameters to return to a market neutral position. Maybe you don’twant to be long or short any more than 500 shares, or perhaps 1,000shares. When you reach that limit, iTradem will generate a buy orsell order (depending if you’re long or short) and transmit it to theNew York Stock Exchange via the SuperDot system or to the Nasdaqthrough SelectNet or one of the ECNs that dominate trading onthe Nasdaq.
We believe iTradem will not only find a place on the floor, buton the Web, with the Internet-version iTradempro.com, enablingus to offer this product to the professional off-the-floor audienceand, in time, to the broader retail market. One of the CBOE traderswho uses iTradem on the floor, would dial into the service via theinternet from his vacation home in Michigan. With iTradem hecould oversee every trade from his trading group, hedging theirpositions.
Moreover, I believe iTradem.com will assist active retailtraders, speeding their options orders to a broker via the Internetor a stock order to any of the ECNs or the SuperDot system. Intime, I believe iTradem, itself, will become an ECN, perhaps eventhe first options ECN, allowing orders to be viewed in a centralmarketplace where anyone with an iTradem screen—whether it’s atrader on the floor or a retail investor in Dubuque, Iowa, or Naples,Florida—can see the bids or offers. We believe this product willsignificantly broaden the number of possible respondents to anorder, instead of the limited number of market makers on the trad-ing floor.what changes, what stays the same 199
The electronic in-roads made by iTradem and competing prod-ucts will speed a process that is bogged down in too many interme-diaries. Today, a customer order goes to an upstairs broker whomay or may not have direct access to the trading floor, who thenroutes it to a floor broker, who executes the trade, and then trans-mits the confirmation back up the food chain. Soon, the customerwill be able to bypass the upstairs broker and direct his or herorder through a brokerage site (which will make sure they have suf-ficient capital and paperwork on file), to an ECN like iTradem.comfor execution.
I believe ECNs for options will succeed, just as they have instocks, because of the narrowing of spreads that will likely occuras a result of the increased access to the marketplace. Stock ECNshelped bring about a more efficient market in Nasdaq, with nar-rower bid/ask spreads, which empowers the individual investor. Afaster, more efficient market will lead to an explosion in optionsvolume as well. Volume is already picking up. On April 18, 2000,daily options volume set a new record at the four U.S. exchanges,with 4,812,712 contracts traded. The previous record had been seton January 21, 2000, at 4,646,849 contracts.
There is both a need and demand for options among retailinvestors who, as we've seen, are invested in the market throughretirement plans, mutual funds, and speculative investments. Butoptions will lag the growth of stocks until the same online accessenjoyed via Charles Schwab, E*TRADE, Ameritrade, Datek, and allthe rest spreads to options.
The growth of the future is going to occur when the online in-vestor can trade options using the Internet, to get their orders tothe floor in a millisecond and back again in a millisecond. I believethis will lead to growth in options volume that will parallel whatwe've seen in equities, from 2.5 million options traded each day atthe four U.S. exchanges to 10 million contracts per day. That will beaccompanied by a growing realization among retail investors that,instead of just trading stocks, they can define their risk ahead oftime using options. By coupling better risk parameters with a fast,accessible and responsive online marketplace, the options marketis poised for growth unlike any we’ve experienced thus far.
The reason this is happening is, simply, the world is a fasterplace. And the marketplace is far more dynamic than it was 5 or200 ~=—ihow I trade options
10 years ago. Retail participation, both as speculative money and401(k) and other retirement investment, has burgeoned. When Ibegan trading, the New York Stock Exchange did about 50 millionshares a day; 55 million was a big day. Today, 50 million shareswould signal a dull opening hour of trade. On a daily basis, 800 mil-lion to 1 billion shares trade on the New York Stock Exchange and,as of this writing, the Nasdaq has had some 2-billion-share days.
The growth experienced in those markets directly reflects theincreased speed and the greater access. This is not just a profes-sional arena any more. The world has come to the market, and themarkets are opening up to the world.
Whether you’re trading stocks through a full-service broker-age like, PTI Securities & Futures, or a discount cyber brokeragesuch as Datek, CyberTrade, Tradescape, or iTradem.com, cus-tomers—not just professional traders—can get to the New YorkStock Exchange, Nasdaq, or ECNs via the Internet (albeit with abrokerage in between). All you need is an account. Once you exe-cute your order online, a computer program at the brokerage firmconfirms that you have enough money in your account to executethat trade. Then, any of the above named brokers will speed yourorder to the destination you thought provided the best price. Theycost slightly more than the deep discount brokers that sell yourorder flow to firms like Knight Trimark (NITE) or Maddoff, but thesavvy customers know the pennies saved can cost 10 to 20 times asmuch as routing your order to the best bid or offer yourself.
