using listed options. Without a doubt, the floorcould handle the size trades that these funds are seeking. Granted,afew years ago there was not the liquidity. But there is much moreliquidity now, some of it due to multiple listing of options on majorstocks such as Dell, Microsoft, and IBM. Those multiple listingshave created opportunities for new specialists, which have re-ceived funding from banks, insurance companies, brokerages, andso forth. The upshot is, there is considerably more capital on thefloor than there has been in the past.
There is another advantage for the funds to trade listed op-tions: open competition. Rather than just receiving one bid or offerfrom a given firm for an OTC option, wouldn't it be better to havequotes on 5,000 listed options from 20 to 50 market makers, manyof whom are backed by the big banks and brokerage firms? Chancesare, the funds would find an efficient market with a narrowerspread between the bid and the offer than in the OTC products.the marketplace 35
Here’s an analogy that might illustrate the point. Say theRolling Stones are in town, and you call a ticket broker to buy aticket. That’s the equivalent of calling a Wall Street broker and ask-ing for an OTC option. What the ticket broker is likely to tell you isit will cost you $500 per ticket for the Stones concert. But if you goover to the United Center, Chicago’s arena where the Chicago Bullsplay and a variety of events are hosted, chances are you could getfar more offers to sell you a good ticket for the concert. And guesswhat as you get closer and closer to the United Center? The price ofthose tickets will probably drop. Why? Competition. One guy is of-fering to sell you a ticket for $250. Another guy overhears his offerand counters with two tickets for $250. And to carry the analogy alittle further, being a trader I understand the concept of “timedecay.” If I’m holding an option that expires in three days, I know Ihave to do something with it TODAY. Because on the fourth day, itwill be as worthless as a ticket you’re trying to sell today to lastnight’s Billy Joel concert.
Get the point? When there is a centralized marketplace wherebuyers and sellers meet, the competition makes for a more efficientmarketplace with a narrow spread between bids and asks. Anyonewho has used the Internet understands how competition createsbetter opportunities for buyers and sellers when you gather acrowd in a centralized marketplace. The dilemma facing those of uswho would like to see a hybrid that merges open outcry and elec-tronics is how to keep the costs of the open outcry (with marketmakers in trading pits shouting bids and offers) in line with thecompletely electronic competition.
I believe the efficiencies and the depth of capital in our mar-ketplace will draw more participants, including the funds. Marketmakers like me will be ready for the challenge, with greater capitalbehind them. As a routine, we see 2,000—and 5,000—option trades,which are the equivalent to 200,000 and 500,000 shares of stock,respectively. That kind of size and volume, I would project, willonly increase.
The good part of those trades for the market maker is younormally get a reasonable edge. The broker handling those large-volume trades normally wants a single price, moving all 2,000 or5,000 options at once. The negative part is, now you’ve got 20 peo-ple all buying the stock and you're trying to hedge the position. Itcomes down to whoever has the fastest connection to the stock36 =how I trade options
Exchange or ECN that will be able to put on the best hedge at thebest price.
But as I’ve said before, stock is not the only way to hedge anoptions trade, and that’s why the centralized marketplace is so im-portant. When you're on the floor, you may remember, for example,that a broker on the other side of the pit wants to buy 1,000 optionsthat may now be a perfect hedge against my purchase of 1,500 con-tracts moments ago. The best pit traders remember where the rest-ing orders are and use those to establish better hedges and, thus,make more trades with less risk. The more often I can hedge option-to-option, the better the use of my risk capital and, equally impor-tant, I get an immediate hedge rather than waiting to see if I missedthe stock and have to chase it up or down. And, if I’m really cre-ative, maybe I can wait to buy or sell my stock after the buying orselling frenzy subsides.
The challenge for the market maker is always making a two-sided market. Even when I’m a raging bull on the floor, | must havean offer to sell. A broker could take me up on that and I'll end upwith a short position, even though I think we’re going higher. Thatis the trade-off for being the risk taker for the customers who cometo the floor, via their brokers, to trade. Market makers act as a kindof insurance company. We assume risk on their behalf by buyingand selling what they need. Our challenge is then to transfer thatrisk with another position, be it in stock or an opposite position inoptions as fast and efficiently as possible.
