ades that require assistance or extra monitoring.
education
As with every other tool we've discussed in this chapter, theamount of education that you need depends on how active andgetting the right tools 187
sophisticated an investor you are or intend to be. One place to startis the options exchanges, themselves, which have outreach pro-grams for retail investors. The CBOE, for example, has educationalinformation on its Web site and also offers periodic seminars on op-tions. In fact, the CBOE’s programs are the créme de la créme,which is not just my hometown bias. Ask anybody who has gone toan options seminar, and they’ll tell you that the CBOE has some ofthe best offerings. Although they are free, they cram a ton of usefulinformation into their two-and-a-half-hour programs.
In addition, many brokerage houses host seminars for theircustomers. So if you have a large account at Schwab, Smith Barney,or Fidelity, you might inquire about upcoming options programs.Our firm, PTI, holds several seminars a year in conjunction withthe CBOE.
Those free, introductory option seminars are a great place tostart. Then you enter the realm of the paid seminars, which may costseveral thousand dollars in tuition. One word of advice, you shouldbe very serious about trading options before you plunk down thou-sands of dollars for a course. Among the various course offerings areseminars through 1010WallStreet.com or StockmarketWorkshop.com.
At our seminars, one of the most frequent comments heard is,“If I knew this six months ago, I'd be a lot richer today!” (Or, “I'd bea lot less poor if I knew this six months ago.”)
The first step on the education trail does not have to be a$3,000 seminar. You can certainly begin with a book (like this one!)and a free seminar to serve as an introduction. But the more you in-vest in your education, the more you will learn. And, the better pre-pared you are going into that $3,000 seminar, the more you willabsorb. Consider too that the $3,000 you'll pay for a two-day semi-nar will yield far more useable material at a far less cost than, say,going back to school for a specialized graduate degree in deriva-tives and trading. Many courses also include videos, audio cas-settes, and other support materials to help you long after theseminar is over. Some courses also allow you to retake the coursefor no addition cost.
Remember, if you eschew the seminar route, you’ll still be pay-ing for your education in the form of trial-and-error mistakes andcommissions on unprofitable or low-profit trades.
Many of those who come to our seminars are already invest-ing, and some have high net worth, often tied up in one or two 
 
 
 
 
 
 
 
 
 
 
 
 
 