This is a far cry from the marketplace of the 1960s and 1970s,when customers called their brokers, who may have called back10 minutes later with a trade. Now, transactions at discount brokerstake 10 to 15 seconds without a live broker and half that time forthe top cyber brokerages.
The derivatives markets and options haven’t grown at thespeed seen in stocks. Granted, overall option volume grew bynearly 60 percent last year. That looks great on the surface, but notwhen you realize it took us 20 years to get there! Just 10 years ago,we were doing 600,000 or 700,000 options a day at the CBOE. Nowwith three or four times the number of stocks, we do double theamount of volume. The reason is simple: The customer doesn’thave the same fast access to the options market as they have in eq-uities. For retail options trades, it’s still much the 1970s model seenin equities.what changes, what stays the same 201
Since options are a derivative of stocks, you might have ex-pected that the growth in options trading would match, propor-tionally, the increase in stocks. So if the New York Stock Exchangewent from 50 million shares a day to 1 billion a day, wouldn’t youexpect to see a 20-fold increase in options volume? The reason op-tions have lagged stocks can be summed up with one phrase: elec-tronic access.
The technology has been available for years, but the tradingfloors have not embraced it. That’s not to say that every exchangemember doesn’t recognize that there’s a value for the public totrade 10 times more often than they do, but the cost of new systemsand turf battles have kept up barriers in ‘hopes of preserving atime/place advantage of being a floor trader. That insular world offloor trading, however, is going to face some major competition.Enter the electronic options marketplace.
The International Securities Exchange (ISE) bills itself as thefirst entirely electronic options market in the United States. TheISE’s application for registration as a national securities exchangewas approved by the SEC in February 2000. Trading began in lateJune of 2000. The ISE eliminates the need for floor brokers since or-ders are inputted by broker/dealers directly into the electronicorder book. I believe that the ISE will be able to move as rapidly astechnology—and the SEC will let them, to establish and promote afully electronic options exchange. Adding credibility to the ISE,several Wall Street giants—Goldman Sachs, Morgan Stanley DeanWitter, among others—have committed to be primary market mak-ers. These firms and many other members of the ISE have made sig-nificant investments in ECNs to hedge their bets as to the futuredirection of Wall Street. (In fact, my partners and I have sold amajority of what is now known as the ECN Primex to Maddoff, Gold-man Sachs, Merrill Lynch, Salomon Smith Barney, and JP Morgan.)
I contend that these name players are committing to the ISE tohedge their bets. If the ISE succeeds in attracting order flow awayfrom traditional open outcry markets, the major participants can’tbe the last to the table. Even before the ISE and CBOE began to com-pete head-to-head, the traditional exchanges fired the first shot inthe competitive battle by making significant reductions to thetransaction costs they charge to nonmarket makers. In an interviewwith the Chicago Tribune, CBOE Chairman William Brodsky ac-knowledged that the ISE is a “serious competitor.” But the CBOE is 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
202 how I trade options
responding with increased trading capacity, as well as automaticexecution for small trades and big block orders. Further, the CBOEhas “reduced fees and we plan to keep them down,” he added.
Eventually, firms executing orders for customers will becharged absolutely nothing. But traditional marketplaces like theCBOE have tremendous overhead to shoulder, and “zero” transac-tion costs will be a crushing burden. As of this writing, the marketmakers are bearing both sides, the fees formerly paid by the cus-tomer and the fees market makers have always paid. How muchmore can the open outcry markets pay and still have a worthwhileadvantage? What’s next? And even after the launch of the ISE,there still will be significant advantages to being market maker atthe CBOE, including exemption from margin requirements on pur-chased or sold stock. There will be some time/place advantage ofbeing at the CBOE. But we must remember that the options mar-ket, overall, is maintained to the benefit of the customer. That’swhy the impact of the ISE on the marketplace cannot be ignored. Itis but one step that will lead to the continued evolution of thismarketplace.
The launch of the ISE will presage a fundamental shift in theway the CBOE is run, eventually opening the door for the Exchangeto act more as a broker. The brick-and-mortar exchanges and eventhe electronic ISE have a limited number of memberships. To be atruly open platform and an even playing field for professional andretail traders alike, there will have to be a marriage of a traditionaltrading floor—such as the CBOE—with an electronic screen-basedsystem.