Assuming risk in a volatile business environment is not for ev-eryone—particularly if you have to think out every move you make.You might do okay in an off-the-floor trading room where you cantake more time to research and plot out your trades. On the floor,you must think and act simultaneously. When a broker yells out anorder, you just have to react.
Luckily, some personalities can adapt to that intense and un-predictable world known as the trading fioor. In everyday life, mybrother, Peter, thinks everything to death. He’s the kind of guy whowill spend six months shopping for a new couch. In the pit, how-ever, he’s a different man. He can make rapid-fire trades as well asanyone. He’s a prime example of someone who slips into a differentpersonality on the trading floor. Perhaps it’s the competitiveness ofthat arena or the adrenaline rush of trading. Whatever the cause,I've seen little, mousy guys turn into Rambo traders. You'd thinkthe marketplace 37.
your eyes were deceiving you when a five-foot-five, 140-pound guytakes on a bulldog mentality.
But that is the pit. It’s an arena where physical presence doesmatter, but it’s not the determining criteria for success. However,you need to be seen and heard to get your share of the trades.That’s why it helps to be like Mike Suarez, one of our traders, whostands six-foot-five and 275 pounds. A former professional and col-lege football player, Mike knows how to take his space in the pit andoccupy it. Then there are guys who stand five-foot-nothing, but areall mouth. What they lack in stature, they make up for in decibel-level. The brokers have no troubling hearing them, but they have towork harder than Mike or my brother, Pete.
The pit, however, is not the only arena for the professionaltrader. Increasingly, veterans like me are moving upstairs to tradefrom the screen. It’s not that it’s easier (except, perhaps, on theknees since you don’t have to stand for six hours a day). But it isdifferent.
At the screen, you don’t have the machine-gun pace of buyingand selling virtually everything the brokers have to offer. There is anatural progression among experienced traders from the floor tothe trading room. Market veterans like myself get tired of standingfor hours on end and our vocal chords get strained from yelling.But that’s not the only entrée into the profession of off-the-floortrading. Many people come to options trading from other busi-nesses that have left them well-capitalized and versed in risk man-agement. If you're trading off the floor, you’re probably like me,surrounded by computer terminals with 20 flashing phone lines atyour side. When the market makes the move you’ve been waitingfor, you either call your broker on the floor and put in your order totrade, or point and click to trade. Maybe it’s not the same adrena-line rush as being on the floor, but it definitely has its own appeal.For one thing, trading off the floor is a strategist’s game. Virtuallyeverything that you see in the outside world can be applied tothe market.
One of my favorite scenes in the movie, The Player, is whenthe producer/director played by Tim Robbins opens a newspaperand starts scanning the headlines. Mergers. Murders. Mayhem. It’sall fodder for a script, Robbins believes.
The same could be said for trading. When you read about thelatest gadget or a new twist on Internet technology or the fact that38 how! trade options
baby boomers are likely to buy more X-Y-Z, you can find some wayto apply it. What company or industry would benefit from that, youask yourself? Who's likely to win as a result, and who is going tolose out.
This strategy is what differentiates trading from gambling, ananalogy that many people like to draw because of the speculative,risk-taking nature of both. When you trade without the marketmaker’s obligations, you have a very good chance of moving theodds in your favor. Just like a card-counter in Vegas, you wait untilthe deck is stacked in your favor, then increase the size of yourwager. The biggest differences are that Wall Street doesn’t buy youdrinks, but it doesn’t shuffle the deck or switch “dealers” either!But you have to have a bit of the gambler’s nature in trading or inany entrepreneurial, risk-taking venture.
You “gamble” when you give up your job and start day trading.Bill Gates “gambled” when he dropped out of Harvard. People takerisks every day, especially in trading. The key is to take risks be-cause the reward is much bigger.
This is much easier to practice off the trading floor, I believe,than on. When you're in the pit, it’s easy to be swept up in the emo-tion. You’re so busy trading that you may not have time to stop tothink about your position. You could be extremely bullish based onthe fundamentals, the technicals, or even biased due to the time ofyear. (October is notoriously volatile in odd-numbered years eversince the Crash of 1987 and the Correction of 1989.) You can go tothe floor, convinced that you’re going to be a buyer and then let theemotion of the floor take your bias away. You'll find yourself leaningtoward the bears, just because the floor has that tone.
