The New Market Wizards: Conversations with America's Top Traders (49 page)

Given this bias, might you not be misled to be willing to sell a deep out-of-the-money option versus another option more readily than you should?

Yes, absolutely. In all classes of options, if you believed the model, you would sell more of these options.

Were you losing money doing that?

No. I was consistently making money, but that kind of strategy—selling deep out-of-the-money options—only leads to consistent profits until a catastrophe arises. Then you lose it all, plus some.

Were you lucky not to hit a catastrophe using that approach?

I was lucky in hitting catastrophes that did not take me out of the game, even though that could have happened.

Can you give me a specific example?

In 1981, I had financed a trader on the American Stock Exchange who sold out-of-the-money options in a takeover situation. I lost about one-third of my capital in that one trade. Emotionally I handled it very well. Unfortunately, about a week later, I had another large loss in a short out-of-the-money call position in Kennecott. Ironically, even though my position was relatively small, the overnight move was so enormous that the loss was substantial. After these two takeovers, I had lost about half my money.

How long had you been trading at that time?

About four and a half years.

Am I understanding you correctly? These two trades alone wiped out approximately half of the cumulative profits you had made on the presumably thousands of trades up to that point?

Right.

How had you done over the four years up to this point in time?

In my first two years in the business, I had back-to-back 400 percent returns. Thereafter. I averaged roughly 100 percent per year.

What about 1981, the year in which you had these two big hits?

I still ended the year with a net profit.

Were your trading profits made strictly by taking advantage of mispricings?

Right. The speculators are usually on one side of the market. For example, they may he buying out-of-the-money calls. At the same time, institutional investors might be doing buy writes, which would be selling long-term calls. To some extent, a smart market maker is a risk transfer agent. He would buy the calls from the institutions and sell the other calls to the speculators, trying to balance the overall position so that there is as little net risk as possible.

Were you always totally hedged?

I always tried to be relatively hedged. in a takeover situation, however, you might think that you are hedged, but the price move occurs so quickly that you really aren’t.

You mentioned that speculators are usually on the buy side of options. In general, do you believe there is a mispricing that occurs because people like to buy options?

If you compare historical graphs of implied volatility versus historical volatility across a spectrum of markets, you will see a distinct tendency for implied volatility being higher—a pattern that suggests that such a bias exists.

Does that imply that being a consistent seller of options is a viable strategy?

I believe there’s an edge to always being a seller, but I wouldn’t trade that way because the implied risk in that approach is too great. But to answer your question, generally speaking, I believe the buyer of options has the disadvantage.

In takeover situations, are there sometimes clues that something is going to happen—for example, an option suddenly starting to trade significantly beyond where it should be trading?

Of course. In fact, in recent years, some of the regulatory people have started to look at these things. There are also some traders who use indicators called wolf detectors. These traders monitor the markets for unusual price moves in the underlying stock, or sudden increases in volume, or a jump in implied volatility for the out-of-the-money options. These types of indications are used as a warning that there may be a wolf out there, so to speak. But that’s not my approach.

How do you protect yourself against the possibility that there may be a surprise takeover in a stock in which you hold a significant short out-of-the-money call position?

In individual stocks, you play the high capitalization issues, which tend to have information that is already in the marketplace. You tend to get far fewer sudden moves when trading the high capitalization stocks.

Do you ever do any directional trades?

Maybe a couple of times a year, I might get a strong idea for a directional trade. Although these types of trading ideas are infrequent, they’re usually right.

Can you give me an example?

When I was trading on the Pacific Stock Exchange, I bought thousands of calls in McDonnell Douglas. At the time, there had been a number of DC-10 crashes, and there was some speculation that they would never fly again. I went home and told my wife about the large position I had in these calls. She was absolutely horrified. She said, “Those planes [DC-10s] are never going to fly again. We’re going to be broke.”

Was this opinion based on the news coverage prevalent at the time?

Yes. It was the climax of fear in the public. You could say my wife taught me to be a contrarian. That trade taught me a lot about the marketplace. When nobody wants to touch the market, that’s the time you have to step up.

Do you remember any other directional trades?

On the day following the 508-point crash in the Dow Jones index [October 19, 1987], due to a combination of pervasive fear in the market and the increased capital requirements by the clearing firm, we couldn’t find anybody to execute our orders in the Major Market Index [MMI] traded on the Chicago Board of Trade. As a result, I was forced to go over there and trade in the pit myself.

