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Finance & Investment: Trading Aces

G. Patrick Pawling

Daniel P. Koutris is on the verge of making a $1.9 million decision. He is a trader at the Chicago Board Options Exchange (CBOE), standing shoulder to shoulder with other traders crammed into the trading pits. The trade Koutris is considering started a couple of minutes ago when a floor broker for Charles Schwab appeared at the back of the pit: “SMH—how are the September 40 calls?”

SMH is Semiconductor Holders Trust, a basket of semiconductor stocks. The broker wants to know for what amount they can be bought and sold. Koutris, turning to face the trader behind him, answers immediately: “$2.60, $2.80.” That means he will pay $2.60 per call if the client wants to sell, and if the client wants to buy, Koutris will sell them for $2.80.

Sophisticated? Extremely. But it illustrates something about the Chicago Board Options Exchange—pronounced see-boe—that will never change. It is one of the most advanced and busiest trading posts in the world, but in many ways it is no different from a Third World bazaar where buyers haggle over sheep and chickens until they agree on a price. Buyers and sellers shout offers, and brokers scream back prices. In the course of a year, traders will buy and sell $3 trillion worth of options. For all their financial weight, options reside in a mysterious place ruled by time, and like people, they often become frail toward the end of their life span.

Buying options gives people the right to buy or sell something—Treasury bills and stocks, for example—at a certain price by a set date. Why not buy the real thing? Leverage. Buying options costs less, but with this savings comes risk. Koutris’ first day of trading was October 19, 1987, the day the stock market fell 22 percent—the biggest percentage drop in its his-tory. (“It’s really something you can’t forget, especially when it’s your first day,” he says.)

Koutris’ day starts with a cup of coffee and a ride into town on the 5:20 train. By 7, he is at the office, skimming business magazines, watching CNBC, and talking with his firm’s researchers. All of Koutris, Fahrenbach and Tenzer’s employees sit at desks in a circle so that they can see and hear each other. Options traders have to think fast, talk fast, and eat fast. They stay on the floor until the orders slow or the day is over at 3:02 pm. Then they return to their offices to discuss the day’s trading and news that comes after close.

All those formulas and flashing figures can be hard on the nerves. But Koutris loves math, just as he loved it as a kid. In fact, one equation keeps rolling through his head: Four children plus four college educations equals X multiplied by Y, with Y being inflation. This equation drives him, but it does not distract him. He does not hesitate. He never seems to hesitate.

At 6-foot-1 and down to 270-some pounds (thanks to the Atkins diet), Koutris is a formidable presence. But he operates with a style that could be called polite firmness. He looks a little like the skipper at an electronic bridge of a ship, surrounded by keyboards, telephones, handheld computers, assistants, and other traders. It is a bright, airy, and open space, and yet it is amazing how hot, close, and sweaty it can get when news is moving and the markets are rocking.

A trader’s obligation to take the other side of marketable trades is what makes options trading possible. Matching individual buyers and sellers would take too long. Besides, there are not enough simultaneous trades to match buyers and sellers, so traders like Koutris make counteroffers. His company trades options on 20 companies, including Advanced Micro Devices and MetLife. Thus if somebody wants to buy 10 AMD options, he will calculate a price that he thinks will meet or beat what his competitors are offering. Koutris has software to help with pricing and risk management, but ultimately it is up to him.

He pauses from scanning the news to rub his forehead. “It’s stressful, yes,” he says. “But every day is a learning experience. And if somebody starts to look at it like they already know it all and there’s nothing more to learn, then they’re not going to make any money. And they are not going to enjoy themselves.” Floor burnout exists, but there are no statistics on the number of traders who decide to pack it in. People who are serious about the business—and who are serious about living a long life—learn to cope. The CBOE officials say they know of no one who has had a heart attack on the floor. But then again, most traders are relatively young.

Each day that he comes to work, he brings with him the memories of his first day on the job. “We didn’t know what was going on,” he says. “I did like one trade that day. Part of it was the initial fear you have on your first day trading, and part of it was just watching in awe. And now in the back of your mind, you remember something like that can happen, so when you manage your risk you look at 50 percent down moves and realize they can happen. It makes us better traders.”

To avoid the appearance of conflict, he does not use options to hedge his own portfolio. “I don’t have an active trading account,” says Koutris, who prefers mutual funds. “I look once a month when the statement comes, but my theory is that people should let the professional manage the money.”