The tone of the trading pit is communicated in many verbaland nonverbal ways. First, there is the market talk. If you want toknow what a trader is thinking, just ask. People on the floor whoshout for a living aren’t shy about expressing their opinions. Thenthere is the floor activity itself. When a broker’s first five orders areall sells, the mood is decidedly bearish.
From upstairs, I can trade more easily without regard for theemotion. At the screen, | am governed by my own opinions and myown emotions. It’s similar to a card-counter at the poker or black-jack table who can move the odds in his or her favor by whatthey’ve seen and what they know. For instance, I know there is anthe marketplace 39
earnings announcement due the next day, or a new product is beingannounced, a litigation settlement, a major trade show—whateverthe event, there may be an opportunity to position myself in a stockin front of an expected announcement. If | expect the announce-ment to be positive, I'll be a buyer. If !’'m expecting negative news,I can be a seller.
I can use this and other means to push the odds into my favor.Here’s an example of what we do all the time when a company isabout to announce earnings: Hewlett Packard is notorious for beingextremely volatile around its earnings. The more Wall Street canpredict a company’s earnings, the less volatile the stock is likely tobe since volatility is a measure of market uncertainty. In HewlettPackard’s case, its earnings tend to be volatile because it is reallya combination of companies involved in printers, computers, andInternet routers.
Hewlett Packard’s earnings may miss earnings expectationsby 20 percent on any given earnings cycle. Because of that, thestock is very volatile ahead of those earnings. Typically, I'm theseller of that volatility. In other words, I’m taking on the risk thatHewlett Packard will not move as much as expectations in the mar-ket. This is best illustrated with a bell curve as shown in Figure 2.1.
Let’s say Hewlett Packard is trading at $100 a share. Undernormal circumstances, the weekly range is between $92 and $108%.That’s normal volatility of around 60 percent. But around earnings,that volatility may increase to around 85 percent or 90 percent witha price range extending between $88% and $112% (Figure 2.1).
(As a reference point, utilities tend to have very stable stockprices and a low volatility value, some as low as 20 percent. Inter-net stocks that are very volatile, perhaps reaching 120 percent, in-dicate we could see wide swings in share prices. On the food chainof volatility, the lowest are the utilities, then the multinational com-panies, then the computer companies, and then higher risk issuessuch as Internet companies, and genetic engineering and biotech-nology stocks. The higher volatility reflects the greater number ofunknowns regarding this company.)
Back to our Hewlett Packard example, during normal “non-earnings” times when the stock is trading between $94 and $106 ona weekly basis, a $100 call might be priced at $3.25. But just beforeearnings are announced, that same call might have a premium of40 ~—s how I trade options
 
Figure 2.1 Hewlett Packard—$100 share, volatility 85 percent, weeklystandard deviation
 
———| iThree = Two One Standard $100 ‘One Standard Two Three8.0. §.D. Deviation Deviation 8D. 8D.S701 $78 $88 778 $112 112 $126412 $142 3
Source: Chicago Board Option Exchange.
$5.50. (The higher the volatility, the higher the value—or pre-mium—on an option. Why? Because the more a stock price bouncesaround, the greater the chance a particular strike price will be hit.)
In these instances, you’re looking for an event outside thenorm. In plain words, you want a stock to rise above your strike ifyou buy a call option or fall below your strike price if you buy a put.With this in mind, you set your parameters for a trade. In this case,I'd sell puts with a $90 strike price and sell calls at $110. The pre-mium on the $90 put might be only $1 a share and $1.50 for the $110call. But if the stock doesn’t open higher than $110 or lower than$90, | can keep that premium as my profit, because the buyer ofthose calls won’t exercise the option.
In this instance, | act like an insurance company that will in-sure your seaside house during hurricane season with a big enoughpremium and an understanding of the calculated risks.
