Most traders know Pete Najarian from his regular appearances as the options guru on CNBC’s popular post-market television program, Fast Money. Nicknamed “The Pit Boss” in homage to his days as a floor trader at the Chicago Board of Options Exchange, Najarian was recently ranked one of the top 100 traders in Traders Magazine.
Pete Najarian has an interesting and colorful background. Before beginning his career as an options trader, Najarian was a professional football player with the Tampa Bay Buccaneers and the Minnesota Vikings. But after several seasons, Najarian gave up that career for a similarly rough and tumble line of work in the options pits next to some of Chicago’s toughest, hungriest and most savvy traders.
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Najarian was lured into options trading in part by his brother, who thought that the competitive environment of the options pits would fit well with the competitive nature Najarian had nurtured on the playing field. After only a short while, it was clear that Najarian had found a new home, thriving as an options trader, becoming a market maker and later a specialist.
Since those days, Pete Najarian has been a major player in the world of options trading and options brokerage. He was a founding member of One Chicago, an electronic exchange geared toward facilitating the trade of futures on individual stocks, indexes and exchange-traded funds. Najarian is also the co-founder of Hedgehog, a trading platform for options, stock and futures traders. And of course, most recently, Pete Najarian has become a widely-followed member of CNBC’s Fast Money crew, providing insightful analysis and commentary on the market action of the day–particularly as it relates to potential opportunities for options traders.
We spoke with Pete Najarian in March, shortly after the collapse and rescue of Bear Stearns
PowerRating). Here in Part 1 of our interview with Pete Najarian, we learn about how he came to be an options trader, which options strategies he prefers to use and why, as well as his thoughts on leverage and whether or not traders need to know how to trade stocks before trying to trade options. Part 2 of our interview with Pete Najarian will be published next week, Friday 25.
David Penn: Could you briefly give us sort of a rundown on how you got involved in options trading in the first place; and maybe just a little bit of some of the different things that you’re involved in as a professional right now.
Peter Najarian: Sure. Well, I actually had absolutely no financial background at all. As a matter of fact, I was a genetics and physiology major in college and then was lucky enough to play professional football. And I just came to the trading floors just to see if it was something that I would like, because my brother told me that it’s a very competitive atmosphere.
And after several months, I decided he was right. I really liked it and became a market maker and eventually became a specialist, meaning that once you’re a specialist, you are completely obligated to stand down there and give markets – does not matter what’s going on in the market itself. And you can’t really walk away.
David Penn: That must have been a pretty heady experience.
Peter Najarian: It was an opportunity that I really liked. It was a challenge and that’s what put me into the options world and learned a lot about the whole progression of LEAPS as well as the competitive markets once things started to loosen up and it was no longer single-listed options but actually listed on multiple exchanges. So that became another competition between yourselves and the Chicago markets against all of the rest of the exchanges across the country that were also trading options.
Occasionally television folks and radio people and newspaper would look for answers to what was going on in the market. I was never very uncomfortable about telling them my opinion and what I was seeing, so over time, it turned into something where they apparently liked me more than I’d expected. And eventually CNBC had me come and sit in one week on Fast Money and I’ve essentially been here ever since; working with the show and just sort of talking about the general markets and then sometimes getting all the way to the specifics of the options markets and what we’re seeing there just because the options market, in our opinion, my brother and myself, really do oftentimes lead you to what’s going to be happening in the markets maybe the next day, the next week or over the next couple of months.
David Penn: How long have you been with CNBC’s Fast Money?
Peter Najarian: The first week that I sat down with the guys was February of 2007 and then I was back and forth from Chicago from that time all the way through early May; and then have been living in the New York area and doing Fast Money five days a week with the guys since May.
“Professional sports are very, very similar to what you face in the markets on a daily basis…”
David Penn: Let’s talk a little bit more about that background. One of the things that I’m sure everybody, when they hear a little bit about your background, gravitates toward is your background as a professional football player.
Is there anything from the world of professional sports that translates well into the world of either trading in general or options trading in specific?
