means you need a minimum of 70 traders on the floor. That means70 salaries plus 70 seat leases at about $10,000 a month. That putsthe making of atrader 9
the overhead of a trading operation at more than $1 million amonth. With seat leases being a fixed cost, the only variable issalary. And that means hiring younger traders who are willing towork at a lower salary. Frequently, I refer to this style of manage-ment as “Fat Brain,” as the young guns are directed by a group oftraders, or in some cases even computers (the Fat Brains), that gen-erate buy-and-sell levels and do most of the hedging, as well.
At my firm, we make sure all our traders know how to trade.Although we use computer assistance, the electronics do not tell uswhen to buy or sell.
For retail investors, this change in the Jynamics of the markethas been part of an overall change for the better. With more bigmoney coming to the floor and a proliferation of stocks with op-tions on them, there is a greater depth and liquidity in the marketthan there has ever been. The four U.S. options exchanges listabout 20 to 30 new issues every month, some of them initial publicofferings (IPOs) that are only six months old.
It’s a different landscape now than when I first came to thetrading floor as a 22-year-old, left largely on my own to cull insightsinto the market where | could. But some of the changes have beenfor the better. Traders download their “sheets”—lists of put andcall option prices and values—at night from the Internet. In manyways, this embracing of technology will help the options pit to sur-vive in the electronic era.
Unlike many of the traditional futures-trading exchanges,which have fought the encroachment of technology, in options wehave embraced technology and brought it into the pit. Ours is ahybrid of open outcry and electronic trading, which many of us be-lieve will extend the life of the trading floor, so that when we be-come fully electronic we won’t have an exchange that looks like aghost town. We will be ready, because we have been at least par-tially electronic for a decade or more.
The electronic revolution on the floor will continue to bringdramatic change in the experience of the retail customer. Responsetimes—from the placement of an order by a customer to executionon the floor—is being narrowed to just seconds. That means virtualinstant gratification for the public. We'll be seeing this, increasingly,with electronic communication networks (ECNs) in stocks, whichbring the market to the retail customer. We've also seen the explo-sion of volume that this direct access to equities has produced. In10 how I trade options
options, technology will mean virtual interaction between the pub-lic and market makers, and that leveling of the playing field shouldlikewise result in massive increases in the volume of options traded.
When I began trading nearly two decades ago, the average re-sponse time was two minutes. First, a customer’s order would leavea desk at a brokerage-house office upstairs and be sent to the pit.There, a teletype machine would print the order out at a desk onthe floor, where a clerk would separate carbon copies of the orderand hand one to a runner (who may or may not be waiting there)who would bring it to a broker in the pit.
In those two minutes, the market could very well have moved,meaning the customer might not get anywhere near the price antic-ipated. Or, if the customer placed a limit order—with a specifiedprice—it may never be executed if the market moved substantiallyhigher or lower.
Today, 90 percent of the orders come to the floor fully elec-tronic. Orders go from a brokerage office upstairs to the tradingfloor at electronic speed. By the time the order is offered in the pit,the response time is something like seven seconds. This means slip-page—the difference between the price a customer sees on thescreen when an order is placed and the price at which the order isexecuted—is greatly reduced. The result is a more efficient marketand a better experience for the customer.
When I began trading, virtually all the trading capital was heldin the accounts of individual traders on the floor. Each trader wascapitalized to the tune of tens of thousands—and in a few cases,hundreds of thousands—of dollars. Since late 1998, the averagefirm on the options floor has multimillion-dollar backing and acadre of young traders. Some of the firms that are offshoots of themajor brokerages may have $200 million to $300 million in backing.From a customer perspective, this amount of capitalization meansthere will be ample liquidity in the market to handle large tradeswhen a Fidelity, a Dreyfuss, Goldman Sachs, or a large hedge fund—which we almost never saw in the market in my early days—comesinto the market.
The marketplace may change, but the attributes of a goodtrader have not. The most important commonality among tradersis discipline. If you’re an independent trader, discipline is your sin-gle most important quality; without it, you have a slim chance ofsucceeding on your own. If you work for a firm, discipline will helpthe making of atrader 11
others have confidence in your ability to trade and carry out aplan. At my own firm, I can only put my trust in traders who I knoware disciplined, abide by the rules, and carry out our strategies. Ineed to know, for example, that when one of my traders is longmore than 5,000 shares, he (or she) will cut his losses or start totake profits. If they can’t carry out those directives, they won’t bewith our firm very long.
