The New Market Wizards: Conversations with America's Top Traders (52 page)

Exactly.

Can you give an example of how this adjustment process works?

A current example is NCR, which is a takeover target of AT&T. AT&T’s bid is $110, and the stock is currently trading at approximately $106. If the takeover goes through, the buyer of the stock stands to make about $2. (About half of the difference between the current price and the takeover bid represents interest rate costs on carrying the stock.) If, on the other hand, the takeover falls through, then the stock can drop sharply—to about $75 based on current market estimates. In this particular case, the relatively close calls are essentially worthless, because the stock is unlikely to go above $110. On the other hand, the much further out-of-the-money 90 puts have some chance of gaining significant value in the event the takeover fails. Thus, in this type of situation, the out-of-the-money puts will be priced much higher than the equivalent out-of-the-money calls.

In other words, this is an example of how an option pricing model could yield very misleading projections in a real-world situation.

Right, because the standard model assumes that the probability of any individual tick being up or down is 50/50. That, however, is not the case here because there’s a much greater probability for a large price decline than a large price rise.

At one time, the mathematical types traded straight off their models, and in a situation like the one I have just described, they would sell the out-of-the-money puts because they appeared to be priced too high. However, the seat-of-the-pants types would look at the situation and realize that there was a real possibility of the stock witnessing a large decline [i.e., a breakdown in the case of a takeover]. The traders using a commonsense approach would end up buying the out-of-the-money puts from the mathematical types and taking them to the cleaners in the process. Eventually, the mathematical types caught on.

In your day-to-day operations, do you basically start off by looking at the model and then making certain mental adjustments?

Exactly. Our basic philosophy is that we have tremendous respect for market opinion. For example, if we believe an option is worth $2 and a knowledgeable market maker is bidding $2 1/2, we assume that nine times out of ten he’s going to be right, because he’s trading one stock and we’re trading five hundred. We will then try to figure out why he’s bidding $2 1/2. If we can identify the reason and we disagree with it, then we may sell the option because it’s overpriced. But most of the time, we’ll decide that his knowledge is better than ours, and we’ll end up adjusting our valuation on the other options in that stock and then buying these other options or the stock itself.

When you adjust your option valuations because someone else is bidding at a price that appears to be removed from the theoretical value, are you simply assuming that they know more about the given company?

Yes, information doesn’t exactly flow perfectly, like they teach you in Finance 101. Frequently, the information will show up first in the option market. A lot of these insider trading cases involve options, and we’re the people who lose the money.

For example, just today they caught an employee of Marion Labs who obviously had inside information that Dow was going to offer a takeover bid for the company. This person had bought five hundred of the July 25 calls at $1 [total cost: $50,000], and the next day the options were worth $10 [total position value: $500,0001. In the old days—before options—someone with this type of information might buy the stock, and even assuming 50 percent margin, the profit percentage wouldn’t be that large. However, now, by buying options, traders with inside information can increase their profit leverage tremendously. Sometimes I feel sorry for some of these people because, until the recent barrage of publicity regarding insider trading, I’m not sure that many of them even realized they were breaking the law. However, since they come to the options market first, we’re the ones on the other side of the trade getting picked off.

I don’t understand. Doesn’t the SEC scrutinize the order flow when there’s an announced takeover to make sure there are no suspicious orders?

Yes, they do, and they’re getting particularly effective in catching people trading on insider information. They have also become much more efficient in returning money to those on the other side of these trades. However, in earlier years, the process took much longer.

One famous example involved Santa Fe, an oil company that was a takeover target by the Kuwaitis in 1981. At the time, the stock was at $25 and the option traders on the floor filled an order for one thousand 35 calls at $1/16. Shortly afterwards, the stock jumped from $25 to $45 and the options went from $1/16 to $10. The floor traders had a virtual overnight loss of about $1 million. Although they eventually got their money back, it took years. If you’re a market maker and you’re broke, waiting to get your capital back is not pleasant. You live in fear that you’re going to be the one selling the option to an informed source.