Peter Najarian: The real answer is that professional sports are very, very similar to what you face in the markets on a daily basis. And the reason I say that is, professional sports give you an opportunity to compete and through that competition, you get knocked down. You get decleated. You get knocked off your feet and you’ve got to get yourself up and pick yourself up and go at it again. And that really is what the markets are all about.
And obviously, you will last a lot longer if you’re not knocked on your fanny and you’re able to stay on your feet more frequently than getting knocked off. But you always know that somebody’s out there that’s going to be right and you’re going to be wrong and you’ve just got to be able to react. And the markets are just like they are with football; you’ve got to react in the market. There are a lot of trades that just don’t work.
And you’ve got to face that going in knowing that the institutional buyers that we often times track when we’re watching the options markets or the stock markets, they can be wrong. Clearly, they’ve been very wrong over this whole mortgage crisis. There is not a single institutional bank on Wall Street, an investment bank on Wall Street that has not had some major write-downs because of what they had done in those markets. And these are the same folks that we all deem as so intelligent that we want to know what they’re doing and we base a lot of our judgments based on what they’re doing with their money.
So I think the easiest translation I can say is that you are going to get knocked down. You are going to be wrong. You’re going to lose money here and there and what keeps somebody around longer than others and I think the average football player when I played lasted just over two years in the NFL lifespan. And the average options trader, when I came to the trading floor back in the early 90’s, their average lifespan on the trading floor was about two years.
So there really are a lot of similarities. And they’re similar in a lot of ways because in some cases, guys do very, very well when they leave the business. In other cases, they just did very poorly and left the business. But the people who’ve been around for a lot of years have managed to lose money but lose it at a slower rate than hopefully they’re making money and because of that, that keeps them around a lot longer.
David Penn: Interesting. When it comes to your own trading, what are some of the main ways that you like to use options?
Peter Najarian: One would be just a straight, naked buy of a call based upon a lot of the different reasons that would put anybody into their positions. But if I deem that the call is just too expensive, either dollar wise or volatility wise, I may not want to own that option naked because there’s just too much exposure.
So when that’s the case, I will usually generally go to one of two other alternatives. One, would be to try a spread. In other words, buying an option and selling an option to reduce the amount of risk, the amount of premium or volatility exposure that I’ve got.
Or, number two, use what’s happening in the markets in my favor by maybe owning the stock and selling that option. I would sell the option based upon the fact that the premium level is so high that if those buyers were right, I will be able to ride it with the stock and then eventually be taken out of my position with the call. So those are really some of the strategies that are probably the most frequently used.
And then of course, there are calendar spreads you can use, using that very, very high priced volatility that somebody has demanded for those options. Using that and to sell that and then buy a different month where the volatility has not expanded to those levels, trying to take advantage of the monstrous movement of volatility, expecting that at some point, that that volatility will contract to the normal level and I will be able to reap the rewards of the premium.
David Penn: Some of these strategies or approaches that you mentioned sound relatively straightforward. They sound like the kind of thing that someone who doesn’t have a great deal of experience with options would be able to do, certainly straight buying a call, for example.
How about some of these other strategies you mentioned, such as the call spreads, the owning the stock, selling the calls, the calendars. How far up the skill level ladder do we have to climb to use that kind of strategy?
Peter Najarian: You know, in all honesty, I don’t think you have to move that far. I think a person would need to know just some of the risk and reward of those other trades. But in all honesty, they’re really relatively simplistic.
When you leave the trading floor, you leave behind the ability to have the trades come to you and put you into positions where you’re more reactive. And any time you’re off the floor and sitting at a desk or sitting in front of your computer, you have to become proactive. And by being proactive, you are being able to put into a position to put these positions on.
With regard to any of the strategies that we just talked about, they aren’t so complex but I think that they do need to be understood. For instance, I rarely would put on positions where I have unrealized amounts of exposure. I always want to know exactly what my exposure is. I try to limit my exposure and limit my risk so that every single night, regardless of what were to happen, I know that I can sleep.
