Jon Najarian: Mercury Rising
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| Trader Jon Najarian
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Option trader Jon Najarian got the name for his market maker firm, Mercury Trading, in 1989 when he was looking out his window at the gilded statue of Ceres, the Greek goddess of the harvest, that stands atop the Chicago Board of Trade and watches over the financial corridor of LaSalle street.
“I decided I wanted a cool name like that,” Najarian remembers. “I picked up a book on mythology and flipped through it till I came to Mercury–the god of commerce, markets, and the protector of traders. I said to myself, ‘Okay, this is it!'”
The gods of trading have indeed been good to Najarian since he entered the markets in 1981. From clerk to floor trader, to founder of his own market maker firm and hedge fund manager, Najarian has scaled the heights of his profession. One of the top three option floor trading firms in the country, with operations on every exchange in the U.S., Mercury trades around 25-40,000 options and three million shares of stock per day.
Najarian’s trading career owed a great deal to happenstance in the beginning. He originally came to Chicago in 1981 to play football for the Chicago Bears, but his career turned out to be a brief one. He played four games with the team as a linebacker but was released after future Hall of Fame linebacker Mike Singletary, who had been holding out, resolved his contract dispute.
But Najarian learned something during his time with the team: He discovered that many of the people who came by to watch he and his teammates toil under the hot sun during practices were traders and brokers. “I was jealous because we were out there sweating and they were just sitting there watching us,” he notes.
After his release from the Bears, his agent had offers for him to play football in Canada, but Najarian said he’d rather hang up his cleats and try to become a stockbroker. His agent, who also owned a seat on the fledgling Chicago Board Options Exchange (CBOE), told him to instead pursue a career as a floor trader–that was where the action was. Najarian decided to give it a go. But he hardly started out at the top.
“He (his agent) made me an offer I couldn’t refuse,” Najarian says, laughing. “He said, ‘I’ll let you come down and work for me for free.'”
| Whenever customers try to compete against the market maker, they lose. |
What Najarian needed was experience, and he got it. He clerked for six months, unpaid, along with two other athletes–a hockey player and a skier–his agent had brought down to the CBOE floor. At the time, many traders and trading companies were trying to groom new floor traders to take advantage of the opportunities in the new and growing options markets, often looking for certain types of people–chess players, backgammon players, bridge players–thought to possess skills suited to options trading. Athletes were another group in demand: Their competitive natures and quick reflexes were an undeniable asset in the lightning fast, rough-and-tumble world of floor trading (which has long been one of the more popular second careers of retired athletes.)
Najarian found he was indeed suited to the floor. After serving his apprenticeship, he bought a limited exchange seat on the CBOE (which allowed him to trade options on 16 stocks) and starting trading. It was a bit slow at first, but things picked up when he moved up to a full seat after a few months. With his soon-to-be famous floor badge of DRJ (“Doctor J”), he settled down in the busy IBM pit–the largest equity option pit on the exchange–and stayed there for the next ten years, establishing himself as one of the exchanges bigger and better-known traders.
His success led him to found Mercury in 1989, which also manages over $8 million in two hedge funds (started in 1997). He now spends most of his time trading “upstairs,” managing the funds, as well as making television appearances and hosting seminars.
Because he started just as listed options markets were in their infancy, we first asked him about his early experiences and how he–and the markets–have evolved.
When you started out, what kinds of strategies did you trade?
Mainly time spreads and volatility, where I was buying volatility when it was cheap and selling it when it was expensive. Generally speaking, I’m a backspreader (backspreads are also known as ratio spreads). I buy premium. I will sell it sometimes, but I prefer to buy it because you get to trade the market instead of the market trading you. Long backspreads work when the market moves, which has certainly been the case this year. If you were selling backspreads, you’d want low volatility–less market movement–and you’d benefit from that and the time decay.
How did you determine what qualified as high or low volatility?
| The first thing to understand is that volatility can be a blessing or a curse. |
The professional firms used computers to do their analysis, of course. But not everyone had one. They didn’t even allow computers down on the floor in the early days, so anyone who had access to one really had an edge in terms of pricing. Now everybody has one, and you can get almost any information you’d want off the Internet–everybody knows when something’s expensive or when it’s cheap. Back then, they had no idea–only the real pros knew. The floor trader’s edge was much greater when I started.
How has your trading changed over the years? Are you doing anything differently now?
There aren’t really new strategies. But you have to know that you can’t do the same strategy in every market and expect it to work. 1997 through 1999 have been bad years for vertical spread traders, because the market has for the most part been moving up so furiously that, like Victor Niederhoffer, you probably got your faced ripped off.
| Most successful retail traders know how to use simple strategies like 1:1 call or put spreads, not butterflies and things like that. |
The people who made a lot of money on the AOLs, Yahoos, Intels, and Ciscos and all the other stocks that have moved around a lot, have either been flat volatility and just traded, like all the new day traders, or people who understand that you give up something when you buy options, because they decay, but you get a lot in return because you can sell more as the market is rising and sell more as the market is falling–which is the most sane way to trade, really.