To trade in the pit, you must have stamina, as well. To earn aplace in the front ranks nearest the brokers, you must stand yourground—literaily. Among the brokers in that inner circle, the mostsought after are those who handle orders from the public. Thesebrokers, working for firms such as Charles Schwab or Fidelity, oftenhave 10- and 20-contract orders to execute on behalf of a retail cus-tomer. For independent traders, these are prime orders that offer usa chance to sell 10 call options on Dell, for example, and then buy 10a minute later in another transaction and make the quarter-pointspread between the bid and the ask. That’s why the crowd is usu-ally the thickest around these “public” or retail brokers.
The orders these brokers execute are generated when a retailcustomer reads an article about a company or gets a tip from afriend and decides to invest in the stock via options. As I'll explaina little later, options are a relatively low cost way to speculate instocks and take advantage of leverage. These retail orders are notbased usually on sophisticated technical analysis that shows an op-tion is under- or overvalued. Nor do they reflect a careful study of acompany based on concerns over upcoming earnings or productdevelopment.
The crowd of traders is a lot thinner around the institutionalbrokers for major houses such as Goldman Sachs, Morgan Stanley, orLehman Brothers. These brokers are executing large orders on be-half of institutional clients. The size, alone, precludes many tradersfrom trading, since these brokers are dealing with a “lot of paper”—often in the hundreds of contracts. Since each options contract rep-resents 100 shares of stock, the exposure is considerable on eachtrade. Additionally, these orders do tend to be based on sophisti-cated analysis of either the price of an option or the fundamentals ofa company. For example, if an institutional investor expects an earn-ings surprise—either positive or negative—from a company, theymay become big buyers of either puts or calls. The market makerwho takes the trade must be disciplined and always hedge those12 how I trade options
large positions because these institutional customers are usuallyacting on time-sensitive information. Thus, the market makers mustbe fast and accurate on their hedging against these trades.
To be a floor trader, in particular, you must be a competitorwho will go the distance. For example, when the CBOE prepared tolist Dell options in 1999, traders were vying for a place even beforetrading began. Traders were staying overnight in the pit to marktheir spots so no one else could muscle in on their floor territory. Atfirst they were coming in at 2 a.m. to secure a spot on the floor, butquickly learned that they needed to arrive by 10 p.m. to get the bestlocation. One of our traders brought an inflatable mattress to workand slept on the floor of the exchange so he wouldn’t lose his spot.There were 20 or 30 traders sprawled out on the floor, using tele-phone books for pillows. Finally, the Exchange drew the line and noone was allowed to spend the night on the floor. Spending the nightto protect your position on the floor may seem a little extreme, butin a business where your position on the floor could mean the dif-ference between getting the other side of a broker order or not,you'll do whatever it takes.
Moreover, trading on the floor is a “people business.” The ob-server sees only the screaming and yelling of prices and the banter-ing among the traders. But when you’re quoting a market to abroker who may be buying 10 options or 500, there is a good deal ofnegotiating going on. You have to have some kind of personalitythat makes you stand out, even if it’s a friendly combative one. Youhave to get along with people in the pit; it can’t always be war.There are literally hundreds of traders in the stock index optionspits. There might be 70 or so in the popular stock options pit, likethe AOL. With this kind of population, you must be able to holdyour own as a trader and as a human being. If there aren’t at leastsome people with whom you get along, it will be you against thewhole pit. That, obviously, doesn’t work very well.
Beyond these qualities, you must also have a quick mind andan ability to focus on several things at once, such as the premiumsquoted on puts and calls on several options and the price fluctua-tions of the underlying stocks. That’s why some trading firms liketo recruit bridge players and chess players, who can think multidi-mensionally, strategically planning several moves ahead. Otherslike card-counters, who can keep track of numbers and combina-tions quickly, as well as the odds of certain events occurring. Manythe making of atrader 13
former athletes go to the trading floor. At my firm, I have seven for-mer football players, including my brother, Pete, and myself.
my path to the options floor
I came to the options pit directly from the football field. It was nota career path I had planned, but it all worked out better than Imight have ever hoped.
