The New Market Wizards: Conversations with America's Top Traders (50 page)

In other words, if the firm’s net position is long, the traders lean to finding mispricings that require implementing a position with a bearish bias.

Exactly. In essence, each trader is really trading a firm strategy.

Is each trader responsible for hedging his own trades?

No. We have twenty-five traders, one of whom is responsible for doing the hedging [i.e., assuring that the firm’s net exposure to price changes is as close to zero as possible]. You might say he’s the air traffic controller.

So the individual traders can buy whatever they think is cheap and sell whatever they think is high, even if it’s a one-sided trade, because they know that the air traffic controller will make sure that the firm’s net position stays close to neutral.

Exactly. When there’s an edge on a trade, part of the cost of taking that trade is that you have to give up some of that edge to somebody else in order to hedge it. The beauty of this system is that the cost of hedging is very small.

Covered calls [buying a stock and selling a call against it] are frequently promoted as trading strategies. As we both know, doing a covered call is identical to selling a put. Is there ever any strategic rationale for implementing a covered call instead of a short put, or is the former promoted because it involves a double commission, or perhaps for semantic reasons—that is, even though the two trades are identical, the covered call
sounds
like a less risky proposition than a short put position?

I don’t know how to articulate the fraud that is sometimes perpetrated on the public. A lot of strategies promoted by brokers do not serve the interest of their clients at all. I almost feel guilty when taking the other side of a covered call position, because it’s obvious that the customer is operating under a misconception.

Then you agree that anyone who wants to do a covered call would be better off simply selling a put, assuming that he plans to initiate and liquidate the stock and call positions simultaneously?

Right. If you want to guarantee an inferior strategy, do covered calls.

I could never understand the logic….

You’ve got the game.

On expiration, small moves in the underlying stock can make a big difference in whether an option expires profitably or unprofitably. It seems like there must be a tremendous temptation for people with a large option position to try to influence the price of the stock at expiration. Does that happen?

When I was a trader on the Pacific Stock Exchange, two smaller market makers wanted to pin the price of a particular stock to the strike. They wanted to sell the stock on the expiration date and make sure all the calls and puts went out worthless. They enlisted the aid of a large market maker in this scheme. The large market maker agreed to join their group and pin the stock at the strike. Instead, he took the opposite position and took them both out of the game. [He laughs at the recollection.]

Actually, there is a natural tendency for stocks to finish at or near the strike. A few years ago I did some statistical work that was quoted in the
Wall Street Journal.
Speculators tend to be long the slightly in-the-money calls and they usually sell their option positions prior to expiration because they don’t want to exercise them. For example, let’s say a stock is trading at 60 1/2. Most of the open interest will be in the 60 calls. The public, which is long the 60 calls, will tend to sell this position as expiration approaches. The market maker will be on the other side of this trade, and in order to hedge himself he has to sell the stock. This chain of events tends to push the price of the stock toward the nearest strike price at expiration. I found that, statistically, a stock is about twice as likely to finish within one-quarter of a point of the strike price at an option expiration than might be expected if there were no correlation involved.

Do you use this finding in any way?

Yes, we play this strategy because it provides an edge.

Any advice for the nonprofessional who trades options?

The OEX RAES (Remote Automatic Execution System) is the public’s edge. The system provides an automatic execution within ten seconds or so.

Why do you say it’s the public’s edge?

Because market makers have agreed to be on the other side. When markets turn extremely volatile, the market makers cannot update these quotes fast enough. Therefore, the public customer has a tremendous edge in those types of markets.

Why should a customer ever go to an open outcry execution if he can use this automatic system?

The RAES only accepts orders of ten contracts or less. If the order size does not exceed this limit, the customer would generally he better off using this execution system.

What do you think are some of the key characteristics or traits of a successful options trader?

You can’t listen to the news. You have to go with the facts. You need to use a logical approach and have the discipline to apply it. You must be able to control your emotions.

Anything else?

Consistency. You need to go for the small theoretical edges instead of home runs.

Is there a certain personality type that is best suited to being a successful trader?

Based on my experience with the traders I’ve hired, I would say that successful blackjack, chess, and bridge players are more likely to fit the profile of a good options trader.

What are some of the misconceptions you have found people have about the market?

They tend to listen to rumors. They’re too interested in who’s buying or selling. They think that type of information is important; yet it rarely means anything.

