Bob Pisani: Options Insider
 |
| Bob Pisani |
It may seem like ancient market history to some, but it really wasn’t that long ago (a little over 20 years) that listed options burst into the world of finance. For several years after, the options market, while prosperous, was still considered the new kid on the block–the province of professionals and only the most astute investors.
It was a new frontier, and there were any number of fortunes made (and lost) as traders explored the possibilities of these new instruments. TradingMarkets.com co-founder Bob Pisani was there at the beginning–he was one of the pioneers in the new frontier. He came from a different discipline than many traders–mathematics, rather than business or finance–but his background was precisely what enabled him to develop the trading models that made him and his firm one of the first major players in the options market.
His interest in the markets stretches back to graduate school. After receiving a Ph.D. in statistics from the University of California at Berkeley in 1971, Bob joined the faculty, conducting extensive research on the securities and options markets. This research led to the development of sophisticated mathematical options models and trading strategies–strategies that, at the time, could only be traded “on paper” because organized options markets did not yet exist.
That all changed in 1975 when listed options first became available for trading on the Chicago Board Options Exchange (CBOE) and the Pacific Coast Stock Exchange (PSE).
| “In the 1970s you could find actual arbitrage opportunities, where there was no chance of loss” |
Taking advantage of the opportunity to apply his strategies in real markets, Bob founded a market maker firm, Galton-Gauss Securities, that traded on the Chicago Board Options Exchange (CBOE) and the Pacific Coast Stock Exchange (PSE) with the express purpose of “achieving extraordinary gains.” Using Bob’s proprietary option trading models, Galton-Gauss did just that for the next half-dozen years.
Bob has continued to trade as well as research and test successful options trading models. He also is a visiting scholar at the University of California at Berkeley. You can access his options indicators (updated nightly) and commentary (every Tuesday and Thursday) through the Option Traders section of TradingMarkets.com. We talked about the growth of the options market, and the general principles of option trading traders need to understand to prosper. Bob was quick to point out that, popular perceptions aside, the concepts option traders need to grasp are not as complex or intimidating as many think.
Mark Etzkorn: You first started doing options research before exchange-traded option came into existence. How did you first get interested in the subject?
Bob Pisani: In the late 1960s there was a little group of grad students at UC-Berkeley who were interested in markets–Richie Sandor, Victor Niederhoffer, Bar Rosenberg, some guys from Ag Econ, just people you encountered in looking for information on markets.
| “There is always an edge–you just have to look a little harder today” |
Paul Cootner was teaching commodities at Stanford and was reputedly making a lot of money trading commodity spreads. I was a graduate student nosing around this information just like the others, but most of them were in Business Administration or Agricultural Economics, and I was a mathematician and looking for something with a little clearer internal structure. Ed Thorp, a mathematician from UC-Irvine, had published a book called “Beat The Market,” which described his approach to warrant hedging, and this area seemed to lend itself better to a more rigorous mathematical approach. I felt that I might have a natural edge there, so I started looking into it.
Mark Etzkorn: What were the practical results of your research? Did you come out of it with a specific trading approach that you were able to apply in the markets?
Bob Pisani: More like a model, based upon market price behavior. This led to valuation techniques for options and other convertible securities, and when exchanges began trading options I was ready to use these models and these techniques right away.
Mark Etzkorn: How has options trading changed since you first got involved? How did you trade then vs. now?
Bob Pisani: It has become much more efficient. In the 1970s you could find actual arbitrage opportunities, where there was no chance of loss. The markets were no so naive that you could purchase an option for less than intrinsic value, but you could buy butterflies for a credit, sell premium which had to disappear, and other things like that.
| “It is hard to get hurt with backspreads if you keep your positions small” |
The Black-Scholes model had been published and Fisher Black started writing a newsletter for options traders that went out to clearing houses and was read by the more adventurous options market makers, Blair Hull began publishing tables for option traders on the PSE floor, and other little services arose that gave market makers option values and deltas. As the market became more educated, the outright arbitrage opportunities disappeared. Slowly, the market adjusted and people stopped giving away money. The market today is far more efficient than it was back then, even than it was in the early 1980s.
Mark Etzkorn: What can the average option trader do today to gain an edge, given the efficiency you talk about?
Bob Pisani: There is always an edge. You just have to look a little harder today. You have to understand the basics and to be more selective in your trades. The market hasn’t totally stopped giving away money, it’s just gotten less generous.
I’ve written in several commentaries how high-return trades get passed on to people who are happy with lower returns. I’ve also written about how you can detect unusual trading that may signify inside knowledge. There are a thousand little tricks you can use. But you can’t just go out with your hat in hand and expect the market to fill it with money. You’ve got to work at it with understanding. But you can still do it.
Mark Etzkorn: If you had to pick a single concept or idea that is most important for options traders to understand, what would it be?
Bob Pisani: Value and volatility. Those are two items, but there are in a sense one concept, and that is something a trader should understand.
Mark Etzkorn: That leads to finding options that are underpriced or overpriced. What’s the best way to do this?
| “The selling premium side is the most dangerous” |
Bob Pisani: You have to have access to a computer program that will scan for you. We do some of this on the TradingMarkets.com Web site each evening. but if you want to get serious you will have to get a real-time data feed and a program that can scan for you during the day.
Mark Etzkorn: Do you think there is a primary misconception about options and options trading that makes it difficult for many traders to prosper in this area?
Bob Pisani: I think the main misconception is that the technology is intrinsically difficult to understand. But it really isn’t. It requires some effort, and trading options is not as easy as just jumping in and buying a corn contract, but I think I can make most options concepts clear to the average bright high school kid.
Mark Etzkorn: If a beginning options trader was looking for one or two strategies to use as he or she was “learning to play the game,” what would you suggest?
Bob Pisani: I would look for backspreads where the edge is very strong in your favor. Be very selective and wait for the best ones. It is hard to get hurt with these if you keep your positions small, and you will learn a lot about how options behave by monitoring and adjusting your positions.
Mark Etzkorn: What aspects of market behavior do such strategies allow you to exploit?
Bob Pisani: You wind down a backspread by taking regular profits. This is its really interesting characteristic. I’ll write an advanced article about this sometime. When you see it happen, you see exactly how the market’s volatility is giving you money, and you see what is necessary to happen for your position to be profitable.
Mark Etzkorn: Do you think option can be useful short-term trading tools, say, for positions five days or less in length, or are they more suited to longer-term plays?
Bob Pisani: Five days is a short time, but if you are really on top of volatility variations you can do quite well with such short-term positions. It does require that you have a good handle on volatility, on IV, time decay, etc.
Mark Etzkorn: Is it true that most professional option traders sell options (sell premium), in one form or another? Is that the route the astute individual trader should take?
Bob Pisani: No. The professionals who last find a strategy that they like and they hone it. Selling options–I assume you mean naked–is not a strategy that you will continue to like for a very long time. Professionals use software like Osrt3 or one of the other packages, or else they assemble their own package from the various tools available, and they develop spread strategies that give them a regular and persistent edge. They sell premium when it is high, but hedge by purchasing other options or the underlying market, and they buy premium when it is low, and again, for the most part hedge by selling something against it for protection. The selling premium side is the most dangerous. The ones who last always protect their short premium positions with offsetting long premium positions, or a position the underlying. The ones who don’t do that don’t last.