188 how I trade options
stocks. If they’re what we’ve described previously as “single-stockmillionaires,” they may be afraid to diversify their holdings be-cause of capital-gain considerations or because they are so emo-tionally tied to the stock they can’t possibly sell. Or perhaps theyjust believe so firmly in the prospects of the company that theywant to hold on. With this scenario, they want to use options toprotect their single-stock holdings, or to begin speculating inother issues.
These retail investors may be a customer of a large brokeragefirm, but their broker may not be knowledgeable about options.Thus, the customer is left on his or her own when it comes to op-tions education. Luckily, there are plenty of alternatives out there,starting with the exchanges themselves. ,
Whatever seminar you choose, make sure that you are a dis-cerning consumer. What is the background of the instructors? Arethey market practitioners, or are they just on the speaking circuit?How long have they been trading? What kinds of materials are in-cluded in the course? Will you receive a big, thick manual, or justsome photocopied graphs and charts? Does the course includevideo and audiotapes that you can use as a refresher?
You don’t need to jump into options as a novice by signing upfor every service and enrolling in every course. But if you’re goingto be a serious investor, able to employ a variety of strategies toprotect your stock portfolio and make profitable trades, you haveto make sure you have ample resources at your disposal.
In every profession, there are the proverbial tools of the trade.Options are no different. And the more you know how to use thetools, the more skilled you’ll be.chapter 10
what changes,what stays the same
The debate still rages about the New Economy versus the Old Econ-omy. At one moment, the high-tech New Economy reigns, leavingthe Old Economy to languish with price-to-earnings (P/E) ratiosthat are as low as its perceived growth prospects. In the next mo-ment, the New Economy is deflating as quickly as a ruptured bal-loon, while investors seek refuge in company names that are morefamiliar and tested by time. But for all the talk about a new para-digm, there is one thing that hasn’t changed. The markets are verymuch the same today as they were when I first came to the tradingfloor nearly 20 years ago.
Fund managers, institutions, and the public alike, still reactthe same way to various market stimuli. In other words, the herdmentality prevails.
When the herd is scared, there is panic. When the herd is con-fident, there is euphoria. These polar-opposite attitudes tend to ac-centuate the market moves, from oversold to overbought, and backagain. When a few members of the herd go in a new direction (andget publicity in the process) you can expect a stampede to follow.
The aspects of the herd mentality—and the opportunities andthe challenges it presents—still dominate today’s market place.What is different, and will become increasingly so, is the impact oftechnology. Whether you’re talking about the world economy or the 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
190 how I trade options
trading floor, technology continues to make inroads, changing thepace, the dynamics, and the participation. I have seen a lifetime ofchange in my 20-year career as a trader. We have gone from thedark ages of paper and pencil to the new age of hand-held comput-ers that can send an order to the New York Stock Exchange‘via aninfrared communications signal. .
Knowing what stays the same and what changes dramaticallywill help traders like me and investors like you to navigate the ter-rain ahead. Who knows what comes next! In late 1999 and early2000, we have seen virtually unprecedented market gyrations.There is no indication that at least for the short-term this is going toease. The market, once enamored with the Internet, is now runningfrom anything dot.com and wringing its collective hands about itsold foe, inflation. Is the sky falling or just getting cloudy?
It’s times like these that call for perspective. As we said inprevious chapters, nothing goes up continuously. Remember treesdon’t grow to the sky. Corrections are to be expected and, by andlarge, they are healthy for the market. But in between the correc-tions and the rallies there are going to be uncertain times.
That’s when it’s important to remember that the marketdoes, indeed, move like a herd. (Think of a cattle drive from someold Western movie, with a few thousand longhorns on the move...) In first-quarter 2000, there was an incredible fertile valley forthe herd to graze in called Nasdaq. And there was this Death Val-ley called Dow Jones. Every week you could track the money flow-ing into the high-tech, Internet, and mid-cap Nasdaq stocks. Asignificant portion of this money was flowing out of more tradi-tional value stocks.
There were various explanations for these phenomena: A com-pany like Gillette can come up with only so many varieties ofrazor blades (amazingly, they even followed an old Saturday NightLive skit and produced a “triple-trac” razor). Shares of consumer-product titan Procter & Gamble (P&G) dropped by more than athird—falling by 27/46 to 60—when it said on March 7, 2000, itsgrowth would not be what Wall Street had expected.
P&G is a classic Old Economy stock, and can sell just so muchshampoo and deodorant given its market penetration, a maturingmarketplace, and a slow-growing population. P&G fell out of favor(at least for the moment), and Wall Street took its money and wentelsewhere to play.what changes, what stays the same 191