Trading pros at the CBOE handle about 1.2 million contracts a day. Almost 95 percent of trades are electronic, but the remaining 5 percent need to be handled by the most sophisticated software of all: the human brain. Though the percentage is small, they are so valuable in terms of the securities they represent that the old outcry system may never entirely die, at least not until machines can think as well as people like Koutris.

And when yelling does not work, old-fashioned hand signals take over. Palms facing inward show an intention to buy; outward indicates selling. A hand in the shape of a C signifies calls; thumb and forefinger in the OK sign means puts. Warning: Don’t itch at the wrong time. If you touch your forehead, that means 10; if you brush your forearm, it is 100; and if you go under the elbow, it is 1,000. Still, the traders, wearing chunky watches and garish multicolored jackets, flash hand signals like third-base coaches stuck on fast-forward. It looks like chaos, but it works.

Back at the pit, the broker who asked about the SMH calls finally announces his intentions: “I have a $2.80 bid for 500.” It is an order to buy $140,000 worth of options. (Each $2.80 call represents 100 shares of stock. Multiply that by 500 calls and you get $140,000.) It is a lot of money, but it is much less than the $1.9 million it would cost to buy outright the 50,000 shares of stock it represents.

This is a fairly large order, so Koutris sells only 200. He hedges by calling an SMH trader on the American Stock Exchange and buys 10,000 shares. The calls he sold represent the right to buy SMH at $40, so buying the stock protects him against the option’s being exercised. It would be costly to buy SMH at, say, $52, for a man who is going to pay Koutris only $40. That is why he bought the $39 common shares at the same time he sold the calls. “Ten or 15 years ago, there were cowboys, and they’d gamble and shoot,” says Koutris. “Some of them made money, and some of them lost money. But that’s not my style. Why does any sane person want to risk all his assets? It’s just not a smart thing to do.”

Koutris puts in a bid at the American Stock Exchange to buy another 15,000 shares of SMH. This will serve as a hedge for the remaining 300 calls he plans to sell the broker. He has gambled a bit, putting the hedge on first when another trader could have beaten him to the sale of those calls, but either way he is taking on some risk. Seconds later, he sells the remaining 300 calls and the deal is complete.

The transaction is over in less than two minutes—selling the calls and buying the common stock to hedge them—and represents more than $2 million. The floor broker swims off into the crowd, and Koutris bends over his terminal, his shoulders sagging for a moment. Just as quickly, his body comes to attention, ready for the next trade.

G. Patrick Pawling frequently writes for Robb Report.

Investing in Options
It is probably easiest to think of options in terms of common stock. One option represents the right to buy or sell 100 shares of stock. A “call” option represents the right to buy (or call) the stock away from somebody. A “put” is the right to sell (to put) stock to somebody. Buying “10 Microsoft April 60 calls” represents the right to buy 1,000 shares of Microsoft at $60 a share, with the value of those options wobbling with the price of the stock.

While the future price of options is unpredictable, there is one thing that has an unrelenting effect on their value: time. The value inevitably degrades as the expiration date approaches. Stock options expire on the third Friday of the month, so in this case, those Microsoft options will be worthless unless they are over the “strike” price of $60 at expiration. When options approach their expiration, traders often buy and sell huge amounts of stock to reduce their options risk, sometimes causing sudden changes in supply and demand. Trading on the third Friday can be a wild ride as traders buy and sell stocks to hedge positions, driving the price of the corresponding stocks up and down.

Taking such a gamble on time causes many people to see options as a speculative dance with the Devil. “People outside the business will say traders are gamblers, and some are,” says Daniel P. Koutris, himself a trader. “But the ones who are successful over the long run are the traders who manage their risk most successfully.” In many cases, options are used as insurance—bought and sold to counter other positions, to “hedge”—the same way house or car insurance can hedge against disaster.

If you own Microsoft stock and think it will go higher in the long run while insuring yourself against a big market decline, you might buy the puts that increase in value as the stock drops. You may still lose money if you decide to sell while Microsoft is down, but you will not lose as much because the drop in stock value will be somewhat offset by the rise in the value of the puts. Maybe you want to keep most of your money in Treasury bills but want a small amount in stocks to participate in any possible upside. Instead of tying up most of your money in stock, you could buy a few options.

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