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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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I find it difficult to believe that youre still one of the slowest traders==== Having toured your operation, I find it difficult to believe that youre still one of the slowest traders. ==== Well, probably not anymore. Were highly automated now. But my on-the-ftoor experience has made us much more inclined to look for less obvious markets in which to offset trades. We look for trading opportunities between less correlated markets. ==== Do yon try to keep the firms total position basically hedged all the time? ==== I try to have a zero delta portfolio [a portfolio that is neutralized relative to directional moves in the market]. The net delta of the firms portfolio [i.e., the contract equivalent net long or short position] is reevaluated within two seconds each time any of the traders makes a new trade. There is a feedback process so that each trader knows this information instantaneously and therefore knows in which direction to lean. ==== In other words, if the firms 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 firms net exposure to price changes is as close to zero as possible]. You might say hes the air traffic controller. ==== So the individual traders can buy whatever they think is cheap and sell whatever they think is high, even if its a one-sided trade, because they know that the air traffic controller will make sure that the firms net position stays close to neutral ==== Exactly. When theres an edge on a trade, pan 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 tor 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 dont 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 its 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... . ==== Youve 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-themoney calls and they usually sell their option positions prior to expiration because they dont want to exercise them. For example, lets 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 publics edge. The system provides an automatic execution within ten seconds or so. ==== Why do you say its the publics 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 be better off using this execution system. ==== What do you think are some of the key characteristics or traits of a successful options trader? ==== You cant 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 Ive 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. Theyre too interested in whos 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 wasnt going to happen? ==== I havent realized that yet. Im 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 dont know what your method is, you dont 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 dont 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, Weve noticed that youre making too much money. You cant 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 mu&t 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 Ustons The Big Player, the book written about the blackjack team that Hull described in. the interview: Listening to Barry narrate his horror story. Ken thought back to a day several weeks earlier when a broker friend who counted cards had come over to his apartment to discuss his favorite subject-losing. Ever since extreme negative swings had led to his personal Las Vegas wipeout several years ago, the man approached the blackjack pit conservatively. He warned Ken about the dangers of the teams escalating betting level. Those swings are wild, Kenny. Im telling you, they can really hurt you. Watch out. So far you guys have been lucky, but those swings are there. 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. Hulls 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. |
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