The option industry must embrace an Internet-based, elec-tronic, and instant-access venue to welcome the new breed of on-line investor, who will add liquidity, capital, and depth to thismarketplace. Then, as the marketplace becomes more liquid andmore efficient, we'll see a narrowing of the spread between the bidsand the offers and greater liquidity across the board. Retail cus-tomers will be able to trade with the market they can view on thescreen as opposed to seeing where the market “was” on the screen.Too often, the prices at which retail trades are executed are differ-ent from the quote the customer saw on the screen. But with moreliquidity and narrower bid/ask spread, there will be greater ease—or less “friction” as we say—to get into and out of the market. In-stead of five market makers trading a particular issue, thanks towhat changes, what stays the same 203
electronic access, some day there may be 500 or 5,000 traders whoare interested in the orders.
My pro-customer perspective may set me apart from the tra-ditional floor broker who wants to defend his or her turf. But,thanks to my involvement in our brokerage operations and the sem-inars that we participate in around the country, I’m on all threesides of the business. I manage a floor-trading/specialist operationon the floor of an exchange, so I know what works and what weneed to be successful in the markets. It keeps me mindful of treat-ing the customer right so they will want to return to our marketsagain. On the brokerage side, I know what the customers’ com-plaints are and what their needs are. And I hear from the cus-tomers, themselves, not some hearsay or focus group telling themoderator what he wants to hear. When it comes to retail trading,customers are indeed concerned about commissions and they careabout speed of execution. They know a lousy execution can costthem more than the next 10 commissions, so they want brokerswho know the difference between a fast execution and a good one.
As an industry, we should care about open access to all par-ticipants. I’d rather see my traders making 10,000 trades a day fora one-sixteenth than 800 trades a day for half. I'd rather make asmaller increment on 10,000 trades than a bigger increment on800. More liquidity will not increase my risk. Rather, it will giveme a chance to spread my risk over more trades and the more vol-ume, the more attractive it is for additional customers to enter themarket.
Increased liquidity is the trader’s friend since it increases thenumber of participants and the volume of trades being made.That’s good protection against the dreaded “Roach Motel” positionthat you can check into but can’t check out of (to paraphrase theinsect-killer slogan).
But first, options must be demystified for people which was onepurpose of writing this book. When I speak at seminars around thecountry, I invariably hear from the skeptics: “If options are so great,why doesn’t everybody do this?” Maybe they’ve made their “mil-lions” in real estate or some other field. They understand stocks, butwith knowledge of options, could they do as well? The answer is yes,as long as the investors are committed to educating themselves. Tounderstand options does take a little work. I remember well that dur-ing my first three months at the CBOE I was miserable because |204 ~==ihow I trade options
couldn’t fathom what was going on. It seemed to me to be a big se-cret because no one was teaching me.
Thankfully, that has changed. There are plenty of reputableplaces to learn about options. With more education, retail partici-pation will increase. Then a natural market process will occur—thebid/ask spread will narrow, making a more competitive market-place for ail participants.
Those who take the time to educate themselves will find theyhave an important advantage in the marketplace. They’re going tobe miles ahead of those who just jump into buying and selling op-tions without understanding time decay or knowing that volatility isthe key component that moves the price of an option up or down.The educated investor/speculator will be attuned to when the mar-ket is nervous or overly confident. Those who take the time tostudy and prepare for this market will know that if you’re buyingoptions ahead of earnings, you’re setting yourself up to lose, be-cause that’s the time that the premium—thanks to volatility—is aspumped up as it could be and if they really want to play direction-ally, they’d better be spreading.
Are options trading courses necessary? Not really. Do theyaccelerate the learning curve? Yes. You could read this book—orany other on options trading—and put yourself through the paces.But that would take you longer than if you sat through a two-dayseminar. It also will depend on how active an investor you intend tobe. For example, if you’re driving to the grocery store, you don’tneed a Ferrari. A mini-van will do the job. But if you’re going to theracetrack, you better have a racecar! By the same token, if you’regoing to buy a couple of options contracts a year, do you need tohave the $3,000 software package? Probably not. But if you’re goingto trade actively or if you hope to support yourself by trading op-tions or enhance your income substantially, then you better haveall the tools at your disposal. You will need to understand far morethan bull call spreads if you want to trade the market in all condi-tions. But if you’re only going to trade in a bull market, you couldrely on that one strategy.