Conversely, perhaps the range for Hewlett Packard is $94 to$106 (or 60 percent volatility), and I don’t expect volatility to in-crease to more than 70 percent. So I’m going to sell the $100 callsand the $100 puts, because | think it’s likely that the stock willthe marketplace 41
trade within the projected range. The option prices reflect whatWall Street thinks the range for the stock will be. So if you buy op-tions—particularly ahead of earnings—you’re buying much highervolatility because the earnings are unknown, and the stock mustmove outside of that wider range for you to make money. In otherwords, you must have an extraordinary move to profit from buyingthat pumped up call or put.
Here’s another analogy we use a lot. Say you’re in Florida andyou're watching the Weather Channel, when suddenly you hearthat a hurricane is fast approaching. If you called the insurancecompany right then to try to increase your coverage, you’d pay avery high premium (if they’d give you a quote at all) because con-ditions at that moment indicate there is a high probability that thestorm will hit and cause a lot of damage. Of course, there is achance that the hurricane may miss the area completely or do onlyminimal damage.
But from the insurance company’s point of view, the premiumthey collect for that insurance policy has to be high enough be-cause there is a good probability that they will have to pay fordamages. And, if the hurricane is downgraded to a storm or goesout to sea, the insurance company can keep the premium and makefew or no payments. Likewise, a market-maker who sells an optionahead of an earnings event when volatility is increasing will want ahigher premium. Why? Because the likelihood of that strike pricefor the option being hit increases with volatility. So if the put orcall is exercised, the market maker has to buy stock at a higherprice or sell at a lower price than the current market. For that pos-sibility, the market maker will have collected a good enough pre-mium to make it worth his or her while—and hedged the positionwith physical stock. And in the event the earnings announcementfrom the company isn’t outrageously good or horribly bad, thenthe market maker gets to keep the premium because the optionsweren't exercised.
Whatever the scenario, as | set the parameters on my tradebased on historic stock-price patterns and an analysis of the valueof the put and call options, | can move the odds in my favor. I canlook at the trading volume for both the stock and the option and theprice pattern two or three days ahead of earnings. That will indicateto me how other people are positioning themselves for that event.These are some of the ways that I can be like the card-counter at the42 ~=—ihow I trade options
table who waits until there are a lot of face cards in the deck beforemaking a big bet.
If you’re playing Black Jack, the card counter wants to knowwhen there are a lot of face cards with a value of 10 in the deck. Asthe game continues, the card-counter knows what’s left in the deckand will increase or decrease the wager accordingly. On WallStreet, if you’ve got a “hot hand” because your analysis is right on,you have been doing your homework, managing your capital, andmaking disciplined trades, there is nothing to stop you.
But one word of caution: Strategies that involve selling optionsand collecting premium should only be used by professionaltraders and very sophisticated investors. I would strongly cautionagainst any retail investor speculating in options by selling pre-mium—meaning selling puts and/or calls. As we'll discuss in thenext chapter, when you are a buyer of a put or a call, you automati-cally Jimit your exposure to the amount of money you paid for thepremium. But when you sell puts or calls and collect the premium,you could end up with an unhedged stock position as the marketmoves sharply against you.
Let’s go back to the bell curve to illustrate the risk when the“unlikely” does happen. In our previous illustration, we saw thatthe first portion of the beil curve is what is likely to happen 68 per-cent of the time, namely the stock ought to trade between $94 and$106 (assuming a current price of $100 a share). Moving farther outon the curve, we see that 98 percent of the time—taking in more ofthe variables from aberrant conditions, events, and so on—thestock should trade between $85 and $115 a share. But that widerrange of possibilities encompasses many “once-in-a-lifetime” proba-bilities. In fact, it’s so far down on the bell curve that you’d expectto see Hewlett Packard trade below $85 or above $115 once in yourlifetime.