With the proliferation of technology, what’s your edge on the floor now?
As market makers, most of the edge we’re able to capture is on the bid and the offer. The customers–retail options traders–aren’t our competition. And whenever the customer tries to compete against the market maker, they lose. This doesn’t mean they can’t make money trading options, it just means they can’t compete with people that are right there in the AOL pit buying on the bid and selling on the offer. No matter how fast your connection is to get your order in through a broker and down to the floor, it’s at least a step behind the floor trader who just has to shout “Buy ’em!” or “Sold!” Even if it’s just one second, it’s a big difference.
The option market maker’s edge used to be that we knew what the options were worth and most of the Street didn’t. Now our edge is that we can buy them in a fraction of a second and then get hedged. For the most part the market has weeded out the “cowboys” who just want to trade deltas–there aren’t too many of those guys left on the floor.
| Whenever you buy an option, you’ll lose if the expected happens. |
Most good traders now trade so they’re hedged within 10 to 15 seconds after buying or selling an option. If you go into the OEX, SPX, or into Amazon.com or Yahoo, for example, from the time a trader buys or sells, he’s out of that trade in 10 to 15 seconds. That’s why we’re not the customer’s competition. Our competition is the rest of the exchange membership on the floor. The customer’s competition is everyone else trading off the floor, and the question is, do they know what the hell they’re doing?
What kind of strategies are best for off-floor traders to use in the options market? What should they understand?
The huge run-up in the prices of the Internet stocks and a lot of other tech stocks has pushed customers toward looking at options instead of stocks because of their flexibility and margin advantages–trading 1000 shares of a $200 stock is unreasonable for most people.
The first thing to understand is that volatility can be a blessing or a curse. Volatility is often very high right before earnings because no one is really sure what the earnings are going to be. As soon as earnings are announced, that volatility drops like a rock. Think about what happened in AOL recently. Its volatility dropped from 120 to 80. So, if you owned an option trading for $5, and volatility drops 40 points, that option goes from $5 to $3 1/4. A lot of professional option traders like to sell premium before earnings.
As soon as option traders understand how volatility works, they want to know how to lessen the potential negative impact: ‘How can I limit how bad things can get when I’m wrong?’ A simple strategy is just to use a 1:1 call spread, buying the 90 call and selling the 100 call, in a bullish situation, or a 1:1 put spread, buying the 100 put and selling the 90 put, in a bearish situation. These are simple trades, but they make a lot of sense in the right situations–great risk-reward ratios. Most successful retail traders know how to use strategies like these, not butterflies and things like that.
Whenever you buy an option, you’ll lose if the expected happens. In other words, the options are priced as if the likelihood of stock XYZ moving between price A and price B is, say, 80%. If you buy that option, you’re not buying because you want the stock to trade between A and B, you’re buying it because you think it’s going to break out of that range. Conversely, you’d sell it if you think it going to stay within that range.
What kinds of things do you try to alert people to in your advisory service?
When a large buyer or seller enters the market, they throw supply and demand out the window. If someone’s buying 2000 of a particular call, the crowd isn’t going to stand in the way. They’ll sell, but they’ll keep moving the price up–a couple hundred at once price, a couple hundred more at another price, say, up to a half-point higher from where the buyer started. That volatility just got pushed way up. The same thing happens with a big sell order.
We report on things like these big supply and demand imbalances when they occur. It’s a way of understanding what’s happening in the market. For example, the options action could be telling us there’s a possible takeover in MediaOne, or there might be a product liability settlement in Phillip Morris because people are in there selling puts like crazy, and so on.
What’s the idea behind the hedge funds you’ve started?
One of them is a protected index fund. We basically buy the S&P 500 and buy long-term puts against it, then ratio sell calls into it. In that scenario we have downside protection from the puts when the market makes corrections like the one on Wednesday (May 5). If the market makes a 10% correction, we’re not going to get clocked. We’re protecting people against a fast meltdown in the S&P.
What it boils down to is that I own the S&P 500, I own a long-term put, and I try to pay for that by selling short-term, out-of-the-money calls. That’s a fund we started in July 97, and from them to now we’re within one percentage point of the S&P 500. Our other fund takes the same approach with the NASDAQ 100. We’re trading about $8 million in these funds right now.
Jon Najarian will be our guest in our next live Trader Forum. He will answer your trading questions beginning at 7:30 p.m. Eastern time, Thursday, May 13. Come join the discussion and learn from one of the top pros in the business!