By nature, | am an optimistic person. But I also know my limi-tations, even though | might extend myself to the end of those limi-tations. Part of what makes up my trading and business acumen isthat I can get out there and dance on the edge. I respect what couldhappen, but I don’t live in fear o¢ it. If fear dominates your thoughts,you're not going to see the opportunities that are available to you.
When I am focused on a goal, | give it all I] have. But when |know, realistically, that | have no chance of succeeding, I switch toan alternate plan. That is a personality trait that has served me wellin trading, in life, and in football. A critical assessment of where I amand where I want to be is the reason why I, in time, became an op-tions trader. And it’s also the reason why my college football careerspanned five schools. Unless I was going to be among the starters, |simply wasn’t going to play. I'd go somewhere else.
I always wanted to play football, a dream that really tookshape for me when I was a 12-year-old “ball boy” for the Vikings,after my family moved from the West Coast to Minneapolis, wheremy father became the Chief of Surgery at the University of Min-nesota. My football dream began to take shape when I played atCentral High School in Minneapolis, a school that was racially andethnically mixed. Among my classmates and friends were “TheArtist Formerly Known as Prince” (a slightly built musician who didnot play football) and his brother (who did), and two other famousmusicians and producers (Janet Jackson’s Control), Terry Lewis,and Jimmy Jam.
A torn-up ankle, repaired with two surgical screws and syn-thetic ligaments, killed my football-scholarship offers from OhioState and Notre Dame. Instead, I went to the fall football camp atthe University of Minnesota, but my ankle wasn’t good enough forme to play on the team. So | sat out that season and enrolled inNormandale Junior College in the spring of 1976. There, | met foot-ball players who were good enough, in my estimation, to play at14 how I trade options
Division I schools, from which most of the pro-ball players aredrafted. Because most of us at Normandale were overlooked bythose Division I schools, either because of physical or academicreasons, most of us played with a chip on our shoulders. This wasgreat for our team, but bad for our opponents, as we led the nationin several categories and our defense, which I co-captained, wasone of the tops in all levels of college football, allowing just overfive points per game. We went on to win a bowl game and sent sev-eral of my teammates to Division I teams, and four of us to profes-sional ball teams.
After graduating from Normandale, I went to the University ofCalifornia at Berkeley for the spring quarter. But I didn’t stay be-cause the team initiated a switch from a four-linebacker defense tothree, and I was concerned that I would become the odd man outamong the four linebackers. So rather than stick around and be thebackup, I transferred to Cornell University in Ithaca, New York. Ai-though Cornell had a good team, it wasn’t Division I. Besides, mybrother David was playing football at a small Minnesota collegecalled Gustavus Adolphus College and he and | had always talkedabout playing together. Figuring this was my last chance to playfootball with my brother and in front of my parents and friends, Itransferred there and became captain of the college football team.
Our team won its share of championships, and my brotherDavid and I were scouted by most professional teams. After prac-tices, the scouts would ask you to run a 40-yard dash, do vertical orhorizontal jumps, or press 225-pounds for maximum repetitions.And, if they represented a team like the Dallas Cowboys, they’drun an IQ test on you. With a degree in art history and design, my“Plan B” was to go to graduate school and become an architect. My“Plan A” was to play professional football.
I was contacted by a number of professional teams, but I didmy homework and decided to play for the worst team, which in 1981was the Bears. I figured that on a comparatively bad team I hadthe best chance to stand out as a rookie and would have a betterchance of making the cut.
I headed for Chicago where the starting middle-linebacker,Tom Hicks, had suddenly quit in a salary dispute. Tom was makingmore money in the off-season as a trader at the Chicago MercantileExchange without getting beaten up to do it. So the Bears (whom,famed ex-coach Mike Ditka once said, “throw nickels around likethe making of atrader 15
they were manhole covers”) lost their starting middle linebackerand any leverage they had over their second round draft choice,Mike Singletary. I guess Mike and his agent understood leverage aswell as any options trader on the floor of the CBOE, because heheld out, forcing the Bears to sign me as a free-agent. That openedthe door, at least for a short while, to play linebacker for theChicago Bears.
