<s> WILey ONLINE TRADING FOR A LIVING
Day Trade Futures Onlineby Larry Williams
Day Trade Onlineby Christopher A. Farrell
Day Trade Part-Timeby John Cook and Jeanette Szwec
Electronic Day Trading 101by Sunny J. Harris
Electronic Day Trading to Winby Bob Baird and Craig McBurney
How I Trade for a Livingby Gary SmithHow I Trade Optionsby Jon Najarian
The Strategic Electronic Day Traderby Robert Deel
Technical Trading Onlineby Robert Roth
Trade IPOs Onlineby Matt Zito and Matt Olejarezyk
Trade Options Onlineby George A. Fontanills
Trade Stocks Onlineby Mark Larson   
how |tradeoptions
JON NAJARIAN
 
®
John Wiley & Sons, Inc.New York * Chichester * Weinheim * Brisbane * Singapore * TorontoI wrote this book to describe how I trade options. No statement in this bookshould be construed as a recommendation to purchase or sell a security, orto provide investment advice. You should understand that as a professionaloptions market maker, I have significantly lower commissions, interest rates,and tax rates than any retail investor. You should always consider commis-sions and taxes prior to making any investment. Options involve risk and arenot suitable for all investors. Prior to buying or selling an option, you shouldreceive and read Characteristics and Risks of Standardized Options, a docu-ment written and provided by the Options Clearing Corporation (OCC).Copies of this document may also be obtained from your broker or from anyexchange on which options are traded. If you choose, you can write to theOptions Clearing Corporation at: 440 S. LaSalle St. Suite 2400 Chicago, IL60605. You can also download pertinent information about options from theirWeb site: www.optionsclearing.com.
This book is printed on acid-free paper. ©Copyright © 2001 by Jon Najarian. All rights reserved.
Published by John Wiley & Sons, Inc.Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning or otherwise, except as permitted under Section 107 or 108 ofthe 1976 United States Copyright Act, without either the prior written permissionof the Publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923,
(978) 750-8400, fax (978) 750-4744, Requests to the Publisher for permissionshould be addressed to the Permissions Department, John Wiley & Sons, Inc.,
605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008,E-Mail: PERMREQ@WILEY.COM.
This publication is designed to provide accurate and authoritative information inregard to the subject matter covered. It is sold with the understanding that thepublisher is not engaged in rendering professional services. If professional advice orother expert assistance is required, the services of a competent professional personshould be sought.
Library of Congress Cataloging-in-Publication Data:
Najarian, Jon, 1957—How I trade options/ Jon Najarian.p. cm.—(Wiley online trading for a living)ISBN 0-471-31278-9 (cloth : alk. paper)1. Options (Finance) 2. Electronic trading of securities. 1. Title. Il. Series.
HG6024.A3 N34 2001332.63’228—dc2100-043738
Printed in the United States of America.109876543221For my daughter Tristen, because when she smiles at meit feels like l’m kissing God.preface
When I set out to write a book about my career thus far on WallStreet and my experiences in the options markets, I didn’t realize |would be triggering the most volatile period in history. Call it para-noia, or sheer coincidence, but as any trader will tell you, the mar-ket just seems to make extraordinary moves as soon as you beginavacation, or when you leave for an out-of-town business trip. Fromthe week I began writing this book, the Nasdaq exploded higher by50 percent, lost 40 percent, and was just beginning to claw its wayback as I finished the final chapter. Armed with this inside knowl-edge, if I ever decide to write another book, you may want to switchyour money into T-bills and wait out the storm.
I didn’t write this book to teach you how to make a million dol-lars in a week or how to day trade your way to riches. There areplenty of books about that out there already. I wrote this book tohelp investors like you learn how to manage your money more ef-fectively through the use of listed options. I wrote this book withthe experience that I earned through trading millions of optionsand billions of shares of stock over the past 20 years. I’ve usedthese strategies through the greatest bull market in history andthrough some of the most volatile trading periods imaginable. I’veused these strategies to manage hundreds of millions of dollarsworth of positions in stocks like IBM, SUNW, MU, EBAY, CMGI, andAOL and I continue to use these strategies today.