But that’s where the models break down because these once-in-a-lifetime events happen much more frequently than the mod-els predict. Stocks (at least at this writing when 24-hour-a-daytrading is still only conjecture) aren’t continuously priced, butrather trade actively for six and a half or seven and a half hoursa day. That means that price moves are often exaggerated whenan event occurs or an announcement is made after the stock mar-ket closes.the marketplace 43
Take an example of what happened to Xerox on October 8,1999, when the company predicted a 10 to 12 percent drop in earn-ings per share for the third quarter (‘USA: FOCUS—Xerox Sees Re-sults Shortfall, Stock Falls,” by Matthew Lewis, Reuters EnglishNews Service, October 8, 1999). The stock had closed the night be-fore at $42 a share. That gives it a range of $39 to $45 for 68 percentof the time, a range of $37 to $49 98 percent of the time, and, in theoutermost reaches of the bell curve, a range of $33 to $51 99.5 per-cent of the time.
But after the news came out, Xerox’s stock price fell 25 per-cent to close at $32 a share on the New York Stock Exchange. Theday after, Xerox opened at $30. That move was significantly belowthe once-in-a-lifetime range for XRX, but it happened and similarevents will happen again.
The mathematical formulas say this should only happen oncein your life. So either XRX has used up its once-in-a-lifetime move(for the second or third time) or (1) the math is wrong or (2) theformula doesn’t take into account the fact that stocks are not con-tinuously priced because we don’t have 24-hour trading. The bellcurve formula is still helpful, but it doesn’t give you an absoluteguarantee of what can or will happen.
In fact, the occurrences of these once-in-a-lifetime movesshow why an average investor ought to be a buyer of puts and callsrather than a seller. Remember, if you’ve made the decision to sellpremium—meaning you’re selling puts and calls and collecting thepremium—you’re acting like the insurance company who will guardagainst catastrophe. Sure, it’s great to collect the premium whenit’s all blue skies and fair weather. But hurricanes do hit the coast-line occasionally. When that happens, do you want to be an insur-ance company? Do you have deep enough pockets to withstand thatkind of risk?
There are three basic rules for any trader: (1) Make money.(2) Do not lose money. (3) Come back tomorrow to trade again. Aswe'll discuss later, there are ways to limit risk and enhance poten-tial profits by trading options.
Options are gaining in popularity among retail investors,both as part of the day-trading craze that has turned attention tothe market and as speculative instruments. Some investors mayhave started out as employees who received stock options from44 show I trade options
the company. Perhaps an executive was given stock options with a$20 strike price when the stock was trading at $17 a share, and nowthe stock is at $22. Those options are suddenly worth a lot morethan the executive may have realized.
From this exposure, many retail investors become intriguedwith options as an investment and speculative vehicle. As I'll ex-plain in a later chapter, it’s possible to trade options with less riskthan buying stock outright. Here’s a preview of a strategy thatmight be used.
Say I’m interested in buying IBM, which is a $105-a-sharestock. If I wanted to buy 1,000 shares, I'd have to come up with the$105,000 or have $52,500 in margin to buy the stock. My premise(just for the sake of illustrating a point) may be that the stock islikely to rise from $105 a share to $150 in three months or so.
An alternative to buying the stock is to buy 10 three-month-out call options for a premium of $5 a share, or a total investmentof $5,000. If the stock, as you expect, rises from $105 to $150 ashare, you're going to make $20,000 or $30,000. If the stock doesn’t,the maximum you could lose is your $5,000 investment. There isn’ta perpetual downside in case a stock makes a big move against you.You’ve defined exactly what your risk is going into the trade andyou’ve only tied up one-tenth of the money you would have neededto buy 1,000 shares on margin, which has additional risks.
- And if you give yourself enough time to be “right”—in thiscase three months—you may see an appreciation in the value of thecalls that you bought.
When it comes to trading options, the two keys are timing andvolatility. With enough time and enough market movement (volatil-ity) there is a greater chance than an option will be “in the money.”
But that opportunity doesn’t mean trading options is a “slamdunk.” So often at the investment seminars | speak at, people ask alogical question: Can I make a living doing this? The short answer isyou can if you have enough money. Remember the higher the returnyou must make to live, the greater the risk you will have to shoulder.So if you have $250,000 to trade and you are looking to make 20 per-cent return, or $50,000, you’d have a shot at this. But if you onlyhave $100,000 to trade and you’re looking to make a 50 percent re-turn, it may be far too risky a proposition. Don’t get me wrong. It ispossible to make six-figure money investing and trading a $100,000account, but rather than playing the odds, you're betting you arethe marketplace 45
one of the 0.1 percent of the population who can accomplish thatfeat. Setting realistic goals for your investing is one of the most im-portant facets of managing your money. Options can definitely helpyou define risk and take less of it when you invest, but to make 100percent returns requires some luck as well.