Do you feel that your past experience on blackjack teams influenced you in moving toward a team trading approach?

The experience was helpful in being able to successfully build a trading team.

Did you enter this business thinking you were going to be a team trading leader as opposed to an individual trader?

I actually went into the business thinking I could automate everything and that a machine would do it all.

When did you realize that wasn’t going to happen?

I haven’t realized that yet. I’m still working on it [he laughs]. We reward people who automate. We want people to work toward that goal.

Some people are fond of saying, “Even a poor system could make money with good money management.” This contention is complete nonsense. All that good money management will do for a poor strategy is to assure that you will lose money more slowly. For example, no money management system can ever be designed to make money playing roulette, because the edge is against you. (The odds would be exactly even, but the zero and double zero give the house a decisive advantage.) In fact, if you are playing a poor strategy (one where the edge is against you), your best chance for coming out ahead is to apply the extreme of bad money management—risk everything on one trade. Why? Because the longer you play with a negative edge, the greater the probability of eventual financial ruin.

Probably the most basic requirement for successful trading is that you must have some well-defined method, or, in other words, a specific approach that gives you an edge. That approach could be buying undervalued securities and selling overvalued securities, as it is for Hull, or it could be some better-than-breakeven way of selecting price directional trades. Without such a method, or edge, you will eventually lose, because the odds are 50/50 before transaction costs. If you don’t know what your method is, you don’t have one. (By the way, buying a stock because your brother-in-law gives you a tip is not a method.)

The Hull interview also helps underscore the distinction between gambling and betting or trading with an edge. Participants in the market may well be gambling. If you don’t have a method (i.e., an edge), then trading is every bit as much a gamble as betting in the casinos. But with a method, trading—or for that matter, even blackjack—becomes a business rather than gambling. Fortunately for traders, whereas the casinos can bar players because they become too proficient, the market has no way of eliminating the skillful traders (other than behaving in a manner that seems to confound the greatest number of people the greatest amount of time). Therefore, if you can devise a method to beat the market, no exchange can come to you and say, “We’ve noticed that you’re making too much money. You can’t trade here any more.”

Once you have a method, you still need money management to prevent an adverse streak from taking you out of the game. It is critical to keep in mind that even if you have the edge, you can still lose all your money. Therefore, the bet or trade size must be small enough to keep the probability of such an event very low. So the appropriate quote is, “Even a good system can lose money with poor money management,” rather than the fallacious contortion of this theme quoted at the start of this section.

This same theme is colorfully described in Ken Uston’s
The Big Player,
the book written about the blackjack team that Hull described in the interview:

Another pertinent lesson that Hull applied to blackjack, as well as trading, is that if you have a winning method, you must have the faith to keep applying it even during losing periods. The trick, however, is to reduce the risk by reducing your bet or trade size so that the ratio between risk and equity stays relatively constant.

Although Hull is predominantly an arbitrage trader, he occasionally takes directional trades, which have tended to be quite successful. Hull’s rules for directional trading, although not explicitly stated, can be inferred from the interview:

1. Trade infrequently and only when you have a strong idea.
   
2. Trade the opposite side of the predominant news stories.
   
3. Time your trade to coincide with an event that has the potential to lead to a panic climax.
   

THE MATHEMATICS OF STRATEGY

J
eff Yass started as an option trader on the floor of the Philadelphia Stock Exchange in 1981. He was so enthralled by the opportunities in option trading that he enticed a number of his college friends to try trading careers. During the early 1980s, he trained six of these friends as traders. In 1987, Yass and his friends joined to form Susquehanna Investment Group. The firm has grown rapidly and now employs 175 people, including 90 traders. Today, Susquehanna is one of the largest option trading firms in the world and one of the largest entities in program trading.

Yass seeks out nuances of market inefficiencies through complex refinements of standard option pricing models. However, the essence of Yass’s approach is not necessarily having a better model but rather placing greater emphasis on applying mathematical game theory principals to maximize winnings. To Yass, the market is like a giant poker game, and you have to pay very close attention to the skill level of your opponents. As Yass explains it in one of his poker analogies, “If you’re the sixth best poker player in the world and you play with the five best players, you’re going to lose. On the other hand, if your skills are only average, but you play against weak opponents, you’re going to win.” Yass will factor in his perception of the skill and knowledge of the person on the other side of a trade and adjust his strategy accordingly. He is willing to subjugate or revise his own market views based on the actions of those he considers better-informed traders.

