Marc Dupee’s Conversation With Dr. J
Marc spoke with Jon Najarian on his way to present at a trading conference in San Diego.
Marc Dupee: Jon, you lived in San Diego?
Jon Najarian: Well, actually La Jolla.
Dupee: Oh, good deal. How old were you then?
Najarian: Probably about three. But I remember seeing the whales go up and down.
Dupee: They’re beautiful. So you’re on every major options exchange except for Philly, right?
Najarian: Except for San- yeah, except for Philly, that’s right.
Dupee: Why aren’t you on Philly?
Najarian: Well, the non-popular answer would be that I can’t get anybody to move there.
Dupee: Oh, nobody wants to move there?
Najarian: No. I mean, there’s so much action at the other exchanges and the other cities are at least perceived by the traders as being nicer. So I’m not trying to put Philly down, but I couldn’t get anybody to go there.
Dupee: Does that somehow hamper your operations because of the market there?
Najarian: No. Because everything trades everywhere. So on Philly, the only thing that doesn’t trade anywhere but Philly is their semiconductor index
^SOX^. So we trade that through brokers. We’re not the primary market maker. But other than that, really, Marc, it doesn’t hamper us.
And I’m not trying to put Philly down. I actually like the city. But none of our younger traders – you know, they all want to go to New York or Chicago. And then lastly they want to go to San Francisco. Even though it’s a great city, it’s not the center of trading. So if they think they’re in the big leagues–it’s kind of like, okay–if you’re really good, you’d want to play for who? Atlanta or the Yankees. You sure as hell don’t want to go up and play for Montreal. And it’s sort of a misperception, among traders that it’s the minor league.
Dupee: I got you. You know, we get this question in the office here a lot. You’re one of the biggest market makers in the US operating on almost every exchange. The question comes about about whether the traders on the floor compete with retail investors.
Najarian: And I say all the time, Marc, that floor traders are not the retail customers’ competition. And the reason for that is simple. I don’t have margin. The customers all have at least a 50% margin that they have to put up. So by me having no margin because the SEC (Securities and Exchange Commission) gives all of us on the US exchanges “specialist relief.”
Dupee: Reg T.
Najarian: Reg-T relief. Because of that, my competition are only the other guys on the trading floor, not the orders coming in from off the trading floor because my time frame to make a profit on a trade might be as quick as 10 seconds, or my time frame to hedge that trade. The time required to take a loss, take a profit, or hedge that trade is probably 10 to 15 seconds. And most of the time the customer is going to be having a substantially longer time frame.
Even if they’re just trading for hours or days, that still means they are not my competition. My competition is the quick-twitch guy standing right next to me in the pit. So the customer who is coming in, the reason they are not our competition is, quite frankly, that they’re going to buy something at $2.00 in the hopes of selling it for $2.50 or $3.00. I’m going to buy it for $2.00, knowing if I sell it for 2 1/16, I just made $6.25.
Dupee: There’s a belief or a saying on Wall Street that you’ve probably heard that the month of January sets the tone for the market for the entire year. ^NDX^ has swung both up and down at least 90 points every day so far and as many as 400 points since the beginning of this year. What do you think that might imply about option trading for the rest of the year? Does it suggest any particular kinds of option strategies?
Najarian: Sure. First of all, Marc, this volatility, you know, unfortunately we all have to get used to it. Customers and market alike. It’s going to be here because of full disclosure, which we refer to as Reg. FD, as in Fred David or full disclosure. Reg. FD means as soon as you know something, you’ve got to tell the whole world when you’re a publicly trading company. So that means it’s got to go out on your website, it’s got to go everywhere. So that causes volatility to really be concentrated on days when firms make any kind of an announcement. And everybody either goes for the entrance or the exit at the same time. So that’s going to continue.
I don’t see any reason that we won’t see volatility increasing throughout the year because, in addition to that Reg FD, we’ve also got the advent of single stock futures. And when you can start trading futures on 1,000 shares of Microsoft or 1,000 shares of IBM or Broadcom, you can imagine what the volatilities are going to be like because futures don’t have up-tick rules like stocks do. So you’ll see people more actively hammering on stocks when the market is going down and, you know, paying obscene premiums for them when they think the market is in a momentum trend to the upside.
