Investing in Options

Who are they?

In many respects, option trading is a game of strategy, much like competitive sports or chess tournaments. The main difference is that in trading there are more players and multiple agendas.

To succeed, it's important to have a knowledge and appreciation of the other players. In general terms, you must gain an appreciation for the behavior and motivations of the different players.

In the option markets, the players fall into four categories:

  1. Option Exchanges
  2. Financial Institutions
  3. Market Makers
  4. Individual Investors

What follows is a brief overview of each group along with insights into their trading objectives and strategies.

Option Exchanges

The exchange is a place where market makers and traders gather to buy and sell stocks, options, bonds, futures, and other financial instruments.

Since 1973 when the Chicago Board Options Exchange first began trading options, a number of other players have emerged. These include the Pacific Stock Exchange (PCX) in San Francisco, the Philadelphia Stock Exchange (PHLX), the American Stock Exchange (AMX) and the most recent addition, the International Stock Exchange (ISE). At first, the exchanges each maintained separate listings and therefore didn't trade the same contracts. In recent years this has changed.

Now that these exchanges list and trade the same contracts, they compete with each other. Nevertheless, even though a stock may be listed on multiple exchanges, one exchange generally handles the bulk of the volume. This would be considered the dominant exchange for that particular option.

The competition between exchanges has been particularly valuable to individual investors who have created complex computer programs to monitor price discrepancies between exchanges. These discrepancies, though small, can be extraordinarily profitable for traders with the ability and speed to take advantage. More often than not, individual investors simply use multiple exchanges to get the best prices on their trades.

For example, traders with access to real-time quotes on all exchanges will see the following data and make their decisions accordingly:

Exchange Bid Price Ask Price
AMEX 10.35 10.75
CBOE 10.45* 10.75
ISE 10.10 10.65*
PCX 10.20 10.90
PHLX 10.25 10.75

For individual investors, the best price (real market) for this option is 10.45 to 10.65 because it represents the best bid and offer (ask) currently available. Thus, for an individual investor looking to sell the August 75 calls, the Chicago Board Options Exchange (CBOE) or the Pacific Stock Exchange (PSE) would be the best choices because they both have 10.45 bids in the contract. Deciding between the two would be simply a matter of choosing the exchange that does the most trading in this contract. The more volume the exchange does, the more liquid the contract. Greater liquidity increases the likelihood the trade will get filled at the best price.

If the trader wanted to buy the XYZ August 75 call, the International Stock Exchange (ISE) would be the best place to go in this case because they offer the contract at 10.65.

Payment for Order Flow
It is becoming more common for brokerage firms and large market making firms to accept what is called "payment for order flow." This means the firm is paid for each order it routes to a particular exchange. While this can help reduce customer commissions, it doesn't necessarily guarantee the best possible execution because, at any given moment, the exchange receiving the order may or may not have the highest bid or lowest offer. While relatively small price discrepancies among exchanges may not be as critical to small traders, they can have an enormous impact on investors who trade large numbers of contracts.

Financial Institutions

Financial institutions are professional investment management companies that typically fall into several main categories: banks, hedge funds, insurance companies, mutual funds, stock funds, and pension funds. In each case, these money managers control large portfolios of stocks, options, and other financial instruments.

Although individual strategies differ, institutions share the same goal to outperform the market (S&P 500). In a very real sense, their livelihood depends on performance because the investors who make up any fund tend to be a fickle group. When funds don't perform, investors are often quick to move money in search of higher returns.

Where individual investors might be more likely to trade equity options related to specific stocks, fund managers often use index options to better approximate their overall portfolios. For example, a fund that invests heavily in a broad range of tech stocks might use Nasdaq 100 Index options rather than separate options for each stock in their portfolio. The Nasdaq 100 Index (Symbol: QQQQ) is known as a tracking stock because its price is based on the cumulative value of the top 100 stocks in the Nasdaq market. Theoretically, the performance of this index would be relatively close to the performance of a subset of comparable high tech stocks the fund manager might have in his or her portfolio.