For a while in 1999 and early 2000, the world turned its back onthese kinds of companies, the type that Warren Buffett would buy—Coca-Cola, Disney, consumer durable manufacturers, and insurancecompanies, just to name a few. Illustrating this trend, Warren Buf-fett said in his annual letter to shareholders of Berkshire HathawayChis firm that invests in a variety of other companies) that 1999 was“the worst absolute performance of my tenure... and compared tothe S&P, the worst relative performance as well” (The MotleyFool.Com—Fool Plate Special, Buffett’s Worst Year at Berkshire).
At the same time, the Nasdaq rose some 380 percent in the 18months from October 1998 through early March 2000.
Then the bottom dropped out.
The herd that has been gorging itself on the green pasture ofNasdaq stocks, developed a severe case of indigestion. And, at therisk of stretching a metaphor too far, the purge began. Nasdaq soldoff hard. The Nasdaq Composite on April 14 had its largest-everpoint loss—dropping by 356.74 to 3,320.04, down 9.7 percent. Thisfollowed a 286.27-point (7.1 percent) drop on April 12, a 258.25-point (5.8 percent) decline on April 10, and a 349.15-point (7.6 per-cent) fall on April 3.
The Dow Industrials, meanwhile, fell 616.23 points, or 5.6 per-cent, to 10,307.32 on April 14. Wali Street pundits said the marketcollapse was the worst ever since the 1987 Crash. But the effectscould be more catastrophic because more Americans own stocktoday—an estimated four or five out of 10, compared with two outof 10 in 1987 (LA Times: Dow Suffers Worst-Ever Point Drop of 616;Nasdaq Falls 355).
The reason for the decline was the specter of inflation in theclosely watched economic reports. That triggered panicked sellingacross the market, but most acutely in the high-flying NASDAQmarket, which lost 25 percent or 1,125 points in one week.
The investment scene changes—dramatically. In late 1999 andearly 2000, I watched the flow of money—and not just speculativecapital—into Nasdaq stocks. More individual 401(k) plans hadbeen allocating capital to Nasdaq stocks with the hope that strongdouble-digit percent gains would continue, outperforming the S&P500 Index-type stocks. The market was hungry to the point of beinginsatiable for any stock that has at least four letters in its symbol.(Nasdaq stocks have four or more letters in their symbols, whileNew York Stock Exchange issues have one, two, or three letters.)190 how I trade options
trading floor, technology continues to make inroads, changing thepace, the dynamics, and the participation. I have seen a lifetime ofchange in my 20-year career as a trader. We have gone from thedark ages of paper and pencil to the new age of hand-held comput-ers that can send an order to the New York Stock Exchange ‘via aninfrared communications signal.
Knowing what stays the same and what changes dramaticallywill help traders like me and investors like you to navigate the ter-rain ahead. Who knows what comes next! In late 1999 and early2000, we have seen virtually unprecedented market gyrations.There is no indication that at least for the short-term this is going toease. The market, once enamored with the Internet, is now runningfrom anything dot.com and wringing its collective hands about itsold foe, inflation. Is the sky falling or just getting cloudy?
It’s times like these that call for perspective. As we said inprevious chapters, nothing goes up continuously. Remember treesdon’t grow to the sky. Corrections are to be expected and, by andlarge, they are healthy for the market. But in between the correc-tions and the rallies there are going to be uncertain times.
That’s when it’s important to remember that the marketdoes, indeed, move like a herd. (Think of a cattle drive from someold Western movie, with a few thousand longhorns on the move...) In first-quarter 2000, there was an incredible fertile valley forthe herd to graze in called Nasdaq. And there was this Death Val-ley called Dow Jones. Every week you could track the money flow-ing into the high-tech, Internet, and mid-cap Nasdaq stocks. Asignificant portion of this money was flowing out of more tradi-tional value stocks.
There were various explanations for these phenomena: A com-pany like Gillette can come up with only so many varieties ofrazor blades (amazingly, they even followed an old Saturday NightLive skit and produced a “triple-trac” razor). Shares of consumer-product titan Procter & Gamble (P&G) dropped by more than athird—falling by 2746 to 60—when it said on March 7, 2000, itsgrowth would not be what Wall Street had expected.
P&G is a classic Old Economy stock, and can sell just so muchshampoo and deodorant given its market penetration, a maturingmarketplace, and a slow-growing population. P&G fell out of favor(at least for the moment), and Wall Street took its money and wentelsewhere to play.what changes, what stays the same 191
For a while in 1999 and early 2000, the world turned its back onthese kinds of companies, the type that Warren Buffett would buy—Coca-Cola, Disney, consumer durable manufacturers, and insurancecompanies, just to name a few. Illustrating this trend, Warren Buf-fett said in his annual letter to shareholders of Berkshire HathawayChis firm that invests in a variety of other companies) that 1999 was“the worst absolute performance of my tenure... and compared tothe S&P, the worst relative performance as well” (The MotleyFool.Com—Fool Plate Special, Buffett's Worst Year at Berkshire).
At the same time, the Nasdaq rose some 380 percent in the 18months from October 1998 through early March 2000.
Then the bottom dropped out.