David Penn: That’s very important.
Peter Najarian: A lot of folks out there don’t subscribe to that. I just feel that I want to be able to sleep and if I’m dead wrong, I already know how much I can lose. And for me, that gives me the ability to go home at night and be able to sleep.
David Penn: Do you think that if people need to trade stocks before they trade options? Or do you think that people can go straight into options?
Peter Najarian: I think as long as they’ve got the education and understanding that the options – it’s fairly straightforward. But it doesn’t always translate for people. People really have to understand all the metrics that go into what prices an option. In other words, you buy a stock; you basically know where the stock is and it includes the dividends and so forth. Where if you’re looking at the options, you’ve got to understand the timeframe. It really is the major difference between the options and the stock. With options, you are limiting your timeframe and you are paying some form of premium to do what you’re doing. But by paying that premium, that is allowing you to do trades with leverage. And that is not leverage that is the ridiculous kind of leverage that doesn’t allow somebody to be able to be in positions without sleep.
I say that because when you use the expression leverage, then people often times go: “Oh well, that scares me off.” Well, it really shouldn’t. I think the case of options, it’s not leverage in a negative way. It’s leverage in a positive way. It’s less capital outlay looking for a similar result but the result is going to be capped because of the timeframe of the options.
“What traders need to understand is how much volatility is attached to the option relative to the normal volatility….”
David Penn: You mentioned that timeframe is possibly one of the things that someone who’s new to options trading needs to maybe adjust their thinking or to understand that it’s a major metric, as you called it. Can you think of another thing or two that are also the kinds of key things that options traders really need to get their hands around?
Peter Najarian: Well, you know, understanding the volatility of the options is probably as critical as anything. A lot of folks think that’s a much more complex idea than it is. Under normal circumstances, an option has a price based upon past history. What traders need to understand is how much volatility is attached to the option relative to the normal volatility. That’s really the biggest, most informative thing that people just really need to get their hands around. I’ll give you a great example, a recent example, of why it is so important.
David Penn: Great.
Bear Stearns. Ahead of all of this craziness that happened, there were the institutional buyers and some speculative buyers but very large paper was trading in there that I would have deemed institutional size. They were willing to pay up to $2 for options that are worth under normal circumstances, about a nickel–and these weren’t normal circumstances. Now that’s a lot of premium and that’s all volatility. That’s an expression of how concerned people really were about Bear Stearns going down for the count.
So traders just have to understand what the levels of volatility are because that really will tell you how much more risk you really are putting on a trade when you decide to go into the options.
David Penn: Would you also say this is an example of what you have said in the past about the capacity of options to lead you to what’s really going on?
Peter Najarian: Yeah, yes. Just because more often than not there is some sort of a fire when you’re seeing smoke. And the smoke for us often times is in the options where it can be very difficult. But you can see volumes trading, whether it’s options or stock.
And when you start to see the accelerated buying of options that really, for the most part, don’t make a whole lot of sense, it does cause you to scratch your head and say, they’re not always right.
There are plenty of examples in the last couple of years, whether they be take-overs or upgrades. You name the catalyst or in the case of some of these negatives lately in the marketplace, the smoke has been there and the smoke has been in there with the options. The leverage of options allows people to put on just an incredible amount of exposure working towards that ultimate of what they think the catalyst is going to be.
David Penn: Do you have an opinion of some of the popular metrics that people use to allow options to lead them? Things like the put-call ratio?
Peter Najarian: You know, everybody loves to talk about the put-call ratio. I think that it gives you some insight. I just don’t think it gives me enough insight. The problem is that sometimes when you’re just using put-call ratios is there are often times good reasons why those ratios have changed. And when I say that, there’s just a multiple of reasons that I don’t even want to bore you with.
But they don’t always give you the true picture in my mind of the direction of the markets.
David Penn: I’ve actually heard some criticism of late about the put-call, somewhat along some of the things that you’re suggesting. People tend to treat it as a binary, on-off sort of thing giving specific signals…
Peter Najarian: That’s very interesting, isn’t it?