Eventually, everyone gets picked off, because if you try to avoid it completely, you’re going to pass up a lot of good trading opportunities. In a nutshell, if you’re too conservative, you won’t do any trades, and if you’re too aggressive, you’re going to get picked off a lot. The trick is to try to strike a balance between the two.

Can you think of a recent example in which you were picked off?

The options for Combustion Engineering are traded on the Pacific Coast Exchange. The options rarely trade. One morning, we received a call from the board broker (the exchange employee responsible for managing order imbalances). He said there was an order to buy several hundred options and inquired whether we wanted to take the other side. The stock was trading at around $25, and we agreed to sell three hundred of the 25 calls at approximately $2 1/2. Ten minutes later, trading in the stock was halted, and there was an announcement that the company was being taken over by a European corporation. When trading resumed several minutes later, the stock reopened at $39, and we were out over $350,000 in a matter of minutes. It turned out that the buyer was on the board of directors of the acquiring company.

What ultimately happened?

In this particular case, we’ve already gotten our money back. The SEC identified the buyer quickly, and because the individual was a high-level foreign executive who didn’t even realize he was doing anything illegal, he returned the money without any complications.

Given that consideration, aren’t you always reticent to fill a large option order in a market that normally doesn’t trade very often?

There’s always that type of reticence, but if you want to be in the business, it’s your job to till those types of orders. Besides, in the majority of cases, the orders are legitimate and nothing happens. Also, under normal circumstances, we hedge the position after we fill the option order. In the case of Combustion Engineering, the stock stopped trading before we had a chance to buy it as a hedge against our position. We still would have lost money, but not as much as we did being completely unhedged.

The more successful the SEC is in catching people trading on inside information—and lately they seem to be catching everyone—the tighter the bid/ask spreads will be. Every trade we do involves some risk premium for the possibility that the other side of the trade represents informed activity. Therefore, if everyone believes that the SEC is going to catch all inside traders, then the market will price away that extra risk premium. In essence, it’s really the average investor who ends up paying for insider trading through the wider bid/ask spreads.

When stocks have large overnight moves, is that type of price action normally preceded by a pick up in the option volume?

Almost always. If you go over the volume data for stocks that were taken over, you’ll find that there was almost always a flurry of option trading before the event.

Do you do any directional trading?

None. It’s my firm belief that the market’s wisdom is far greater than mine. In my opinion, the market’s pricing of an item is the best measure of its value. The odd thing about believing in efficient markets is that you have to surrender your beliefs and ego to the markets.

Several years ago, a director of the Office of Management and Budget made a statement that budget projections should be based on the assumption that long-term interest rates would eventually decline to 5 to 6 percent, at a time when rates were over 8 percent. The market-implied interest rate level reflects the net intelligence of thousands of traders battling it out daily in the bond market. In comparison, the OMB director’s personal opinion doesn’t mean anything. If he’s basing government policy on the assumption that long-term interest rates will be 5 to 6 percent, when the market’s best guess is 8 percent, he’s doing grave harm to society. Presumably, if he were smart enough to predict interest rates better than the market, he could make a fortune trading the bond market, which he obviously can’t do.

My guess about where interest rates will be in the next twenty years is better than that of almost any economist, because all I have to do is look at where the bond market is trading. If it’s trading at 8 percent, that’s my projection. Someone can spend millions of dollars developing an elaborate interest rate forecasting model, and I’ll bet you that over the long run the bond market’s forecast will be better. The general principle is that if you can give up your ego and listen to what the markets are telling you, you can have a huge source of information.

I know that your bottom-line advice to people regarding trading is: Don’t think that you can beat the market. However, is there any advice you can offer for those who do participate in the markets?

If you invest and don’t diversify, you’re literally throwing out money. People don’t realize that diversification is beneficial even if it reduces your return. Why? Because it reduces your risk even more. Therefore, if you diversify and then use margin to increase your leverage to a risk level equivalent to that of a nondiversified position, your return will probably be greater.