The herd that has been gorging itself on the green pasture ofNasdaq stocks, developed a severe case of indigestion. And, at therisk of stretching a metaphor too far, the purge began. Nasdaq soldoff hard. The Nasdaq Composite on April 14 had its largest-everpoint loss—dropping by 356.74 to 3,320.04, down 9.7 percent. Thisfollowed a 286.27-point (7.1 percent) drop on April 12, a 258.25-point (5.8 percent) decline on April 10, and a 349.15-point (7.6 per-cent) fall on April 3.
The Dow Industrials, meanwhile, fell 616.23 points, or 5.6 per-cent, to 10,307.32 on April 14. Wall Street pundits said the marketcollapse was the worst ever since the 1987 Crash. But the effectscould be more catastrophic because more Americans own stocktoday—an estimated four or five out of 10, compared with two outof 10 in 1987 (LA Times: Dow Suffers Worst-Ever Point Drop of 616;Nasdaq Falls 355).
The reason for the decline was the specter of inflation in theclosely watched economic reports. That triggered panicked sellingacross the market, but most acutely in the high-flying NASDAQmarket, which lost 25 percent or 1,125 points in one week.
The investment scene changes—dramatically. In late 1999 andearly 2000, I watched the flow of money—and not just speculativecapital—into Nasdaq stocks. More individual 401(k) plans hadbeen allocating capital to Nasdaq stocks with the hope that strongdouble-digit percent gains would continue, outperforming the S&P500 Index-type stocks. The market was hungry to the point of beinginsatiable for any stock that has at least four letters in its symbol.(Nasdaq stocks have four or more letters in their symbols, whileNew York Stock Exchange issues have one, two, or three letters.) 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
192 how I trade options
Fund managers were following suit, knowing that their in-vestors would be looking for those same kinds of returns. It’s likegoing to a tailor and saying that you don’t want cuffs on your pants.If the tailor keeps coming out with cuffs, he’s going out of busi-ness—and you'll be going to a new tailor. It was the same consumer-is-right attitude seen among retail investors, which was promptingmoney managers to shift out of value and into growth by thedroves. If they didn’t, they feared being abandoned by individualinvestors.
The herd had been on a feeding frenzy when it came to a vari-ety of Nasdaq stocks. Rather than just dot.coms, investors werelooking for companies that will provide information for the Internet,particularly in business-to-business applications. Just consider thehoopla surrounding 3Com’s Palm Computing spin-off. Shares ofPalm, which is the world leader in personal digital assistants orhand-held devices, were priced at $38 a share, then opened at $145and ran up to a high of $165 on the first day of trading, before clos-ing up 576 at 956. (TheStreet.Com: Palm’s Stock Soars on FirstDay, while 3Com Dives, March 2, 2000).
Then came April 2000, and the Nasdaq rocket ship appeared torun out of fuel. On April 14, the biggest losses were seen in sectorssuch as Internet, wireless and biotechnology which had beenthe darlings of Wall Street’s beauty queen contest and had postedthe strongest gains in 1999. Even blue chips like General Electricand IBM and widely held stocks like Wal-Mart were not immunefrom the April 14 sell-off.
That purge forced mutual-fund managers to switch into theselling mode, as they had to raise cash for anticipated redemptionsfrom their own panicked fund investors. That, in turn, created anopportunity for bottom-fishers to snap up some under-pricedstocks. But keep in mind the trader’s adage: bottom pickers getstinky fingers.
While the technology sector was, at least on April 14, 2000, outof favor, there is no doubt that technology will lead this economy.And while inflation fears may induce the Federal Reserve to raiseInterest rates to slow down the U.S. economy, there is no denyingthe inextricability of the Internet in our businesses and in our lives.
Thus, even when the herd makes panic moves, these suddenchanges in direction will produce opportunities for the more clear-headed. For example, on January 6, 2000, Lucent Technologies,what changes, what stays the same 193
which makes telecom and networking equipment, said it expectedto report fiscal first-quarter earnings of between 36 and 39 cents ashare, compared with previous analyst expectations of 54 cents.The stock fell 3% to $69 a share on that day, then fell more than $16a share more in after-hours trading (ZDNet Inter@ctive Investor,“Lucent Sees 1Q Shortfall,” January 6, 2000).
When I saw this stock, which had been trading at $80 a share,decline to $50 a share, I bought some for my daughter, Tristen (nowa year-old investor!). Why? Because I like buying stocks on panicsand being a contrarian investor. When the market panics, the resultis usually overselling. Lucent’s price recovered to.around $70 be-fore the technology purge on Nasdaq. Not 4 bad return on a buyingopportunity created by Wall Street’s herd mentality. But panics, aswe've seen time and time again (and will undoubtedly see countlessmore times) bring opportunities for buyers willing to withstandsome near-term volatility.
For me, a trader who thrives on volatility, I know that a marketpanic is like 6,000 people trying to get out of one exit door whensomeone screams, “FIRE!” It’s going to get ugly. When those fundmanagers, trying to hold the loyalty of a fickle investing public, seean earnings shortfall, they don’t want that company’s stock in theirportfolios. Prices drop 20 percent or 30 percent as sellers rush tounload their holdings. That’s a time when a buyer like me considersgetting involved. Granted, I might bet on the upside with options.But Lucent, to me, was a different situation that enticed me to be abuyer, particularly on behalf of my daughter who has a lifetime ofinvesting ahead of her. As a computer networking stock, Lucent isstill in a growth sector of the market as far as I’m concerned. Buy-ing in on a drop like this was like being at the blackjack tables andknowing there is an abundance of face cards in the deck. I may losesome hands, but the odds have moved solidly in my favor and nowis the time to increase the size of my bets.