That doesn’t mean there are no opportunities for the retail in-vestor. But you have to do the proverbial crawl before you walk, andwalk before you run. So begin with learning the trading methodolo-gies, which you can practice with simulated trading. Then once youbuild a confidence level, you can put some money on the line. Butas in most new ventures, you must begin small as you learn—be-cause the name of the game is risk management.chapter 3
a case for options
If you’re interested in equities, you might ask for one good reasonwhy you should use options to invest and speculate instead of pur-chasing the stock outright. To answer that, I will give you severalgood reasons.
stretching your capital
As a leveraged instrument, options allow you to participate in theupside potential of a stock with far less capital than by buying thestock outright. For example, if you’re bullish on IBM when it’s trad-ing at $100 a share, you could buy 100 shares for $10,000, or getsuper-aggressive and buy that same 100 shares with $5,000 of yourown money and $5,000 on margin (which would require you to payinterest to the brokerage firm).
Alternatively, you could buy one options contract for a pre-mium of $5 a share, or a total cost of $500. (Remember one op-tions contract equals 100 shares of stock.) Let’s say your optionhas a two-month timeframe and a strike price of $105. That meansif the stock were to rise above $110 a share—the $105 strike priceplus the $5 a share premium you paid—you can exercise your op-tion and own the stock at $110 a share. In fact, the buyer can, athis or her discretion, call those 100 shares of stock any time fromthe moment they buy the call option, until expiration. Comparethat to the capital requirement of $5,000 on margin or $10,000 foran outright purchase of the stock. I'd say the option investor got48 how I trade options
both a better deal and tied up a lot fewer greenbacks to accom-plish the same thing.
managing your risk
There’s no such thing as a risk-free trade, unless maybe you're buy-ing short-term Treasuries backed by the U.S. government. By usingoptions, however, you are able to define the exact amount of riskthat you’re willing to take when you enter the trade. The stockbuyer or seller has virtually unlimited risk that can escalate in theevent of a margin call, or a short squeeze. If you buy 10 call optionswith a premium of $5, your total risk—if that option expires worth-less—is $5,000. If the underlying stock drops from $100 to $5 ashare, you still can’t lose any more on those call options than thepremium that you paid—in this case, $5 times 1,000 shares (10 op-tions contracts, each representing 100 shares).
With the outright purchase of a stock, however, you could,conceivably lose all of your investment. If you bought 1,000 sharesof a $100 stock, that, theoretically, means you've got $100,000 atrisk. If the shares decline sharply in value or (as happens onlyrarely) lose all of their value because of some underlying problem,a stock could potentially go to zero. Those problems might bealleged corporate fraud, such as in the case of Centennial Tech-nologies Inc., which has faced lawsuits rising from allegations of in-flated sales and net income (Dow Jones, April 30, 1998, “CentennialTech/Final Court”), or legal exposure, such as in the case of DowCorning and the breast implant litigation (Dow Jones BusinessNews, April 13, 2000, “Appeal Hearing Over Dow Corning Breast-Implant Settlement Plan Ends”). .
The trade-off, however, is time. If you buy a stock, you own it;you can hold it for a day or the rest of your life. An option only hasvalue for a defined period of time. If you buy March calls in January,those options will have value for two months. After the third Fridayof the expiration month (March in this example), the option is nolonger exerciseable or assignable.
sophisticated trades
When you buy a stock, you're long that security. To make money,the share price has to increase. Or, you could sell a stock to takeacase for options 49
a profit or—as we'll discuss in a moment—short a stock becauseyou think it’s going down. Basically, there are two ways to playstocks—you buy ’em or your sell ’em.
But there are myriad of ways to play options. Even retail in-vestors can undertake at least a half-dozen options strategies, com-bining buying and selling put and call options. (We’ll discuss thesestrategies in later chapters.)
taking advantage of a trading range
If you buy a stock and it stays in a trading raage, your investment ison hold. You don’t make money