Proper use of options and the strategies I teach you in thisbook have helped me and my trading firms protect and profitthrough whatever the market has thrown at us. I know from experi-ence that derivatives and spreading strategies can lessen your ex-posure to adverse market conditions, whether you’re bullish orbearish. Controlling or limiting risk is a key factor to staying at thetables longer in games of chance and for my money, no casino offersvill preface
better odds than you can get on Wall Street once you understandhow to use options correctly. Options can also significantly in-crease your profit potential and, as a result, your rate of return oninvested dollars. Proper use of derivatives and related strategies al-lows you to keep considerably more of your hard-earned dollars insafe havens such as government bonds or CDs, while you investsubstantially fewer dollars in defined risk instruments. Any wayyou slice it, comparable upside performance with reduced riskmeans you’ve put yourself in a position to win.
Additionally, I wrote this book for investors who want to knowhow to protect their existing investments in stocks or mutual funds,or perhaps create some cash flow from their long-term holdings.
Finally, because investors regularly ask me what the life of afloor trader is like, I thought that this book could answer some oftheir oft-repeated questions: What amounts of risk do market mak-ers take? How much can we make? How stressful is this job?
I have tried to use examples from my actual trading experi-ences to answer these questions and illustrate how you can expectoption strategies to react. My goal was to make this book both in-teresting and comprehensible, so that you can begin using optionsto manage and build your financial future. I hope you share yourknowledge and success with other investors.
Jon NAJARIAN
Chicago, IllinoisOctober 2000acknowledgments
I would like to acknowledge many people who have helped in mygrowth as a person and as a trader. For shaping me as a person, Ihave to thank my mother Mignette and my father Dr. John Najarian,for raising me with love for all God’s creatures and respect for myfellowman. Without your support during my multiple college ca-reers and at the launch of my trading career, I could not have madeit. You are shining examples of how good we can be and I love youfor teaching me so much. I hope my wife Brigid and I can give ourfamily as much love and support as you have given me. I also wantto thank my brothers David, Paul, and Peter. You guys make enjoy-ing life a full-time job and remind me that what we do for a living isonly part of what makes our existence special. I must also thank mywife Brigid for her love, for her support, and for providing time forme to write this book.
I want to thank my friend Tom Haugh for giving me my start intrading and for his friendship and stewardship of our many busi-ness ventures. I want to thank Bill Ray, Dan Haugh, Dan Sheridan,my brother Pete, and Mary Gallagher-Parks for doing such a greatjob trading and managing the Mercury Trading Group, so I canwork on projects such as this book. I want to thank the traders atthe Chicago Board Options Exchange for their entrepreneurialspirit and their willingness to push the envelope to bring morecustomers into our markets. Likewise, ] want to thank my competi-tors on the AMEX, PHLX, and P'CX for keeping my focus on improv-ing customer service and making our marketplace more efficient.Thanks to the shareholders ard staff of PTI Securities & Futures,including Dan Haugh, JD, Dave, Bill, Cliff, Larry, Robin, Margaret,and Matt. I want to thank Rance Masheck and his team atStockMarketWorkshop.com for bringing thousands of investors intothe options markets. I want to thank the attendees of our tradingx acknowledgments
seminars, individuals who use 1010WallStreet.com, and our clientsat our brokerage firm for keeping me in touch with what’s reallyimportant to them. Your input is a thousand times more valuablethan any focus group.
I want to thank Bob Sirott and Fox television for believing inme enough to give me a weekly investment show. I want to thankCBS radio and WSCR, Sports Radio 670, for creating a daily outleton the radio for my financial reports and for giving me a weekly in-vestment show. I want to thank my editor Pamela van Giessen ofJohn Wiley & Sons for keeping this project moving. | also want tothank the animated and talented Tricia Commins for her patience,skill, and hard work, without which, this book would not have beencompleted.
J.N.x acknowledgments
seminars, individuals who use 1010WallStreet.com, and our clientsat our brokerage firm for keeping me in touch with what’s reallyimportant to them. Your input is a thousand times more valuablethan any focus group.