The practices were tough, but the camaraderie was excellent.Walter Payton, the Bears’ best-known running back, was on theteam. (Waiter used to call me “Elvis,” because | had hair in thosedays—a lot of hair—which has since been replaced by a bit moreforehead and a short ponytail in back.) Mike Singletary had signedwith the Bears by the time the preseason began. It was obvious tome that Mike was a real talent, but | wasn’t about to quit ... 1 wasever the optimist. | was going to give it my all, but I knew thatSingletary was the star of the future.
If events had played out differently, | could have held on andbeen a back-up. Or, perhaps I would have gone to another team andhad a satisfactory career for five or seven years. But my career infootball was not to be. My last preseason game was against KansasCity. To this day, | remember how big that stadium was and howlarge the crowd. It seemed surreal, because when you're on thatfield, all you can focus on is the play you’re executing. It was as ifthe crowd was silent. My last play for the Bears was on the suicidesquad covering a kickoff. ] made the tackle and broke my helmet inthe process. It was a pretty good collision, and my tackle hadknocked the back down inside the 20-yard line. Unfortunately,there was an offside penalty against us, so we had to back up fiveyards and re-do the kickoff. On the next play, the running backdowned the bail in the end zone and, thus, ended my brief profes-sional career.
After that fourth preseason game, | was told at breakfast onSunday to “bring your play book. The coach wants to see you.”Those are never the words you want to hear as a pro ball player. |handed in my play book and was given a return ticket to Minneapo-lis. | went home a 22-year-old ex-NFL player with a few choices, butno real plan. I decided against playing football in Canada because,true to my nature, if it wasn’t the big league, I didn’t want to bepart of it. One of my driving motivations has always been to distin-guish myself in whatever field I choose.16 how I trade options
That’s when I decided to become a trader. You see, when I waspracticing with the Bears during the long hot Chicago summer, thefans who came out to watch us at three o'clock in the afternoonwere stockbrokers and traders. Why? Because as soon as the mar-ket closed around 3 p.m. Central time, they were free. I was fasci-nated by the markets and by the fact that it would be wonderful tofinish your day at 3 p.m.! Minus another plan, a career as a stock-broker seemed to be the best choice for me.
So I told my plan to my football agent, Dick Lurie, who alsohappened to be an options trader. “If you want to get into the mar-ket,” he told me, “you ought to trade options.”
The notion of options trading was completely foreign to me,but I agreed to give it a go. A few days later, I was a clerk at the Ex-change, completely in another world.
Dick was a good guy, but he didn’t have the time or the tem-perament to show me the ropes. | was left to absorb what I couldabout options on my own. That was probably the most difficultthing for me. I was used to being in a world—most recently foot-ball—where I knew exactly what was going on. Things were prettyregimented for football players: Break down tendencies on film. Putin new defensive sets. Practice against the other team’s offensiveformations. But in the options pit, nobody hands you a play bookand puts you through the paces. Everyone is expected to learn to“read the tape” on his or her own. Options trading was so new thatthose who really understood calls and puts were desperately tryingto keep the knowledge for their own benefit. It would be like givinga prospector a map to your gold mine. Why would you do it?
The main reason I was unhappy was that | thought I wouldnever be good enough at options trading to distinguish myself inthat field. | was lost half the time with no one to teach me while themarket swirled around me. (As a teacher and a lecturer now, I re-member how that felt. I believe this experience as a rookie helpedme to become not only a better options trader, but a better trainer,as well.) But I was as tenacious about this career as I had beenabout my football career—I wasn’t about to quit. I had been raisedto believe that if I was going to be successful, I would have to give itmy all.
Being the son of Dr. John (with an “h”) Najarian is a wonderful,but difficult, role. My father was famous for his skill as a surgeonwho performed some of the earliest organ transplants in the country.the making of atrader 17
His picture on the cover of Newsweek, in surgical gown and maskand performing a transplant, is framed on my office wall. I am im-mensely proud of him and the rest of my family, which alsoincludes my brother, Pete, a former linebacker with the Seattle Sea-hawks, Minnesota Vikings, Sacramento Surge, and Tampa Bay Buc-caneers and now an options trader; my brothers, David and Paul,who live in Minneapolis and operate several fast-food franchises inthe Twin Cities, and my mother, Mignette, who raised us to try tobe our best. But as my father’s son, I knew what it was like to growup in the shadow of a famous and accomplished man. He was bothmy role model and my challenge.
my education on the floor
Through hard work and innovation, I managed to learn about op-tions trading during my time as Dick’s clerk. He hooked up with aNew York stock specialist firm, a partnership that enabled us under“Reg T” to trade stocks without putting up any margin. When Istarted, options traders had to put up a margin on the stocks theyused to hedge their positions. Later, that rule was changed and op-tions traders, like stock specialists, could trade without margin aslong as they had sufficient hedges in options against the stock theywere trading.
