John Nyaradi: Hi, everyone, I’m John Nyaradi, publisher of Wall Street Sector Selector, a financial media site specializing in exchange traded funds and global markets and economic analysis. Today, I’m pleased to welcome our special guest, Dan Passarelli. Dan, welcome to Wall Street Sector Selector.
Dan Passarelli: Hey, thanks. Glad to be here.
John Nyaradi: Dan is an author and options educator and founder of Market Taker Mentoring LLC. He has been in the options industry for more than 17 years as both a floor trader and options instructor. He has taught at the Options Institute at the CBOE and the Options Industry Council and is author of a previous book, “Trading Options Greeks.” Now he has a new book out, The Market Taker’s Edge: Insider Strategies from the Options Trading Floor, from McGraw-Hill, and that’s what we’re going to talk about today. Dan, let’s start with the title, “The Market Taker’s Edge.” In your book, you talk about market takers and market makers; please give us an overview of that and how that all works.
Dan Passarelli: Sure. They’re kind of the two warring parties in this epic battle. When I started my career, I started as a market maker on the floor of the CBOE, the Chicago Board Options Exchange and, you know, I made my first trade as a professional. But then after a while, I started teaching classes for the CBOE and learned the other side of the world, which is really the world of the people who are the position traders, people like you and me, who maybe trade from home or from their laptop, but taking a position and trading with the market maker, hence becoming market takers.
John Nyaradi: So for the guy at home, the retail guy, how do you get an edge?
Dan Passarelli: It’s a challenge because the edge that the guys on the floor have is the bid-ask spread and if you trade a lot, you can make a lot off that edge. So the market takers need to overcome that and really the way they can, the way they can overcome that loss of edge and get an edge for themselves is by implementing volatility analysis into their trading. There are plenty of traders out there who see a stock chart, recognize a bullish pattern and say, oh, well, I guess I’ll buy some calls to get bullish, but they don’t look at the volatility. They don’t know, in relative terms, am I buying cheap options and getting a good deal on them or am I buying expensive options and is it just a sucker bet for me. So all traders need to look for that volatility edge.
John Nyaradi: How about selling versus buying an option? Is a market taker better off selling or buying options?
Dan Passarelli: The answer to that question is wrapped within the premise of the book, really. It could be either. It depends. I have heard a lot of people say the only way you can make money trading options is to be a seller. And then I’ve heard people say the risk-reward of sellers is terrible, you have to be a buyer. You’re both right. It depends on the situation and it depends on the timing and specifically it depends on the volatility.
John Nyaradi: How about out of the money versus in the money options?
Dan Passarelli: That’s another thing I address in the book, how to get an edge by selecting the best strategy. If a stock is in a slow and steady trend, you’re probably better off buying an in-the-money option and just capitalizing on that slow and steady rise. If you’re looking for a sharp breakout to the upside, you’d probably be better off taking the greater leverage out-of-the-money option and that’s where you really get the most bang for your buck. And understanding these little quirks, these little nuances of which strike price do I choose, which month do I choose, how do I construct the optimal strategy, there is indeed an edge in that for traders, as well.
John Nyaradi: You spend a lot of time talking about risk and how to hedge risk. Risk management seems to be the key for professionals.
Dan Passarelli: Yeah, it is. And, you know, once again, that’s something that’s overlooked by many, many traders. If you do overlook the risk of a trade and you don’t pay close attention to risk management, you can turn a good track record into a horrible P&L at the end of the year. I know plenty of people who are really great at reading charts and really great at figuring out the numbers and annual reports and can put on strategies, but they just don’t follow through with the risk management and don’t take the necessary precautions and then their winners are okay but their losers are horrible.
John Nyaradi: You talk in terms of position risk and overall portfolio risk.
Dan Passarelli: Yeah, in one of the chapters on the book, I describe how option trading is kind of fractal. Every spread has its own defined risk-reward, but within every spread, there are options that make up the individual legs that have their own unique risk-reward. And you need to understand the risk-reward of each of the components and you need to understand the risk-reward of the greater spread and then further, you can look at the entire portfolio as one big master spread.
John Nyaradi: Talking about spreads, do you have a favorite spread? Is there a best spread?