There will be more opportunities in the future for companieswith technologies like flat-screen picture tubes and smaller, morepowerful semiconductors, than those companies that make prod-ucts for a mature consumer market. And in a global economy, thereare worldwide opportunities in technology that are just being real-ized. In a rugged terrain like Finland or remote locations like someareas of Mexico, Africa, South America, and China, wireless com-munication will be easier to employ than the hard-wired variety,194 how I trade options
presenting a lucrative market to some technology companies(MOT, NOK, ERICY, QCOM, etc.). On the other hand, just how muchsoap can the world buy?
That’s why when P&G took its plunge earlier in 2000, peoplelike me were not diving into a great value. Rather, I consideredthis stock to have growth prospects that were less than the over-all market just because of its product niche. That scenario still fa-vors the technology sector. Technology, I am convinced, is not justthe proverbial wave of the future. It is the backbone of the pres-ent. I don’t have to look any farther than the trading floor to seethe evidence.
When I began trading there were about 80 stocks on the CBOEfloor and no indexes. I had to get in about six o'clock in the morningto do two-and-a-half hours worth of analysis because our comput-ers were so slow. I would go to the floor with stacks of computerprintouts showing the price matrixes of the stock options I wastrading. If IBM was at $80 a share, I'd flip through the pages to seethe $75 calls were worth 7% and had an 80 delta, or that the $80calls were worth %s and had a 52 delta.
With every % or % move in the stock, I would have a column tofind values on my printout on a piece of paper. If the stock moved$3, I'd have to sort through a stack of paper a few inches think. As Itraded more and more stocks, adding issues like Starbucks to myusual activity in IBM, the stack got bigger.
At that time, it was against the rules of the exchange to havea computer in the trading pit. The only device that was allowed wasa calculator. This, the exchange felt, would make the marketplace alevel playing field. The only advantage you had then, presumably,was your own wits. But upstairs, traders had as much computerpower at their disposal as they could get—although in those earlydays it was a far cry from the fast, agile technology of today. Whatfinally brought the computer to the trading floor was the indis-putable fact that there were more stocks than traders to efficientlyhandle them.
The CBOE went from 80 to 500 to 1,000 stocks and then to2,900, but the number of memberships did not increase. In fact,the number of memberships on U.S. options exchanges has beenreduced significantly while the number of issues has grown geo-metrically. In the late 1970s, the CBOE bought the Midwest Op-tions Exchange during the first round of consolidation. The CBOEwhat changes, what stays the same 195
negotiated to absorb is cross-town rival with the caveat that thememberships would expire 10 years later.
The next round of exchange consolidation occurred when Iwas on the board of directors of the CBOE. The New York Stock Ex-change (NYSE) decided it no longer needed to support its fledglingoptions exchange, as the threat of side-by-side trading of stockswas no longer the biggest threat to the world’s largest marketplace;electronic communications networks (ECNs) were. So, the NYSEput its options exchange, the smallest of the then five exchanges,up for bid. The CBOE won the right to absorb the 165 optionclasses, which included the likes of Chase Manhattan Bank, May-tag, Campbell’s Soup, and Quantum Hard Drive. The CBOE paid$5 million in cash, and created a stream of payments to the NYSEmembers that would run seven years, until April 30, 2004. TheCBOE also built the newest, most modern home for the NYSE di-rectly under its main trading floor. True to their options roots,when the clock strikes midnight on April 30, 2004, the 75 member-ships on the CBOE/NYSE option floor will expire. Thus, the net ef-fect in the overall options market place is a reduction in the numberof market makers, although the number of stocks with listed op-tions continues to build at an astonishing rate.
What does that mean? You don't need computer analysis andtheoretical values to figure that out. More option classes and fewertraders meant traders had to become active in more issues. If youused to handle two or three stocks, you were then trading five orten, if you were really a great trader. Today, I think our averagetrader handles 20 or 30 stocks because of the assistance of the com-puter. Gone are the days of the stacks of computer printouts andlargely manual analysis. The average trader goes to the floor withhandheld Pentium-powered workstations with either infrared com-munication capabilities or a connection to a wireless LAN. It’s got astylus for its touchscreen. These handheld computers with touch-screens allow traders to report their transactions almost instanta-neously, with just a few taps of the stylus. Further, these handheldcomputers also allow traders to send a stock order directly to theNew York Stock Exchange, Nasdaq, or a myriad of ECNs. With onetap on my screen, I can hedge almost instantaneously while keep-ing track of my options positions.
What has made this possible are the wireless LAN and in-frared communication devices that the CBOE has not only allowed 
 