So anyway, what sorts of trades, that was your specific question. What sorts of trades do I think investors will be able to employ to profit from that? Anything from a simple bull call spread, Marc, to put spreads to more advanced strategies like straddles, or positioning yourself for the wonderful possibility of making money in either direction that the market might move.
The customers we talk with and the traders that I work with use those strategies most effectively three to four weeks ahead of the earnings announcement because that’s the time when the firms can pre-announce and that’s when they have to announce surprises, either good or bad. And that’s why we’ve moved our time frame because of this Reg FD which went into effect. The time frame, in fact, for putting on spreads or straddles has moved from two weeks ahead of earnings to four weeks ahead of earnings. Now you need that extra time because there’s a window that the firm can’t speak during that quiet period that you’re familiar with, Marc. And that quiet period, you know, is usually 10 days on either side of their earnings announcement. So knowing that, the most likely time for them to pre-announce is that two to three weeks further out into the future ahead of their earnings.
Dupee: And with the greater volatilities, you’d put your strikes further away from where the price is at currently as well as ahead in time?
Najarian: If I were positioning myself directionally, Marc, I would do that. If I were thinking that, for instance, Yahoo!, which announced earnings this week, was going to miss estimates or I think they’re going to have flat growth going forward, but I’m not certain. If I put on a straddle ahead of that, I want to put it on right where it’s trading, you know, three or four weeks before the earnings date. So if that was at $35 a share, you know, you can imagine how profitable that was because that’s where Yahoo! was three and four weeks ahead of the earnings. And yesterday it traded down to $24. That’s an 11-point move. I’ll guarantee you, if you had the money straddled, the 35 straddle wasn’t trading for $11.
Dupee: Definitely not. You know, back in the “old days” before they allowed computers on the floors, I’m amazed at how you and the other traders could keep all of those numbers in your head, quote a market on them, and then keep track of all the other like bids and offers around the pit for puts and calls and then for ten strikes above and below the market.
How did you all keep track of that before computers? How would you do that as volatilities changed throughout and in fast market conditions. Was there a standard 1/8 or a 1/4 or a 3/8 spread quoted to make a market you made that market?
Najarian: For the last ten years we’ve been using computers that drive our quotes. We call them auto quotes. And basically we feed in our volatilities that we think the stock is going to trade at. And we can move it up or down, you know, at a moment’s notice. But specifically what we’re doing is we’re letting the computer move all the calls up with every up tick of the stock and all the puts down. And then, of course, conversely the computer would automatically move the calls down and all the puts up if the market were to down tip.
Dupee: That’s what you were showing me at one of your trading posts on the floor of the CBOE. Your trader in that pit pushes the button every time he gets hit, clicking the volatility up. And that’s part of the iTradem system you invented with some partners.
Najarian: Yes, exactly. It’s part of our systems, yes. But basically, in the old days we used to have to scream out those bids and offers. And that’s why traders ended up with voices like mine, maybe sort of gravelly or deep or whatever because you’ve been screaming too much. Today there is still open outcry, there’s still that competitive screaming to get some broker’s attention or to trade with another trader. But primarily the computer probably moves 95 percent of all of the quotes you see on your screen. They’re driven by a computer, with every tick of that stock, up or down. And because of that, market makers can make markets in ten times as many stocks. And that’s why we’ve gone from 80 stocks trading on the floor in the early 1980s to now over, I think, 1,600 stocks trading on the floor today.
Dupee: Was it always that way before computers that you would have a standard spread that you’d quote, an eighth? Or what would be your goal in making a market?
Najarian: Our goal was always that we would make and quote the tightest market we could to attract business. Because if I put up a very wide quote, then the customer might figure it’s a roach motel: a stock you check in to, but can’t get out of. So to encourage the volume and to build up an interest, we would narrow the spread in some cases, especially during the late ’80s and early ’90s. In some cases, we would be considerably tighter for the option than the underlying stock (to attract business). On virtually every Nasdaq stock that the option is quoted, the in-the-money calls or puts will probably be quoted at a quarter wide, while the stocks themselves were, of course, wider. There was that class-action suit against Nasdaq that proved they colluded to set their prices a half-point wide of the Nasdaq.
