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THE MARKET TAKER'S EDGE
INSIDER STRATEGIES FROM THE OPTIONS TRADING FLOOR
By DAN PASSARELLI
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
MY FIRST YEAR IN THE OPTIONS BUSINESS
What I Learned and How I Learned It
If there is one thing that characterizes the career of a successful trader, it is humility. No one is bigger than the market. No one can predict the future. No one wins every time. The market has a way of humbling the best of us. Confidence, but not arrogance, is the common thread among those who make it in the options game in the long run.
As a trader on the floor of the Chicago Board Options Exchange (CBOE) for many years, I had the opportunity to watch wave after wave of aspiring traders embark on the journey to carve out their careers in the markets. The Designated Primary Market Maker (DPM) in our pit—the Ford pit—and other traders employed clerks to show them the ropes and groom them to trade. As one would imagine, not all of the clerks ended up as traders.
Over time, I developed a knack for being able to tell which clerks would go on to become successful traders and which ones would not. The ones who watched and listened, learned and internalized—who knew only what they knew and assumed no more—were the ones who stood a fighting chance. The know-it-alls, who had the "secret recipe" for success, who always thought they knew where the stock was going—and who always had an excuse for why it didn't go their way when they were wrong—were the ones destined for an early departure from their careers in options.
There was one particular clerk in my pit who would frequently engage me in conversations always beginning with something like, "Hey PAS (on the CBOE floor, PAS was my acronym that was displayed on my badge), you have to buy these so-and-so calls. Look at this chart; this stock is going up! You can't lose! Blah, blah, blah ..." This poor young man never made it onto a seat. He never gave himself the chance. Mastery of the options game is about learning to exploit the nuances of a game of chance, not predicting the future. This poor sap never appreciated the statistical nature inherent in option trading and never bothered to try to learn.
Followed by humility, another one of the top attributes among successful traders is a lust for learning. The market is dynamic. Winning trading systems have a way to—as the saying goes—work until they don't work. Then, when the goose stops laying the proverbial golden eggs, the trader needs to recalibrate, learn from his or her mistakes, adjust to the new market conditions, and start anew. As an author and lecturer, I am still a student of the market. I have been since the onset of my career and always will be.
Every story has a beginning. The tale of my career in the options game is no different. The beginning of this story, like others, sets the stage for the trials and tribulations that unfold later. So, before delving into the complexities of options, let's first examine some basics.
OPTION BASICS: RUDIMENTARY EXPLANATION
Traders who are just starting out in options tend to start with the rudimentary building blocks to gain an academic understanding. To that point, let's begin with the basics of an option contract's inner workings.
Options are contracts between two parties: a buyer and a seller. There are two types of conventional option contracts: calls and puts.
A call is the right, but not the obligation, to buy an underlying asset at a fixed price, called the "strike price," within a given time constraint set by the expiration date.
A put is the right, but not the obligation, to sell an underlying security at a fixed price, also called the "strike price," within a given time constraint set by the expiration date.
The rights extended in these contracts can be bought or sold. A trader who buys an option creates a long (ownership) position in the contract. A trader who sells (writes) an option creates a short (obligatory) position. Buyers of options have the rights stated previously, which they can exercise at their will. Sellers must perform their obligations at the discretion of an option owner (holder) who exercises. When options owners exercise their right to buy or sell the underlying asset, sellers who are short an option will, in turn, be assigned and therefore be called upon to fulfill their obligation.
Long contracts can be sold to close (ending the right) before their expiration date. Short options can be bought to close (ending the obligation) before the expiration date. So, expiration of the contract or exercise or assignment may not occur.
As mentioned, every story has a beginning. But the standard, academic explanation of options stated here is not the only way to begin this saga. In fact, it is not at all how my foray into options began. As discussed in the introduction of this book, I began my career—and therefore my options education—on the floor of the Chicago exchanges. I am truly fortunate to have started in the business in such a manner, as it is surely the best way to achieve a mastery of options, in my humble opinion. But, for all its advantages, during my rearing as a budding trader, the prevalent trial-by-fire education method proved to be nonnurturing—to say the least.
Many of the educational options courses of which I have been a part since working with stay-at-home traders spend hours on the rights-and- obligations discussion stated previously. This circumstantial minutia was merely assumed knowledge for any new entrant on the trading floor in my early days as a student of the market. Aspiring traders clerking on the floor, striving to master the art of trading, would move forth with a rapid trajectory, soaking in knowledge through every pore.
The chronology of concepts absorbed on the floor is mere chicken-versus-egg trivia. From day one on the trading floor, I was submersed in options lingo, culture, and trading activity during the workday. I—and my ambitious fellow traders-in-training who were hungry for an opportunity to conquer the pits—would eat, drink, and sleep options after leaving the confines of the walls of the exchange, reading books, reviewing the day's activities, and preparing for the next trading day.
Clerks first needed to gain enough knowledge to perform the duties required to assist the trader for whom they worked. If a clerk couldn't do his job, he was fired. Knowing just enough afforded the clerk the opportunity to keep his or her job. But knowing enough to keep your job, however, required a fair amount of knowledge, some of which was what would be considered that of an advanced nature. Any precursory information not relevant to the task at hand could be easily "backfilled." And it could be learned at a later time. You have to know what you have to know.
For example, traders would often ask their clerks for their profit and loss, or P&L, on a particular trade. To an options market maker, the nature of this question was that of theoretical profit (more on that later), which required some math and knowledge of option metrics and pricing to answer. At its simplest level, it is a comparison of the trade price to the theoretical value that is generated by the trader's pricing model—a fairly simple arithmetic calculation. The answer to the question might be something like, say, 6 cents per contract on, maybe, 100 contracts. The simple reply that would satisfy the trader's question would be "6 cents." In fact, on a busy day, a more detailed answer would likely result in the clerk getting chewed out for the distraction. Six cents; that's it.
But, in the equity options world, 6
Excerpted from THE MARKET TAKER'S EDGE by DAN PASSARELLI. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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