Through our partnership with the specialist’s firm, we had anopportunity to make good money in stocks, especially shortingthem in a hedged transaction known as a reversal. Interest ratestopped 16 percent in those days. Imagine selling 100 shares of IBMat $100 a share, or $10,000. With interest rates at 16 percent, youcould earn a lot of interest on that money, and the margins werehuge since the other option market makers didn’t have access toour Reg-T exemption.
I would arrange the stock loans (because the person shortingthe stock must borrow from someone who has access to lendablesecurities) with Merrill Lynch or Drexall Burham for hundreds ofshares at a time. There were months when our rebate checks (in-terest paid on the stock we sold short) would exceed several hun-dred thousand dollars. As lucrative as that was, those proceedsnever seemed to trickle down to me, the clerk. So when anothertrader named Thomas Haugh, whom I had met playing softball inmy off hours, asked me to come to work for him, | jumped at the18 how I trade options
chance. Tom paid me $100 a week and taught me all that I needed toknow about options. He was—and still is—a brilliant trader. In fact,we still work together in PTI Capital Management LLC, a Chicago-based proprietary trading firm and iTradem.com, our all-electronicbrokerage for securities, options, and futures.
Jom’s strength was as a market technician, particular inspreading techniques (which I'll explain a little later in this book).Working with him, | began to understand the possibilities in thismarket that, for six months, had eluded me. I saw that if I bought“this” and sold “that,” I had the potential of making more moneythan just trading one position with a hedge.
Unfortunately for Tom and me, we were trading in the “darkages” of 1981 and 1982 when computers were extremely slow. Print-ing our “sheets’—endless lists of options prices—took hours. Wecame in at six in the morning to get ready to trade at nine. Often,after the close, we’d go to the gym to work out and then come backto the office and work until 10 p.m.
We'd scan the sheets for options that, based on our analysis,were under- or overvalued, which we would then want to buy orsell. Perhaps there was an option trading at $3.50 that we thoughtshould be valued at $4.00; we’d want to buy those. Or, perhaps anoption was trading at $5 that we thought was more fairly valuedat $4; we’d sell that one. Even though options were trading on onlyabout 80 stocks in those days, we’d find enough opportunities tohave spreads all over the floor.
By comparison, with faster and more powerful computers, theanalysis that used to take Tom and me hours to do can be accom-plished in six to eight minutes—and for 1,500 stocks instead ofjust 80.
Tom began to let me put on the spreads that I would find,which introduced me to trading on the floor with the money he wasmanaging. Then | wanted to trade for myself. Tom knew I didn’thave enough money to back myself, so he set me up with a friend ofhis who put up my trading capital and let me keep 50 percent of myprofits. For the first time, | not only knew the game, but | had a planto succeed.
Then I made it to the front of the IBM options pit one day andtraded in the big league. The rest, as they say, is history.
In football, some people can’t get past the big bodies slam-ming into each other to truly understand the intricacies of thethe making of atrader 19
game. For a long time, I was like that in the market. I saw the action,but I did not fully comprehend what was really going on. I couldn’tsee the strategies that the players were using or understand howthe market was reacting and why.
In 1981, the money supply was everything. It was the one eco-nomic factor that everybody waited for and reacted to. Then, by1987, it was the trade deficit. There were even some who believedthe trade deficit had become so large it actually caused the stockmarket crash of 1987.
Through early 1999, it was inflation. All eyes were on the un-employment figures for signs that the economy was growing tooquickly and the Fed would have to raise rates. In late 1999, the dol-lar had our attention. In early 2000, we’re mesmerized by the gyra-tions of Nasdaq and the Internet.