I want to thank Bob Sirott and Fox television for believing inme enough to give me a weekly investment show. I want to thankCBS radio and WSCR, Sports Radio 670, for creating a daily outleton the radio for my financial reports and for giving me a weekly in-vestment show. I want to thank my editor Pamela van Giessen ofJohn Wiley & Sons for keeping this project moving. I also want tothank the animated and talented Tricia Commins for her patience,skill, and hard work, without which, this book would not have beencompleted.
JN.x acknowledgments
seminars, individuals who use 1010WallStreet.com, and our clientsat our brokerage firm for keeping me in touch with what’s reallyimportant to them. Your input is a thousand times more valuablethan any focus group.
I want to thank Bob Sirott and Fox television for believing inme enough to give me a weekly investment show. | want to thankCBS radio and WSCR, Sports Radio 670, for creating a daily outleton the radio for my financial reports and for giving me a weekly in-vestment show. I want to thank my editor Pamela van Giessen ofJohn Wiley & Sons for keeping this project moving. I also want tothank the animated and talented Tricia Commins for her patience,skill, and hard work, without which, this book would not have beencompleted.
JN.contents
chapter 1the making of a trader
chapter 2the marketplace
chapter 3a case for options
chapter 4beyond the basics
chapter 5from the short side
chapter 6playing the broad market
chapter 7when to do what—and why!
chapter 8building a team—the day-trading firm
chapter 9getting the right tools
chapter 10what changes, what stays the same
glossary
index
21
47
111
133
155
173
189207223chapter 1
the making of a trader
Options trading can be a crazy business, with thousands of sharesof stock traded every few seconds to hedge positions with facevalues in the millions of dollars. But if you like action, there is nobetter business. | intend to show you how options can become apart of your portfolio, whether you have $50,000 in stocks and mu-tual funds or whether you're a multimillion-dollar speculator. Withproper training and dedication, you can use options to both in-crease cash flow and safeguard your investments.
Trading, like life, does not come easily, and my career in trad-ing is no exception to this rule. My success has been the result ofseizing opportunities, enduring losses, and adapting strategies tochanging times. The options market is where | earned my graduatedegree in making money. Now, | want to share my knowledge andexperience. Why? Because a healthy options market benefits all ofus—professional traders, retail investors, and speculators alike.
breaking into the markets
What made my success possible was a focus and a dream—quitesimply, I wanted to distinguish myself in whatever field I played. Iplayed on the football field for most of my life before becoming atrader. I made it to the NFL, fulfilling my dream to play professionalfootball, an accomplishment that still makes me proud. But likemany dreams in life, it was cut short. In my case, after four exciting,2 how I trade options
but all-too-brief preseason games, I was cut from the ChicagoBears. In September 1981, I went home, bruised in spirit and proba-bly in body as well. I was down, but certainly not out.
Tronically, it was the football field that led me to trading—aclassic example of one door opening when another door shuts.After I was cut from the Bears, my agent asked me if I wanted toplay football in Canada. I declined, but said I thought I would like tobecome a stockbroker. When he asked me why, | said that I had meta number of brokers before and after our practice sessions with theBears. Who else had time after finishing their working day to be outthere watching us sweat under the summer sun? If stockbrokersearned a good living with such great hours, that’s what I wanted todedicate myself to become. Hearing my ideas, my agent told me,“You don’t want to be a broker, kid. You want to become a trader onthe Chicago Board Options Exchange.”
He reasoned that the hours were the same as a stockbrokerand that my physical attributes would serve me much better on atrading floor than sitting behind a desk. While I weighed the advan-tages of each situation, my agent made me the magnanimous offerof trading for him for free. When he threw in a free apartment inChicago, my mind was made up. That’s how, at the age of 22, withmy ego still bruised from my failure on the football field, I foundmyself standing on the floor of the Chicago Board Options Ex-change (CBOE). It was a hive of activity that swarmed around me.Traders in loose-fitting jackets with three-letter badges clipped totheir lapels shouted at each other about bids and offers for putsand calls. Clerks screamed block stock trades. Computer screensglowed. Time clocks clicked and teletype machines rat-a-tat-tatted.It might as well have been some strange land where an incompre-hensible language was spoken—I understood so little of what wasgoing on.
Nobody had taught me the ropes. What little I learned in thefirst three months | picked up on my own—the jargon, the hand sig-nals, and the pit culture where muscles and bravado were consid-ered good traits.