Yass has a quick mind and talks a mile a minute. We started the interview in his Philadelphia office after market hours and finished at a local restaurant. Although I had my doubts about Yass’s restaurant selection abilities (for reasons that will quickly become evident), the food was superb. Unfortunately, the food quality was matched by the restaurant’s popularity, and hence noise level, leaving me with cassette recordings worthy of the deciphering capabilities of the CIA. We obviously appeared to be a bit strange to a group of nearby diners who upon leaving couldn’t resist inquiring why we were recording our dinner conversation.

When did you first get interested in markets?

When I was a kid. I loved the stock market. I used to tear the paper out of my father’s hands to check the stock quotes.

Did you trade any stocks as a kid?

I loved TV dinners. The first time I tried a Swanson’s TV dinner, I thought it was so delicious and such a great idea that I wanted to buy the stock. I found out that Swanson’s was owned by Campbell, and I got my father to buy ten shares of the stock for me.

Do you still love TV dinners?

Yes, and I also love all airplane food. I agree with Joan Rivers, who says she’s suspicious of anyone who claims they don’t like airplane food.

I’m not sure I still want to go to dinner with you later. So what happened to Campbell after you bought it?

The stock never went anywhere.

I’m not surprised.

It went up
eventually.
I would have done OK if I had held on to it for the next thirty years.

Was that your first stock market transaction?

Yes.

How old were you then?

Eleven.

Did you buy any other stocks as a kid?

When I was about thirteen, I bought Eastern Airlines. I flew to Florida at the time, and I thought it was a good airline. I also bought a realty company that eventually went bankrupt. I always lost. I remember my father saying to me, “The stock was around a long time before you bought it. Just because you bought it now doesn’t mean that it suddenly has to go up.”

In high school, I discovered options. I would check the option closing prices and find what I thought were huge mispricings. For example, one time Alcoa closed at $49 and the 45 call was trading only $2 1/2 above the 50 call. By buying the 45 call and selling the 50 call, I would lose $2 1/2 if the stock went down $4 or more, but I would win $2 1/2 if the stock went up $1 or more. It seemed like a great bet. I convinced my father to do the trade for me. The stock went up, and the trade worked out.

Did you do any other option trades in high school after that?

No, I discovered that the closing option price printed in the newspaper was really just the last sale, which could be very stale. For example, an option might have finished the day 11 bid/12 offered, but if the last sale was at 13, that’s the price that would be printed in the paper. Once I discovered that these quotes were not real, I realized that most of the trading opportunities that I found were really nonexistent.

How did you even know about options in high school?

The company my father worked for issued warrants when they went public. I asked my father to explain warrants to me. Since a warrant is nothing more than a long-term option, I understood the basic concept.

After you graduated from college, did you go on to graduate school? Or did you go directly to work?

My plan was to take a year off and travel across the country. I did, however, end up going on one interview with an investment house, which I won’t name. I was interviewed by the head of the options department. I think I might have insulted him, and I didn’t get the job.

Since you’re not naming the firm, why don’t you be more specific.

Well, our conversation went something along the following lines: He said, “So, you think you can make money trading options.” I then told him about what I thought was important in making money in the options market. He asked me, “Do you know this year’s high and low for IBM?”

I answered, “I think the low was 260 and the high was 320, but it’s absolutely irrelevant. If you’re wasting your time thinking about that, you’re on the wrong track completely.”

He said, “Well,
I know
what it is; I think it is very important.”

I replied, “Great! Just hire me and I’ll show you why it’s immaterial.”

In our subsequent conversation he indicated that he didn’t know the definition of
beta
[a technical term used to describe a stock’s volatility relative to the overall market]. He said, “I don’t bother myself with that kind of stuff.”

I said, “Terrific! Just hire me, and I’ll explain it to you and show you how to use it.” Amazingly, I didn’t get the job. [
He laughs heartily at the recollection.
]

I know that you’re a serious poker buff and apply many of the strategies of the game to options. When did you first develop an interest in poker?

I started playing poker during college. My friends and I took poker very seriously. We knew that over the long run it wasn’t a game of luck but rather a game of enormous skill and complexity. We took a mathematical approach to the game.

I assume that you’ve played at casino poker games. I’m curious, how does the typical Las Vegas game break down in terms of the skill level of the players?