 
 
 
 
 
 
 
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196 how I trade options
but pioneered. All around the trading floor are little black discs—miniature satellite receivers that these handheld devices can “talk”to throughout the day. Plus, we have the ability to access theNYSE’s SuperDot, InstiNet, Island, Archipelago, BRUT, or the elec-tronic Nasdaq marketplace via SelectNet.
So when our traders are standing in the middle of an optionstrading pit, one part of their job is completely different from whatI experienced in the old days of the early 1980s. And part is exactlythe same. They are still standing in the pit, staring at the pricescreens and contemplating “what if” scenarios in their heads. Theyremember from our morning meeting sessions that, for example,we think it’s better to be a seller of CMGI options and a buyer ofAOL (or whatever the analysis, depending upon the day). And, justas when I began trading, the SEC demands that we not only tradeour opinions but also make a two-sided market. You may want tobe a seller of a particular option ahead of a company’s earnings.But if someone comes into that pit with a sell order, you're sud-denly a buyer.
“What’s the market for March 150 calls?” somebody yells out.
“3%... 3%,” the market-maker replies, giving the requisite bidand ask prices, respectively.
“Sold,” the broker says. The price moves based upon the sup-ply and demand for those options, just as prices have been movingon the whims and actions of buyers and sellers since the birth ofcommerce.
As a market maker on the floor, you’re hedging your position afraction of a second later. And good traders will remember (just asthey did when | started out and before that too) what the majorplayers around them have been doing. They may recall, for exam-ple, that the Merrill Lynch broker was bidding just below the mar-ket price for a call some 20 minutes ago, or that a Schwab brokerwas offering puts above the market an hour ago. A good floortrader has a mind like a good computer, able to multitask, tradingand hedging his or her own position while keeping track of what’shappening around the pit. Those resting bids and offers may bethe quickest, safest hedge once the market starts to move and thetrader that remembers that those orders are there is in a better po-sition to lock in profits, or limit losses when the stuff hits the fan!
Speed is just as important as it was 20 years ago. When a bro-ker is looking for a market, you had better be the one to make thewhat changes, what stays the same 197
best market first. Remember from our earlier chapter that the bro-ker is obligated to trade with the trader that makes the best market,highest bid and lowest offer, first. Brokers still don’t disclose howmany options they want to buy or sell, but anybody worth his salthas to know that a big institutional house like Goldman Sachs won’tbe doing a 10-lot trade.
Those are the same skills and nuances that | dealt with 20years ago, when I first put on a trading jacket. What has changedthe game, though, is