David Penn: Along that line of perhaps myths about options trading, if you were going to give a table-pounding rant about one topic in options trading that drives you crazy, what might that rant be about do you think?
Peter Najarian: Oh, boy. I often times hear people pounding about the table, the rants on volumes that end up being fairly meaningless. I mean, often times, I hear people talking about well, there was just this amazing amount of volume in the options of a particular stock. Well, what they’re missing out on is the fact that the volume is based upon a relatively simple but slightly complex dividends play for a stock which is something that’s gone on in the markets forever.
It’s not illegal. It’s just a way that people try to play dividends when they’re paid out. In particular, anything of any significant size on the dividend payout where there’s an amazing amount of call buying, call selling, same strike can fall prey to this trade. They’re doing it based on the idea that they’re going to exercise the long calls and let the short calls go out worthless and hope to be able to capture the dividends. That really is the whole trade.
But it’s amazing how often I hear people talking about a gigantic amount of volume and that’s really all it’s tied to is the dividends. And it’s meaningless. It’s not directional, it’s just a meaningless trade and I hear that on a consistent basis. It doesn’t make me angry, it just makes me kind of snicker and laugh because I’m looking at it saying well, that’s just a dividend trade.
David Penn: Sure, sure.
Peter Najarian: You see it around stocks. I’ll give you a great example. Look at option volume sometime around an Altria Group
PowerRating), for instance, ahead of their dividends. And you will see hundreds of thousands, sometimes millions of options trade in something like Altria Group and it’s an absolutely meaningless trade to anyone as far as giving them an indication of a direction for the stock.
“The more complex the trade becomes with options, the more expensive it becomes and the more you really have to be right to make any money on the trade…”
David Penn: You talked about some of the strategies that you use and how some of them are things that certainly a beginner or maybe an advanced beginner options trader would be able to use. Are there other strategies out there that you think that a new options trader should be aware? I know straddles are some that some people recommend for new options traders. What’s your opinion of them?
Peter Najarian: My biggest issue is this; when it comes to some of the more complex strategies, when you start getting past some of the very, very simplistic trades that are out there, the more complex the trade becomes with options, the more expensive it becomes and the more you really have to be right to make any money on the trade. There are just too many pieces of the puzzle that between the commissions and the overall cost, they just become almost impossible to make money unless you just were right beyond all words.
I think it’s interesting; even the institutional folks that we all deem to be the smartest on Wall Street, they do very, very simple trading. And because of that, I think they’re using the same kind of ideas. If you’re looking for a specific type of reaction to the stock, you don’t really need to get too complicated with the trades. And I see all kinds of these complex trades that go out there that it just seems like they’re just too much. They’re over-thinking it.
David Penn: Sure. I’ve actually wondered if people who are considering trading options hear about some of these or heard about them in the news or what have you and they’re actually maybe intimidated out of trying to trade options because of them.
Peter Najarian: Yeah, that’s – I would be.
I’ve got to be honest with you. When you leave the trading floor and you see – I mean, now the trading markets in general have tightened up, I think, over years because of the competition. You’ve got many stocks where you’ve got to look down every single exchange that exists out there. You’ve got six exchanges trading the options. So you’re going to have relatively tight markets.
But when you start getting into some of these crazy – this straddle trade or this thing or that thing and you get into all these names that even I think intimidate people, there are so many pieces to that puzzle and you’re giving up money on every option trade that you put on, even though the markets are tighter these days, you’re still giving up that bid-ask spread.
Now, you can trade in between it but you’re giving up some of that bid-ask spread to be able to put this trade on. And the cost is high and the return continues to get lower because of the cost becoming more expensive as you are paying for the offers or selling the bids.
Be sure to catch Part 2 of our interview with CBNC’s Fast Money Man: Pete Najarian as he talks about some of his most interesting trades of 2008, his opinion on in-the-money versus out-the-money options, exiting winning options trades and more. Part 2 will be available one week from now on Friday, April 25th as part of our Big Saturday Interview series here at TradingMarkets.