Dan Passarelli: The biggest mistake that beginners make is that they get too fancy too fast. Your goal as a trader should always be keep it as simple as you possibly can. With my students and in my own trading, I go out of my way to keep things as simple as possible. But as far as a favorite strategy goes, I kind of just let the market tell me what to do. I mean the goal with putting on any trade is to make sure that you’re giving yourself the best risk-reward that you can and exploiting that specific scenario to the best possible extent. So, you know, if I make five trades in a day, they might all be a different spread because the situation demands a different type of spread.
John Nyaradi: So people should learn several strategies, not just be really good at one thing?
Dan Passarelli: I teach my students to be option traders, not to be credit spread traders, not to be income traders, not to be call traders, but to be option traders. You need to be versatile. If you don’t understand options in general, you’re not going to be successful in the long run because there can be stretches of years where certain strategies are kind of out of favor and don’t really have a market that’s conducive for trading them. So you really need to have a mastery of a good number of different strategies and recognize the opportunities when they arise and be nimble enough to capitalize on them.
John Nyaradi: Can you talk about some things that people need to watch for in terms of the psychology of trading?
Dan Passarelli: It’s a mental game, that’s for sure. I come across plenty of traders who let trading get in their head in one of two ways, either getting a little bit brash or where they just lose all confidence. I’ve been in this business for 17 years and I still strive to try and learn something new all the time. Because you know what, if I don’t, I’m going to get passed up. I’m going to get passed up because either market conditions change and I can’t adapt or technology and the way trading is done will change and I’ll get passed up. And there have been big changes in that over the last ten years.
John Nyaradi: How do you handle losses?
Dan Passarelli: The goal really is to approach it as logically and non-emotionally as possible. Sometimes that’s hard to escape, but one thing is for sure, you will have a losing trade at some point. In fact, if you’re like a normal person, you will have lots of losing trades, everybody does. How you deal with that ultimately will determine your success or failure.
A quick story; when I first got started in this business, I was a clerk on the Chicago Board Trade Floor and I was thinking about whether or not I wanted to try to become a trader.
So I asked one of the traders on the floor, “You know, hey, I’m thinking about being a trader, what does it take to be a good trader?” He looked at me and he said, “Well you know, you’ve got to be really good at losing money.”
At the time, that sure didn’t make a whole lot of sense, but I get it now. It’s so easy to say, oh, it will come back, I’ll just average price here and the next thing you know you’re in big trouble.
John Nyaradi: How much do people need, like a little guy like me, to trade options? Do you need $5000, start with $10,000, $50,000?
Dan Passarelli: Please don’t start with more than $5000. You will make silly mistakes in the beginning. I mean you’ll make mistakes for a long time until you really get better. So I encourage people to start out paper trading and then start trading one or two lots in a $5000 account and then move on from there.
John Nyaradi: So if you do that, is it realistic to become a professional options trader from home?
Dan Passarelli: Yeah, yeah. I mean that’s the goal for a lot of traders. I’d say, yeah, that is realistic. Because now the technology that you and I have today in a typical options-friendly retail account is way better than I had when I was trading on the floor on the exchange when I first started back in the late ’90s.
John Nyaradi: We’re talking in late summer of 2011. As you’re looking at the world today and your option trading is there one thing on your mind right now, one thing people need to be thinking about?
Dan Passarelli: In many ways, it’s no different conceptually than it was 10 years ago, 20 years ago, a hundred years ago. There will be the so called black swan events in the future. It could be tomorrow; it could be next month, a year. Just going forward, every once in a while, the market will fall drastically within a short period of time. You know that will happen and so you must protect yourself as a trader or investor and you’ve got the tools to do that. The technology, the low commissions, the vehicles like options are there, but if you don’t have the education, they’re not going to do you any good. So people really need to learn to use the tools before them and take advantage of them and protect themselves from these highly unlikely but big potential catastrophic events in the market.
John Nyaradi: Well, folks, we’ve been talking with Dan Passarelli, author of The Market Taker’s Edge: Insider Strategies from the Options Trading Floor from McGraw-Hill. Just follow the link below which will take you to amazon.com to learn more about Dan’s book. It’s a great book and can help you become a market taker yourself.
Dan, it has been great chatting with you today. I appreciate your time. Thanks for joining us and I know we’re all looking forward to talking with you again soon.
Dan Passarelli: Certainly, I really enjoyed myself. Thank you.
The Market Taker's Edge