As I have seen countless times in the past 20 years, just whenyou think something is the answer to all of the market’s questions itturns out that something else is wielding more influence. In the in-vestment world today, anything “dot-com” is the rage. But while theInternet is useful technology, it’s really a twist on an old theme.Once it was railroads that connected towns and markets. And thenradio was the hot new medium. Who knows what will follow theInternet.
One thing is certain: Whatever appears on the horizon willsomehow become a traded security, and securities will always needmarket makers like me. But that doesn’t mean the opportunitieswill be limited to only a small inner circle. On the contrary! Whatthe e-trading explosion has showed us is there are the vast legionsof retail investors willing to trade and invest in stocks on theirown—and online. Once the options market becomes demystifiedfor them and electronic access is improved, the options market willbecome as fertile a field for these retail investors as the stock mar-ket has been.
how investors can use options to their advantage
While my arena has been the trading floor and my off-the-floor trad-ing operation, Mercury Trading, there is increasing interest in theoptions market among retail investors and speculators. The retailaudience that has poured billions into the stock market, speculat-ing in stocks from Blue Chips to dot-coms, is learning more and20 ~=how I trade options
more about options. At the same time, the options industry is ea-gerly educating the retail market about trading options, includinghow to use these derivative securities to participate in the marketwith limited risk.
Options carry no guarantee of return, just as with any invest-ment. There are strategies that can help you to maximize your re-turn while keeping your risk within defined parameters. Tradingoptions successfully will require you to do your homework and toplan out your strategy. But it’s not impossible, and as you'll read inlater chapters, there are many strategies to profit in bull markets,bear markets, and when the market (or a particular stock) is in arange. This is a message that I bring home at the myriad of optionsseminars that | speak at around the country every year. ] teach in-vestors that, with the proper training and dedication, you can useoptions to increase profits and protect your investments. Investingin options is not a “get rich quick” scheme, but with a long-enoughtime horizon and a little homework, it’s possible that options willbecome the most important part of your investment strategy.
The options market—where I had my baptism by fire—is theplace in which I “grew up” professionally. As I stated at the begin-ning of this chapter, a healthy options market benefits all of us,professional and retail speculator alike. As you'll read in Chapter 2,retail investors don’t compete with professionals. Our games areentirely different. But the liquidity that each group brings to themarketplace can only make it a healthier and more profitable placeto be.chapter 2
the marketplace
The floor of the Chicago Board Options Exchange (CBOE) is a hy-brid environment. Like its parent exchange, the Chicago Board ofTrade, the options-trading floor has pits where traders in coloredloose-fitting jackets call out their bids and offers. But electronictechnology has made strong in-roads onto the floor. Large, elec-tronic screens flash above the pits—or posts, as they're alsocalled—where stock options are traded. These big screens bear aclose resemblance to the departure and arrival monitors at air-ports. But the technology doesn’t end there.
In the pit, the market maker, whose job is to make a two-sidedmarket for put and call options, is more than likely holding courtaround a cluster of computer screens that display the orders to beexecuted. Traders with handheld computers scan their screens forthe latest analysis of bids and offers. Headsets and computersabound. Traders have every gadget from-Palm VII’s, cell phones andbeepers, to strings of batteries to run everything.
One trader passed me on the floor the other day wearing aheadset (a kind of limited-range cell phone that only works on thetrading floor) and a computer in a ballistic nylon case slung overhis shoulder. In his hand, he clutched a Palm VII and a calculator.All he was missing was a satellite dish on his head.
Technology will extend the life of our trading floor and ourpit, as other exchanges debate the futures of open-outcry. Eventhough purists like me have been irked at times by “Gameboytraders’—so named for the handheld computers they use that22 how I trade options
resemble the popular video game hardware—technology is our fu-ture. As I stated in the opening chapter, technology will speed theflow of customer orders to the floor and technology will allow firmsto hire legions of young, inexperienced traders who are willing totake direction from a computer screen.
To be honest, the hybrid trading floor, where traders and com-puter screens commingle, is fitting for a derivative marketplacesuch as options. Think about it. Our stock and trade is the next gen-eration of financial instruments. We trade speculative instrumentsthat, in virtually all cases, no one wants to buy and hold (unlikethose shares in the electric company your grandfather bought andput in the desk drawer for 30 years).
But when | buy an option, I do not own a piece of a company ora bond that will pay me interest. | own the right to own or sell some-thing. In form, options are