Luckily, I hung in there. In many ways, I suppose I had nochoice. I wanted to distinguish myself just as my father, a notedorgan-transplant surgeon who made the cover of Newsweek andTime, had in his field. None of my three younger brothers or I grewup in our father’s shadow, but we were certainly aware of what athe making of atrader 3
famous, successful, and wonderful person he was. It would be ex-ceedingly difficult to achieve success that would rival my father’sin Minnesota, so Chicago seemed like my best bet at being someoneother than Doctor Najarian’s son. But in my early days in the op-tions pit, my career didn’t seem too promising.
It was 1983 and I had moved up from runner and arbitrageclerk for a New York Stock Exchange (NYSE) Specialist firm, to afloor trader at the CBOE. I was making a living on scalping andsmall spreads on the Midwest Options division of the CBOE. TheCBOE had purchased the competing Midwest Options Exchangeand absorbed its 350 members into the C3OE in the late 1970s.Those of us who traded on the brown badges (versus the bluebadges of full CBOE members) could only make markets on 16 op-tion classes. The remainder of the CBOE was off limits to us. Fortu-nately, I could afford the $19,000 for a brown badge with theremainder of the money paid to me by the Bears. A full CBOE seatwas eight times more than that—$155,000—and since neither couldbe used as capital in your trading account, the full seat was out ofthe question. But I knew if I was going to make it to the big time, Ihad to find a way to get the full seat. Luckily for me, the man forwhom I was working wanted to take the summer off and offered methe chance to trade on his full CBOE seat. I seized the opportunityto be part of the big show. Nearly 19 years and billions of dollars ofstock options later, | still remember the day my opportunity cameand I stepped up to the challenge.
It was as if I, as the linebacker I once was, had intercepted theball and now had a chance to run for a touchdown. But the tradingpit, like the football field, tends to have many people standing be-tween you and the goal.
One of your obligations as a market maker on the floor is mak-ing a two-sided market. So if a broker has a customer order to exe-cute—whether it’s buying or selling puts or calls—the traders onthe floor have to make a market for both the price at which they willbuy and the price at which they will sell. Because of this obligation,the Securities and Exchange Commission (SEC) allows market mak-ers to be exempt from Reg-T, a part of the 1934 Securities Act thatmandates customers have a minimum of 50 percent of the value ofthe stock that they are buying in their trading accounts. Withoutcustomer margin requirements, we option market makers can tradehundreds of thousands or even millions of dollars of stock per day,4 how I trade options
so long as we meet minimum hedging requirements and providethat two-sided market.
The options pit, like other traditional exchanges, still operatesas an open outcry auction where bids and offers are called out bybuyers and sellers. In the pit, the brokers congregate in the center,like the target of the bull’s eye. Traders stand in concentric rings,with the veterans and those who have earned their place standingnearest that center where the brokers hold court. The brokers yellout their customers’ orders to the traders who surround them inthe pit. When the pit is crowded, chock full with hundreds oftraders, the brokers’ voices don’t project more than five or ten feet.And when a broker yells out an order, the traders chime in at once,with varying bids and offers. A millisecond after the bids and offersare shouted aloud, the broker determines which trader made thehighest bid for the broker’s customer who is selling or the lowestoffer when the customer is buying. That’s why a trader’s proximityto the brokers is very important.
Brokers have two primary concerns when they are trading fortheir customers. First, they want a trader who won’t stiff them.Trading floors don’t have cameras trained on every trader, record-ing every shouted word. It’s just not feasible. So the broker andtraders depend on each other’s word that when they agree on atrade, it’s done. No backing out when the market is 200 pointslower. In our business, if the other traders and brokers don’t trustyou, you might as well be invisible. Second, they need a trader whowill bid and offer large quantities, so they don’t have to breakdown an order into many small pieces. The more names a brokerhas to write on a given ticket, the greater the chance for a mistake,either in quantity or price. The broker’s job is a lot easier when heor she can depend on your ability to take on reasonable and some-times even unreasonable size to fill their order. Keep in mind thatbrokers don’t get paid for bidding or offering. They get paid for fill-ing orders. An honest trader who will do size is every broker’s fa-vorite trader.