Market Makers

Market makers are the traders on the floor of the exchanges who create liquidity by providing two-sided (bid and ask) markets. In each pit, the competition between market makers keeps the spread between the bid and the offer relatively narrow. Nevertheless, it's the spread that partially compensates market makers for the risk of willingly taking either side of a trade (the buy side or sell side).

For market makers, the ideal situation would be to "scalp" every trade. For example, in a busy market, one customer order may come into the pit to sell 100 June IBM calls at the market. At the same time, another customer may want to buy 100 June IBM calls at the market. If the current bid-ask for the contract is 7 - 7.25 and the same market maker fills both orders, she'll sell 100 contracts for 7.25 and buy 100 identical contracts for 7. This way, she earns the ΒΌ point differential on the spread for each contract. This works out to a quick profit of $2,500 (100 contracts x $0.25 x 100 shares).

More often than not, however, market makers don't benefit from an endless flow of perfectly offsetting trades to scalp. As a result, they have to find other ways to profit. In general, there are four trading techniques that characterize how different market makers trade options. The same market maker depending on trading conditions may employ any or all of these techniques.

  1. Day Traders
  2. Premium Sellers
  3. Spread Traders
  4. Theoretical Traders

Day Traders
Day traders, on or off the trading floor, tend to use small positions to capitalize on intra-day market movement. Since their objective is not to hold a position for extended periods, day traders generally don't hedge options with the underlying stock. At the same time, they tend to be less concerned about delta, gamma, and other highly analytical aspects of option pricing.

Premium Sellers
Just like the name implies, premium sellers tend to focus their efforts selling high priced options and taking advantage of the time decay factor by buying them later at a lower price. This strategy works well in the absence of large, unexpected price swings but can be extremely risky when volatility skyrockets.

Spread Traders
Like other market makers, spread traders often end up with large positions but they get there by focusing on spreads. In this way, even the largest of positions will be somewhat naturally hedged. Spread traders employ a variety of strategies buying certain options and selling others to offset the risk. Floor traders primarily use some of these strategies like reversals, conversions, and boxes because they take advantage of minor price discrepancies that often only exist for seconds. However, spread traders also use strategies like butterflies, condors, call spreads, and put spreads that can be used quite effectively by individual investors.

Theoretical Traders
By readily making two-sided markets, market makers often find themselves with substantial option positions across a variety of months and strike prices. The same thing happens to theoretical traders who use complex mathematical models to sell options that are overpriced and buy options that are relatively under priced. Of the four groups, theoretical traders are often the most analytical in that they are constantly evaluating their position to determine the effects of changes in price, volatility, and time.

Individual Investors

As option volume increases, the role of individual investors becomes more important because they account for over 90% of the volume. That's especially impressive when you consider that option volume in February 2000 was 56.2 million contracts-an astounding 85% increase over February 1999 (Source: Options Industry Council).

The Move to Online Trading
By mid-1999, online investors accounted for $420 billion in assets. By 2002, it is estimated that almost 14 1/2 million people will have $688 billion in online brokerage accounts.

The Psychology of the Individual Investor
From a psychological standpoint, individual investors are in interesting group because there are probably as many strategies and objectives as there are individuals. For some, options are a means to generate additional income through relatively conservative strategies such as covered calls and bull put spreads. For others, options in the form of protective puts provide an excellent form of insurance to lock in profits or prevent losses from new positions. More risk tolerant individuals use options for the leverage they provide. These people are willing to trade options for large percentage gains even knowing their entire investment may be on the line.

In a sense, taking a position in the market automatically means that you are competing with countless investors from the categories described above. While that may be true, avoid making direct comparisons when it comes to your trading results. The only person you should compete with is yourself. As long as you are learning, improving, and having fun, it doesn't matter how the rest of the world is doing.