I tend to agree. I like to say that diversification is the only free lunch on Wall Street.

The way I would put it is that not diversifying is like throwing your lunch out the window. If you have a portfolio and are not diversifying, you’re incinerating money every year.

The type of professional option arbitrage trading in which Yass engages obviously has little direct relevance to most ordinary traders. However, there are still some significant messages here that have broader application. Perhaps Yass’s most important point is that it is critical to focus on maximizing gains rather than the number of wins. One obvious application of this concept is that regardless of your trading style, a betting (i.e., trading) strategy that increases the stakes on trades deemed to have a higher probability of success could significantly enhance the final results. Another point emphasized by Yass is that our initial impressions are often wrong. In other words, beware of acting on the obvious.

“We has met the enemy, and it is us.”

The famous quote from Walt Kelly’s cartoon strip, “Pogo,” would provide as fitting a one-line summation of the art of trading as any. Time and time again, those whom I interviewed for this book and its predecessor stressed the absolutely critical role of psychological elements in trading success. When asked to explain what was important to success, the Market Wizards never talked about indicators or techniques, but rather about such things as discipline, emotional control, patience, and mental attitude toward losing. The message is clear: The key to winning in the markets is internal, not external.

O
ne of the hazards of doing a book of this sort is that you can go through the arduous process of transforming a rambling 250-page raw transcript into a readable 25-page chapter only to have the interview subject withhold permission to use the material. (In order to provide an atmosphere conducive to openness on the part of those I interviewed, I felt it necessary to offer them the right of final refusal.) One of the traders I interviewed, an individual who had made several hundred million dollars in trading profits for his firm, felt that the resulting chapter, which contained a lot of copy related to intuition, dreams, Eastern philosophy, and trading anecdotes, presented an image of him that would be viewed askance by his corporate clients. I prevailed upon him, however, to allow me to use the following excerpt anonymously, as I felt it offered an unusual and insightful perspective on trading.

I still don’t understand your trading method. How could you make these huge sums of money by just watching the screen?

There was no system to it. It was nothing more than, “I think the market is going up, so I’m going to buy.” “It’s gone up enough, so I’m going to sell.” It was completely impulsive. I didn’t sit down and formulate any trading plan. I don’t know where the intuition comes from, and there are times when it goes away.

How do you recognize when it goes away?

When I’m wrong three times in a row, I call time out. Then I paper trade for a while.

For how long do you paper trade?

Until I think I’m in sync with the market again. Every market has a rhythm, and our job as traders is to get in sync with that rhythm. I’m not really trading when I’m doing those trades. There’s trading being done, but I’m not doing it.

What do you mean you’re not doing it?

There’s buying and selling going on, but it’s just going
through
me. It’s like my personality and ego are not there. I don’t even get a sense of satisfaction on these trades. It’s absolutely that objective. Did you ever read
Zen and the Art of Archery?

No, I have to admit, I missed that one.

The essence of the idea is that you have to learn to let the arrow shoot itself. There’s no ego involved. It’s not, “I’m shooting the arrow, and I’m releasing it.” Rather, the arrow is shot, and it’s always right.

The same concept applies to trading. There’s no sense of self at all. There’s just an awareness of what will happen. The trick is to differentiate between what you
want
to happen and what you
know
will happen. The intuition knows what will happen.

In trading, just as in archery, whenever there is effort, force, straining, struggling, or trying, it’s wrong. You’re out of sync; you’re out of harmony with the market. The perfect trade is one that requires no effort.

You talk about knowing what will happen. Can you give me an example?

The current decline in the mark versus the yen is something that I just knew would happen.

Before the mark went down versus the yen, it had trended in the other direction for quite some time. How did you know when the timing was right for the trade?

The trigger was actually a Freudian slip. I was talking about the yen/mark rate with another trader when it was trading at 87.80. I kept on referring to the price as 77.80. The other trader finally said, “What are you talking about?” I realized that I was off by ten big figures in my price references. Obviously, there was some part of me that was looking for the rate to go down to that level. It was literally bubbling out of me.