Up to this time, I had been virtually invisible to the brokers inthe IBM pit because I had just moved up from the brown badge—the minor leagues. I hadn’t had an opportunity to establish my rep-utation yet, and I hadn’t broken into the inner circle.
To break into that inner circle, you have to know what you aredoing. After a year of fighting for two and three lots on the Midwestthe making of atrader 5
seat, | was ready to trade some size (twenty and thirty lots) androck-and-roll. Being six-foot-two and, in those days, 230 pounds, Idid have a physical edge when it came to making my way throughthe ranks. But bulk alone would not earn me a place in the inner cir-cle. It would take intellect and ability to do that.
At nine o’clock that morning, I started on the edge of the IBMoptions pit, where I had been trading for nearly a month. It was thebiggest and busiest pit on the floor. As traders ebbed and flowedinto and out of the pit over the next hour and a half, | made my waycloser to the inner circle. By late morning, with the ranks thinnedby traders who were having a late breakfast or an early lunch, Imade it to the center. There I was, on the trading floor’s equivalentof the one-yard line. I was eye-to-eye with brokers from the biggesthouses—-Salomon, Merrill Lynch, Goldman Sachs, Morgan Stanley—and I was the newcomer. It was as if I had intercepted the ball andnow had a chance to run for a touchdown.
Then, as luck would have it, the IBM pit started rocking androlling.
“Jan 95 calls!” a broker yelled out.
That was verbal shorthand for January call options with astrike price of $95 a share. That meant, if you bought that call you’dhave the right to be long IBM shares at $95. In those days, IBM wastrading around $88 a share, and put and call options with strikeprices from $80 to $100 were actively traded.
Since the big traders the brokers usually relied on had left forlunch, the broker who wanted January 95 calls had to rely on me. |had both the best bid and the best proximity to that broker. Herewas the opportunity I was working for; now I had to prove I was pre-pared to handle the action.
“Even to a quarter!” I yelled back.
I quoted both the bid price-—buying at $4.00-even—and the askprice—selling at $4.25. But at that point I did not know if the brokerwas looking to buy or sell, or how many options were involved in the' transaction. Brokers, working on behalf of their customers, neverdisclose more information than is absolutely necessary.
“Buy ‘em at four-and-a quarter!” the broker responded.
“Sell you 20!” I yelled out. I threw out an amount that I felt com-fortable selling. I wasn’t going to look like a lightweight by offeringfive options, but I wasn’t going to sell 100 either.
“I'm looking for 10,” the broker replied.6 how I trade options
“Sold!” I yelled triumphantly.
At the end of this seemingly complicated ritual, which tookabout 10 seconds, I had sold 10 January IBM call options with astrike price of $95 a share for a premium of $4.25. Since each op-tions contract is worth 100 shares, I was short 1,000 IBM shares at$95 ($4.25 x 100 shares x 10 contracts). Those options were worth-less until IBM shares rose close to $95 a share, but I still had anopen position to cover to hedge my risk.
The more sophisticated you are, the more choices you have tohedge your position risk. In a perfect world, you'd sell 10 calls at$4.25 and buy 10 from someone else at $4.00, and make $25 per con-tract. If I could fully capture the spread between the bid and theoffer on that 10-contract trade, I would have made $250. Since I wasa rookie, | took the safe way out and decided to hedge my positionwith stock. I signaled for a “crowd clerk,” whose job was to facili-tate stock trades for the options traders on the floor. Getting his at-tention, I pulled my index finger toward my forehead and then heldup my clenched fist. This told the clerk that I wanted to buy 1,000shares. (A single finger pulled toward my forehead told him Iwanted to buy. Having my palms out and facing away from mewould have told him I was a seller. A clenched fist indicated thatI wanted to buy at the whole number, in this case $88 a share). Mo-ments later the clerk flashed back his confirmation that I hadbought 1,000 shares of IBM for $88 a share.
 
Trade 1: Sold 10 Jan ’95 IBM CallsStrike Price $95/sharePremium Collected $4.25/shareHedge: Bought 1,000 IBM shares at $88 a share
Trade 2: Bought 10 Jan 95 IBM CallsStrike Price $95/sharePremium Paid $4.00/shareHedge: Sold 1,000 IBM shares at 87% a share.Net result: Made $0.25 a share, or $25 per contract, forprofit of $250 on 10 options contracts. Lost $0.125 a shareon 1,000 IBM shares for loss of $125. Net profit on tradesbefore commissions, $125.