There is no one strategy that is always going to work. Yourtrading arsenal needs to include the knowledge of bull call spreads,bear call spreads, iron butterflies, and so forth, because the marketis constantly changing. What worked in the last six months won’twork in the next six months. The market rotates in and out ofwhat changes, what stays the same 205
sectors. It doesn’t go straight up or straight down; there are alwaysgyrations in between.
As retail investors continue on the options learning curve, thiswill create more and more demand for faster access to our market.Increasingly, the world is demanding instant gratification. You canbuy everything from groceries to books to movie tickets online. Asthis retail audience becomes more acquainted with options, theyare going to push for that kind of instant access.
Unfortunately, a retail options-trading is a much slower pro-cess. You have to go through a broker, who makes sure you're qual-ified to trade options. You have to have a margin account to tradeoptions. You have to sign disclosure statements that you under-stand that options have a limited life. Admittedly, certain peopleshouldn’t trade options, especially if the money they have to in-vest—if ever lost—would affect their livelihoods or their lifestyles.
As I’ve seen in the seminars I’ve given around the country,there are a growing number of retail investors who will readilycome to the options marketplace, with an understanding that op-tions allow you to define your risk when you enter your trade. Plus,the volatility of the overall equities market has also shown a clearcase for options. Investors see hot stocks like eBay, Qualcom, andJDS Uniphase. They see Internet issues go from $40 to $300, andthey want in on some of that action. But who can buy a $300 stock?Very few people. And the risk at lofty prices (as we've seen in theApril 2000 “correction”) is that the price could very well declinefrom $300 to $200 or $100 or even lower! With those prospects,most of us wouldn’t want to buy 1,000 shares of a $100 stock tospeculate.
With options, I could put on a trade and control 1,000 sharesof a $100 stock for, $5,000, $10,000, or $20,000, depending on mytimeframe. What does that mean? For one-tenth or one-twentieth ofthe money, you could put on a limited-risk trade and benefit in thesame way as the risk-taker, who bought the stock at $300 a shareand hoped it didn’t tank.
Additionally, you can risk a lot less money and never have amargin call for buying and selling options. Once you've paid for theoption, that’s it. There is no margin call because of an adverse mar-ket move. That could be some very good news for Internet-stock in-vestors who bought on margin and then faced some hefty margincalls in April 2000.206 how I trade options
Options speculators are coming from the ranks of peoplewho took a stab at day-trading stocks. They understand that, withoptions, they could still take advantage of the upside and down-side potential of a stock—but with less risk and, thanks to lever-age that’s inherent in options, less capital requirements. Thiscould be a part-time job or their next vocation. Or, perhapsthey’ve been investors who held only mutual funds and now wantto create a portfolio of their own using stocks. They realize, too,that options can be part of that strategy, hedging stock risk andparticipating in market moves with defined risk and less capital.That’s the direction that options trading is taking, and the growthcould be off the charts.
Several dynamic factors are coming together, from electronicexchanges to Internet access for speculators. Along the way, retailinvestors are becoming more comfortable with the idea of manag-ing and trading their own money. Investors want to be empowered.They want to make their own investment picks and put their moneyon the line. But they don’t—and can’t—be exposed to unlimitedrisk. That’s where options come in. With a little homework anddedication, investors can do this. The marketplace is changing,and the savvy ones among us will embrace the change, and wel-come the new participants.glossary
American style option: A call or put option contract that can be exer-cised at any time before the expiration of the contract. Most exchangelisted options are American-style options.
assignment: When an option is exercised by the holder of that option,the option is assigned to the writer of that option. The writer of a call op-tion is obligated to sell stock at the striking price of the call option; thewriter of a put option is obligated to buy stock at the striking price of theput option.
at the money (ATM): An option whose strike price is approximately thesame as the current price of the underlying stock or future. For example,with IBM trading at $110, both the $110 call options and $110 put optionsare at the money.
bar chart: A bar chart is a price chart that depicts each trading period(month, week, day, hour, minute, etc.) as a vertical line (bar) rangingfrom the low price to the high price. Most bar charts also include twosmall hash marks on either side of the bar: one on the left that denotesthe opening price and one on the right that denotes the closing price.
bear call spread: Net credit transaction. Maximum loss = Differencebetween the strike less the credit. Maximum profit = Credit. Requiresmargin.
bear put spread: Net debit transaction. Maximum loss = Debit. Maxi-mum profit = Difference between the strikes less the debit. No marginrequired.
bear spread: A one-to-one spread established by selling a lower strikeoption series and buying a higher strike option series. Both option seriesare on the same underlying asset, are of the same type, and expire in thesame month. 