To encourage the volume end of the options, we set our markets inside of that spread. So we were actually taking more risk that the underlying specialists were.
Dupee: And was that arbitrary? How did you come up with that? Just to draw business in?
Najarian: Yeah. I mean stocks, as you know, have been trading on the New York Stock Exchange since, whatever, 1792. And options are really only 27 years old on the listed market. The CBOE began trading them in April of 1973. So they’re relatively young, relatively new. And that’s why, to build business in that new product, we really needed to be better than the underlying. So things like leverage that the customers get with options and the ability to control their risks, all those sorts of things helped build the product. But clearly one of the deciding factors was that we were narrower on our spread than the underlying securities.
Dupee: And now how is that playing out, how are the spreads determined? Is it similar to those days?
Najarian: It’s no longer really that we’re setting a narrow price to encourage business. Now it’s that we have to set narrow prices because that option can trade on the CBOE, AMEX, PHLX or PCX.
So there are four and in some cases five (exchanges) because the ISE, International Securities Exchange also exists. So there are five exchanges that business could be trading at. So basically to compete with the other exchanges, we’ve always thought that our best advertising was our quote. So let me just make a more competitive quote than the other guy, and I’ll get the business.
Dupee: I really liked your book, your well-explained book, How I Trade Options.
Najarian: Oh, thank you.
Dupee: You cover a variety of option strategies – spreads, straddles, strangles, iron butterflies, etc. Of course, it would depend on market conditions, but you’ve been trading for a long time, and I wondered if you have a preference for any one option strategy when trading for your own personal account or for one of your hedge funds.
Najarian: I would have two, really. I mean if I’m looking for that extraordinary move and I want to hit a home run, I’m more likely to be doing a straddle or back spread, because that’s the one that’s going to accelerate. The velocity of profits on those trades is greater than any other trade.
The other – the one we use most frequently is just a directional trade, a bull call spread or the bear put spread. The directional trades, where instead of buying that $80 or $100 stock like IBM, I can buy a 10-point or a 20-point bull call spread and maybe put, you know, only $5 or $10 on the table instead of $100. Those are the ones we think are the best.
Dupee: Excellent. One of the things that struck me when you took me down on the floor of the CBOE back in November was the way that the clerks with their auto quotes manipulated the volatility. And what you told me then was that they would click the button up when volume increases. So it struck me that volume perhaps even more than wide price ranges is the key determinate used to jack up volatilities and thereby option prices.
Najarian: Yeah. We use it as an indicator of sentiment. So once we see a big firm moving in and accumulating a lot, in the column that I write on TradingMarkets, we talk all the time about dollar-weighted volume, falling into a stock.
Dupee: Right. Right. One of the things that you mentioned in the book The Best: Trading Market’s Conversation With Top Traders was you monitored block option volume and that it was a good leading indicator of impending short-term stock moves.
Najarian: Yes.
Dupee: How can the average retail trader get information on block option trades like that?
Najarian: Right now I don’t know of a source, which is why we’re putting it up on our website in the next couple of weeks. The reason we developed it was we didn’t see it anywhere else. And I’m not trying to be sly about this, but I don’t know anybody else that does publish that kind of information. So what we did was we created our own matrix and our own search that scans all of the volume in all of the stocks and then looks for blocks of whatever we see that given day. If it’s a busy day, we might move it up to 500 or 700 contracts. If it’s a slow day, I might drop it all the way down to maybe 300 contracts. But I rarely, if ever, need to drop it down lower than that. Because the other small trades are just fluff. They’re not indicative of institutional buying interest or selling interest of a given stock.
Dupee: So that’s only available on 1010WallStreet.com at this point?
Najarian: Right.
Dupee: Are there any other surrogates that would come close to it so that an average trader can get an indication about block option volume that you’re aware of?