 
 
 the making of atrader 7
From that trade on, I was not invisible to the brokers. I’d beshort the stock one minute and long the next. Sometimes I had aprofit on the put and call spread, and on the stock I bought and soldto hedge my position. Most often, I scratched—or made no profit—on the stock, or lost an eighth on the stock, while making most ofmy profits scalping in and out of the options (for example, buy atan eighth and sell at a quarter). When the traders came back fromtheir lunch, they expected to be able to move me out of the way, butthat didn’t happen. Then they hoped I'd be forced to step behindthem and get shoved to the back because | failed to respond withmarkets and size for the brokers, but that didn’t happen either. |stayed on the front lines the rest of the day, buying and selling putsand calls all day and making bigger and bigger markets. The more Itraded, the more confident I became. I knew the other big tradersdidn’t appreciate the fact that I'd moved into the neighborhood,but that was their problem. Like thousands of traders before me, Isaw my opening and went for it. Once I had my feet under me, no-body was going to stop me. This was pure unadulterated excite-ment and I knew at that moment that I could make my place in thisbusiness.
the front lines of capitalism
My “marketplace” for options, for most of my 20 years of trading,has been the trading floor of trie CBOE, which I consider to be thefront lines of capitalism. This business is fast and a trader needs tobe hedged at all times. We half-jokingly compare this business todashing in front of moving bulldozers to pick up dimes off theground. Fumble for the dime, ard you could be flattened.
Since I trade, increasingly, off-the-floor myself these days, |know the “upstairs” traders at the desk of any brokerage firm ortrading house have the same ego and attitude as the floor traders.Those off-the-floor traders may be trading huge sizes—500 or1,000 option contracts at a time, and each contract is worth 100shares of stock. Many of those upstairs traders long to be on thefloor where the action is. There is an immediacy we experience onthe floor that does not translate to a screen upstairs. You may be aNasdaq dealer, wheeling and dealing large lots of shares, but whenyou have an options trade to execute, you still have to call the floorto trade.8 how | trade options
Today, much of my time is spent managing trading firms thatoperate as separate entities under the “Mercury Trading” umbrella.Our firms, located in San Francisco, New York, and my hometown ofChicago, are designated primary market makers—or specialists—in 95 different stocks, such as Micron Technology, Sun Microsys-tems, and Biogen. Each day we trade nearly 35,000 option contractsand nearly $100 million worth of stock.
Options trading has changed since I started out in 1981 whenthere were 70 stocks with options on them and no index products.Today, we have options on 1,600 stocks trading on the floor of theCBOE alone. Seats at the Exchange were worth $155,000 in 1981;today, they’re worth about $600,000. Volume on the New York StockExchange can easily top 1 billion shares on an active day, a dra-matic rise from the 48 million shares per day when I began trading.
The floor has also changed. We trade much more now, given astrong influx of both institutional and retail paper. But more andmore, the ranks on the floor are young traders with handheld com-puters the size of a Palm Pilot that record their trades automatically.Many of those computers automatically analyze the market, letting atrader know if an option is “expensive” or “cheap” by color-coding—red for overvalued and green for undervalued. Some of thesenovices can’t even buy or sell unless the computer tells them.
It rankles veterans like me to see a floor dominated by tradersholding their miniature computers. But I know why they’re there.Trades have become yet another commodity. Why pay veterans likeme to trade when you can get computer-savvy youngsters who aremore than willing to stand on the floor and trade for $40,000 to$70,000 a year, following the instructions of a handheld computer.It’s not so amusing when the computers go down and the tradingpits become silent, either because the traders don’t know how totrade unassisted or their firms have instructed them not to tradewithout electronic guidance.
Granted, it’s not as “pure” as some of us old-timers (at age 42)would like. But there’s no denying that this new breed of trader hasaccompanied a large influx of capital to the floor. Even tradingfirms with millions of dollars in backing can’t just hire 100 experi-enced traders to go down to the floor. There are 70 different pits or“posts” on the floor where we trade options on 1,600 stocks. That