 
      
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
208 glossary
bearish: Expecting a decline in the market in general or a decline in theprice of one particular asset.
bid: The highest price anyone is willing to pay for a security.
Black-Scholes: Fischer Black and Myron Scholes developed a formula tocompute the values of European-style call and put options.
breakout: A breakout occurs when price bursts out of a congestion pat-tern like a trading range, flag, or pennant, or through some other supportor resistance level. Sometimes breakout is used to describe upside movesonly, while breakdown is used to describe downside moves.
bull call spread: Net debit transaction. Maximum loss = Debit. Maximumprofit = Difference between strikes less the debit. No margin required.
bull put spread: Net credit transaction. Maximum profit = Credit. Max-imum loss = Difference between the strikes less the credit. Requiredmargin.
bull spread: A one-to-one spread established by buying a lower strikeoption series and selling a higher strike option series. Both options seriesare on the same underlying asset, are of the same type, and expire in thesame month.
bullish: Expecting an increase in the market in general or an increasein the price of one particular asset.
butterfly spread: A long butterfly usually refers to the sale of two con-tracts on one option series and the purchase of one contract of a loweroption series and one contract of a higher series. All contracts are on thesame underlying asset, are of the same type, and expire in the samemonth. A long butterfly is also the result of combining a short straddlewith a long strangle, or of combining a bull spread with a bear spread.
call: This option contract conveys the right to buy a standard quantityof a specified asset at a fixed price per unit (the striking price) for a lim-ited length of time (until expiration).
candlestick chart: A price chart that uses rectangles that range fromthe opening price to the closing price of each trading session. The rectan-gle is dark (usually black) if the closing price is lower than the openingprice (a down day), or light (usually white) if the close is higher than theopen (an up day). Candlestick charts, which originated in Japan, are verysimilar to bar charts, although they predate them by a number of years.The high and low price extremes extend as vertical lines above or belowthese rectangles, forming “wicks” to the bodies of the “candles” repre-sented by the rectangles. If the high and low of the day are identical to theglossary 209
open and close, no wicks will exist; conversely, if the open and close arethe same price, no rectangle (body) will exist. Like bar charts, candle-stick charts can be constructed on any timeframe.
close (or closing price): The final trade price of the day (or other timeperiod). In futures markets, the close is a representative price of the lastminute of trading. In stocks, the close is the last recorded trade price.
closing transaction: Selling a previously purchased option or buyingback a previously written option, effectively canceling out the position.
collateral: This is the legally required amount of cash of securities de-posited with a brokerage to insure that an investor can meet all potentialobligations. Collateral is required on investments with open-ended losspotential, such as writing naked calls or puts.
commission: This is the charge paid to a broker for transacting the pur-chase of the sale of stock, options, or any other security.
condor: A type of butterfly where instead of selling two options of thesame series, two adjacent option series are sold. See butterfly spread.
congestion: A period of nontrending or sideways price movement, oftenin a narrow range (or an increasingly narrow range, as in the case of tri-angles and pennants). See trading range.
continuation pattern: Price action that interrupts a trend and implies acontinuation of the trend (rather than a trend reversal) when the patternis complete. Triangles, pennants, and flags are examples of continuationpatterns.
contract size: The number of units of an underlying asset bought by ex-ercising a call option or sold by exercising a put option. In the case ofstock options the contract size is 100 shares of the underlying asset. Inthe case of options on futures contracts, the contract size is one underly-ing futures contract. In the case of index options, the contract size under-lying asset is an amount of cash equal to parity times the multiplier. Inthe case of currency options, it varies.
correction: A shorter-term countertrend move. See also pullback.
cost of carry: The interest cost of holding an asset for a period of time.This is either the cost of borrowing funds to finance the purchase, inwhich case it is called the real cost, or it is the loss of income becausefunds are diverted from one investment to another, in which case it iscalled the opportunity cost. 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
210 = glossary
covered: A short option is considered covered if there is a correspon-ding offsetting position in the underlying security or another optionwhere no margin requirement results from the short option.
Cox-Ross-Rubenstein: John Cox, Stephen Ross, and Mark Rubenstein:the inventors of the binomial option pricing model.
cup-and-handle pattern: A cup-and-handle is a reversal pattern formedwhen a market makes a rounded bottom (the “cup”), begins to rally, pullsback (the “handle”), and resumes the uptrend. See also running cup-and-handle.
daily range: The difference between the high price of the day and thelow price of the