Najarian: If they go to the CBOE’s website, just CBOE.com, it will tell them the most active options that are trading for free. They can go on there. And it will tell them, okay, Cisco is the most active option today. And, you know, it’s trading 60, 000 contracts or something like that. But I don’t know anyplace that takes the data and filters it like we do.
Dupee: You cover a lot in your book, and I know you’re going to be doing several seminars this spring, within the next couple of months for TradingEvents. Is there stuff that’s not covered in your book that you will be teaching at the upcoming seminars or maybe you could speak a little bit about what will be in store at your seminars.
Najarian: Well, given what’s happened in the markets, the most popular stuff that folks want to hear about is how do I fix what went wrong. So those repair strategies that we talk about in the book are probably the most popular and most frequently asked questions for us at those seminars. So we cover that in great detail.
You bought a stock. It’s now down 30% or 40%. Is there anything you can do to fix it if you still believe in the stock but you’re no longer comfortable with the prospect of waiting for that recovery which might be years? Is there a strategy, an option strategy you could employ to help you right now? And our answer is, of course, yes, there is.
So that’s the sort of thing, we’re going to cover. We’re going to spend a lot more time than I could in the book on things like LEAPS, those long-term options and how customers can use those as a surrogate. At our brokerage firm, the folks that have used those as a surrogate have done substantially better than the folks that have been in straight equities because, you know, the straight equity buyer is subject to a lot more volatility and they’ve got a lot more money on the table. So the LEAPS can help them use leverage in their favor and it can also allow them diversification into other stocks so they are not in that thing that I call the “right church, wrong pew” (where a trader might be in the right sector but the wrong stock).
Dupee: So you’re going to have some of your traders at these seminars to help attendees do drills and walk away from that seminar able to take the strategies and immediately apply them?
Najarian: Yes. We’re going to have several of our traders with me at the seminars. We’re going to give them this good solid information for two days. In the case of the Chicago seminars, we’re actually going to bring them down into the pits (of the CBOE) and let them do some trading, you know, with funny money rather than having to put the real dough on the table. And we think that for the customers that need it or want it, they’ll be able to counsel with the brokers from our firm and actually design various investment strategies if they’re clients of our brokerage. That’s one of the services we provide.
Dupee: Excellent.
Najarian: They’d be able to sit there and say, “Hey look, I’m a very risk-tolerant guy and I’d like to be more heavily invested in these sectors.” We’d map out, you know, an option strategy for them in those sectors. So that’s something that we think will really benefit the customers that are both active and need a little bit of handholding.
Dupee: How much capital and how much training in either hours, weeks, months, or years do you believe that somebody new to options who is a dedicated and disciplined individual would need to make a living of, say, $100,000 a year trading options?
Najarian: If – let’s see. I’d say, if you had a $300,000 account and you were not day trading, you were just making longer-term investments, it would be very attainable to do that. If you’re an active trader, you know, as a customer, an active option trader, for you to look at having maybe only 150 or 200 to make that same – to meet that same goal, I think that’s very doable also. And I can’t really imagine too many opportunities unless you’re just, you know, one of the lucky guys who gets the insider track on a hot idea where you’re going to be able to say that with straight equity investments.
Dupee: And how many hours or weeks do you think it would take someone who’s dedicated to acquire the skills and become proficient enough to be able to do that?
Najarian: Reading books like the one that I’ve written and/or attending some sort of conference would really speed up the process. But I’d say for the most part, people should give themselves two to three months to get comfortable with it before they’re really ready to start making larger investments and larger profits.
Dupee: Full-time study?
Najarian: No. I’d say part time, but doing it actively and continuously.
Dupee: I got you.
Najarian: So probably reading or doing some sort of practice with it every day, five days a week.
Dupee: The ITradem system is now in widespread use on the floor of the exchange, right?
Najarian: Yes, it is.
Dupee: And in the book, you forecast it has the potential to become an ECN, perhaps even the first option ECN. Has ITradem evolved into a de facto option ECN or how is that playing out?