In a typical game with eight players, on average, three are pro, three are semipro, and two are tourists.

That sure doesn’t sound like very good odds for the tourists!

You have to be a very good player to come out ahead over the long run.

Given that high skill level, what percentage of the time do you actually walk away a winner?

On average, I guess that I win about 55 percent of the time.

Does it bother you when you lose?

It doesn’t bother me at all. I know that I’m playing correctly, and I understand that there is nothing that you can do to smooth out the volatility. I rarely second-guess myself when I lose, since I know that in the short run most of the fluctuations are due to luck, not skill.

Is the strategy in poker primarily a matter of memorizing the odds for various hand combinations?

No, memorization plays a very small role. Understanding the probabilities sufficiently well to know which hands to play and which hands not to play is important, but that’s just basic knowledge. The really great poker players have an understanding of proper betting strategy. What information do you get when your opponent bets? What information do you give up when you bet? What information do you give up when you don’t bet? We actually use poker strategy in training our option traders, because we feel the parallels are very strong. I believe that if I can teach our trainees the correct way to think about poker, I can teach them the right way to trade options.

Can you give me a specific example?

Assume that you’re certain that you have the best hand, and the last card has just been dealt. What do you do? A novice trader would say, “I would bet the limit.” However, that is often not the right move—even if you’re sure that your opponent will call. Why? Because sometimes when you pass, he’ll bet, giving you the opportunity to raise, in which case you’ll win double the bet size. If you think that the probability is better than 50 percent that he’ll bet, you’re better off checking. By using that strategy, sometimes you’ll win nothing extra when you had a sure chance to win a single bet size, but more often, you’ll win double the bet size. In the long run, you’ll be better off. So, whereas betting when you have the best hand may seem like the right thing to do, there’s often a better play.

What is the analogy to option trading?

The basic concept that applies to both poker and option trading is that the primary object is not winning the most hands, but rather maximizing your gains. For example, let’s say you have the opportunity to buy one hunded calls of an option you believe is worth 3 1/4 at 3, giving you an expected $2,500 profit. Most market makers would say that you just buy the option at 3 and try to lock in the profit. However, in reality, the decision is not that simple. For example, if you estimate that there is a 60 percent probability of being able to buy the same option at 2 3/4, your best strategy would be to try to buy at 2 3/4, even though doing so means that 40 percent of the time you’re going to miss the trade entirely. Why? Because 60 percent of the time you’re going to win $5,000. Therefore, over the long run, you’ll average a $3,000 gain [60 percent of $5,000] in that type of situation, which is better than a sure $2,500 gain.

Were you aware of that analogy when you first started trading options?

Yes, the poker world is so competitive that if you don’t fully capitalize on every advantage, you’re not going to survive. I absolutely understood that concept by the time I got down to the options floor. I learned more about option trading strategy by playing poker than I did in all my college economics courses combined.

Are there any other examples you can give that provide an analogy between poker strategy and option trading?

A classic example we give all our trainees is the following: Assume you’re playing seven card stud, and it’s the last round of betting. You have three cards in the hole and four aces showing; your opponent has the two of clubs, three of clubs, nine of diamonds, and queen of spades showing. You’re high with four aces. The question we ask is: “What bet do you make?” The typical response is, “I would bet as much as I can, because I have four aces and the odds of my winning are huge.” The correct answer is…

You pass, because if he can’t beat you, he’s going to fold, and if he can beat you, he’ll raise and you’ll lose more.

That’s right. He might have the four, five, and six of clubs in the hole. You can’t win anything by betting; you can only lose. He knows what you have, but you don’t know what he has.

So what is the analogy to option trading?

Let’s say that I believe an option is worth $3. Normally, I would be willing to make a market at 2 7/8 / 3 1/8 [i.e., be a buyer at 2 7/8 and a seller at 3 1/8]. However, let’s say a broker whom I suspect has superior information asks me for a quote in that option. I have nothing to gain by making a tight market because if I price the option right, he’ll pass—that is, he won’t do anything—and if I price it wrong, he’ll trade, and I’ll lose.

Along the same line, if a broker with superior information is bidding significantly more for an option than I think it’s worth, there’s a very good chance that he’s bidding higher because he knows something I don’t. Therefore, I may not want to take the other side of that trade, even though it looks like an attractive sale.