I heard rumors that the Chicago Mercantile Exchange was considering calling a trading halt. [The CME trades the S&P 500 index futures contract.] If true, this would have represented a drastic action. I immediately ran to call up my desk to try to research what had happened after past trading halts. However, after about thirty minutes, they couldn’t find out anything. I sensed that the CME was about to halt trading. I called back the desk and said, “Make sure that we’re long on any trading halt.”

Why did you want to be long?

Because the fear was all out of proportion to reality. I had to be a buyer. We have a philosophy that involves always trying to provide liquidity to the market. The Merc eventually halted trading and about three minutes later a commission house broker was trying to get a bid on a one-hundred-lot sell order. The market was trading at 290 and nobody was bidding any size. I bid 285 and he sold me a hundred. A few minutes later, he sold me another fifty at the same price. Those were the only trades transacted at 285. The market closed at 400 that day.

Of course, in hindsight, that was a great trade—you ended up buying the low. But couldn’t the rationale of buying because fear was out of proportion to reality also have been used as a reason to go long the previous day when the Dow Jones collapsed by over 500 points?

There was a specific event tied to the timing of that trade: the CME was going to halt trading.

Any other directional trades that come to mind?

I went long the stock market on the morning of January 15, 1991, the day of Bush’s original midnight ultimatum deadline to Hussein. Everybody thought the market would go down 150 points if the war started. I thought, “How bad can this war be?”

Your assumption was that Bush would move as soon as he could?

My assumption was that the uncertainty had to diminish, and therefore I had to be long the market. My strategy was to put on half the position that morning just before the deadline expiration and the other half after the war had started.

Putting on the first half before the start of the war certainly proved to be the right move. But do you remember why you didn’t wait to put on the entire position until after the war had actually started?

It was just a matter of the fear and uncertainty in the market. My head trader put that trade in the LTG account. A few years earlier, I had criticized one of my arbitrage traders for wanting to take a net long position by saying, “What do you think, you have a line to God?” So putting the trade in the LTG account was his way of making fun of me.

Did you end up buying the other half of the position after the war had started?

No. I would have put it on if the market had opened down, but instead the market opened up sharply higher.

Your main profitability, however, doesn’t come from directional trades?

That S&P 500 trade amounted to close to $4 million in about thirty minutes, which certainly helped our P and L for that day. But overall, I would say that those types of trades account for only about 5 percent of the firm’s total trading profits. Our basic methodology is still buying undervalued securities and selling overvalued securities. It all goes back to the blackjack philosophy that, if you have the edge, in the long run, you’ll make more money by doing a lot of transactions.

Have your strategies changed from the basic concept of buying the cheap options and selling the more expensive ones?

Speed has become much more important and strategies have become much more complex.

Is that because the easier plays are gone?

This is always a horse race, and unless you’re running very fast, they’re going to catch you.

Do you now have to focus on intermarket trades instead of intramarket trades? Has the single market mispricing disappeared?

Absolutely. Your return on capital would be very small if you weren’t trading across markets.

There are many other major firms, such as CRT, utilizing similar trading strategies. Don’t you find yourself competing with these other firms for the same trades? How do you avoid getting in each other’s way?

You have to realize who is driving the market. None of us would be here if it weren’t for the institutions who want to do the trades. They have a need to alter their risk profile, and we take the other side. Also, we do differ from some of these other firms you mentioned in that we look for the less obvious offsets.

What does that mean?

It’s an outgrowth of my days as a floor trader. I was one of the slowest floor traders ever. Because someone else would always get to the primary market first, I had to look someplace else. I would end up offsetting a trade in a market that was not as highly correlated. For example, if the OEX options were priced high and the arbitrage traders were sellers, they would offset these positions in the S&P 500. Instead, I would end up hedging the position in the NYFE [New York Futures Exchange] and MMI, because the other OEX traders would already have hit the S&P 500. [The OEX contract is based on the S&P 100, which is extremely highly correlated with the S&P 500 but less correlated with the other stock indexes, such as the NYFE and MMI.]

Having toured your operation, I find it difficult to believe that you’re still one of the slowest traders.

Well, probably not anymore. We’re highly automated now. But my on-the-floor experience has made us much more inclined to look for less obvious markets in which to offset trades. We look for trading opportunities between less correlated markets.

Do you try to keep the firm’s total position basically hedged all the time?

I try to have a zero delta portfolio [a portfolio that is neutralized relative to directional moves in the market]. The net delta of the firm’s portfolio [i.e., the contract equivalent net long or short position] is reevaluated within two seconds each time any of the traders makes a new trade. There is a feedback process so that each trader knows this information instantaneously and therefore knows in which direction to lean.