Najarian: Well, right now where it stands is Merrill Lynch has a verbal commitment with us. Merrill Lynch is going to take a seven-figure investment in us. That’s really going to ramp up our critical mass that we can build because they are going to pay for a lot of the infrastructure to build out what we hope will be that first options ECN. Right now we’re doing millions and millions of shares through the system every day and tens of thousands of options contracts. At this point, I’d say maybe six months from now, we’d be at the level where we could seriously look at–and we have spoken to two of the big options exchanges about being a facility that we could run on their floor–being an ECN.
Dupee: I see. And if that occurs, do you think that this will continue to level the playing field for retail options traders?
Najarian: Absolutely. The fact that a customer might be able to get a shoot in a spread, for instance — right now there’s no facility anywhere that allows the customer to send a bull call spread down as a spread and let people bid on it in an auction-like fashion. Instead, it’s just sent to one exchange and the guys on that exchange look at it. They may, or may not, share any information with the outside world.
With our system, people would see that somebody’s willing to buy 10 times the 65 calls and sell the 75 calls. And instead of just kind of getting a little click, or whatever, involved with doing that pricing, all of a sudden, perhaps even another customer could interact with that order and say, “You know what? I’m bearish on that same stock that this guy’s bullish on, and I’m going to sell that thing.”
So I think that the more we can widen out the number of players and expand the base, the better prices are going to be for everybody getting in and getting out of the market.
Dupee: There was a lasting message that I walked away with after spending that afternoon in November (2000) with you down to the floor. We were sitting up there on the observation deck above the AOL pit watching your brother Pete trade. And you were sitting there talking about that discipline. You mentioned, for instance, in giving examples about discipline that Pete, who played pro football for years, goes to the gym every day for one hour, no matter what. And that he only drinks coffee on Fridays. Could give us your thoughts about the importance of discipline in trading?
Najarian: Sure. As you know, Marc, from being involved as much as you are, no one is going to make any money in this market if they’re not disciplined. A lot of folks get lucky and make some money. But those folks usually make a small fortune. Unfortunately, they usually at some point had a big fortune and they turn it into a small fortune because they didn’t have discipline.
So what we think is that, unless you’re just as lucky as the guy who created Broadcom and sold it to Yahoo! at the absolute top, there’s virtually no way you will have that kind of a fantastic windfall.
The lack of discipline on any investor’s part will mean that they’re not going to be successful, long term. And that’s the single biggest reason why we would not hire a trader that didn’t have discipline. They could be slightly slower than another trader, they could be smaller physically, even though in the pit physically large guys do have an advantage–they take up more space. They can yell loud and all that sort of stuff. But this guy could be substantially less physically imposing a figure and be much more successful if he’s got more discipline. So discipline is the number one criteria we use to select traders. And I have no doubt that a customer without a trained discipline won’t be lasting very long.
Dupee: What does discipline actually mean here?
Najarian: Specifically the biggest things I’ve seen — the problems that everybody has are when they make an investment and they don’t have a goal for the trade. Now, I don’t care if it’s a trader on TradingMarkets, you know, that really is a true trader–that jumps in and out of the market in a quick-twitch fashion–or if it’s an investor. If you buy that thing, you’ve got to have a goal for the trade. Now, a quick-twitch trader might have a goal of, you know, I’m going to take a half a buck out of this and I’m gone. Fine. So then, you’ve already defined what your goal is. You’ve got to be able to set your loss the same way.
So you say, “My goal in this trade is I think for the next 10 minutes AOL is going to rally as they approve the Time Warner deal.” Fine. You buy it. If it starts going against you, you cut that loss at the same half-point level. But you can’t eat like a bird and defecate like an elephant. So if you’re not willing to take losses and cut them in a very unemotional way, you won’t make it. Especially when you get to our level with the amount of leverage we use. Because we’re using a hundred times more leverage than a customer is. So that just means that the mistakes are exaggerated a hundred times more.
Dupee: So the primary thing, then, is being able to cutting your losses as quickly as possible.
Najarian: Yes. We will let the profits worry about themselves. We worry about cutting the losses.
Dupee: Gotcha.
Najarian: And I’ve never seen a successful trader that didn’t have those traits.
Dupee: Great. Listen, thanks very much for taking the time, Jon, and good luck out in San Diego.
Najarian: Absolutely, Marc. Thank you.