Dan Passarelli: Options Trading Strategies Interview
Tim Bourquin: Hello everybody and welcome back to TraderInterviews.com. Thanks for joining me for another show this week. We're going to be speaking with Dan Passarelli and Dan is a trader and he's got a website we're going to talk about as well. But we're going to find out about how Dan approaches the markets and finds good trading opportunities as well. So Dan thanks very much for joining me on the phone today.
Dan Passarelli: Thanks Tim. Thanks for having me.
Tim Bourquin: Well, let's talk about your overall philosophy and approach to the markets. What kind of trader do you kind of classify yourself as?
Dan Passarelli: Well when I started out, I started as a market maker and I traded for a number of years down on the floor of the Chicago Board Options Exchange and basically, any trading that I do now, I take from that experience. And without getting too far ahead of ourselves, having learned options there gave me a deep profound understanding of options, which makes me a better trader really in whatever style I execute now.
Tim Bourquin: And there are a lot of former market makers now trading their own accounts, some with varying degrees of success. What is it about being the floor trader that would help you trade now on your own?
Dan Passarelli: Well, you know it's funny as a market maker, a lot of people don't really think about market makers in this regard. But as a market maker, I was always kind of forced to take the wrong side of every single trade. Because I'm there making the market, providing liquidity, buying bids and selling offers when the rest of the world is buying calls in a particular stock, I'm the guy who has to sell them. And so because of that, I got really, really, really good at managing positions. And I also necessarily had to get really good at the really fine nuances of options because I would take really big positions and try and make very small profits. So I had to really get to know the inner workings really, really well.
Tim Bourquin: Well since 90% of traders lose out there, does that necessarily mean that market makers win 90% of the time?
Dan Passarelli: Well, maybe the good ones do. But no, I think that that's kind of a common misnomer about the retail market taker/market maker relationship. Really, it's a symbiotic relationship. Really, they're not in competition against each other at all. In fact, they can both thrive together. Just because a market maker makes money on a trade that he took the other side of it doesn't necessarily that the trader who traded "against the market maker" is going to lose money. They can both make money and that's the beauty of options. It's not a zero sum game.
Tim Bourquin: A lot of people have heard of course the fact that the only option traders who make money are the ones who are selling options, not buying options. What are your thoughts there?
Dan Passarelli: Oh, man I love to talk about this too Tim. That is another one of the biggest misnomers too. Anybody who believes that surely was not trading a year and a half ago when the market fell out of bed. The people who are the income generating traders or the options sellers, most of them got creamed and a lot of them are no longer in business. In order to have longevity in this game, you need to know how to both be an option seller and also be an option buyer. You need to be nimble and you need to be hedged.
Tim Bourquin: So what does it mean then when somebody - I guess the question I should ask then is let's get into how you know when to buy or sell options. I know that's a very general question, but maybe you can just give us some basic information starting out there.
Dan Passarelli: Sure. Well there's a lot to it and I talk about that in my webinar series extensively. That's really a major focus of Market Taker Mentoring and really a niche that I teach my students. And although it requires a really long drawn out conversation, let me kind of give you a little bit of an overview. Whenever you buy options, you're buying volatility. Both in terms of the volatility of the underlying and also in terms of implied volatility, which is the volatility component of options. And likewise when you sell options, you're selling volatility. So therefore if you want to get an edge on any option trade that you make, you need to take a look at that volatility that you're buying or selling and see what its relative expense is. If you're doing things like buying straddles or back spreads or even any trade as simple as buying calls or puts, you need to make sure that the volatility you're buying is cheap. And when you're doing volatility selling strategies, like credit spreads, Iron Condors, Butterflies, even covered calls, you need to make sure that you're selling a high level of volatility.
Tim Bourquin: What do you mean? Let's start by saying, when you say buying and selling volatility, what do you mean by that?
Dan Passarelli: Sure. Sure. Okay. So, you kind of look at it two ways. Let's take a straddle, that's a very classic volatility trade. A straddle is when you buy a call and a put. Now granted if you just buy a call or just buy a put, the concept is the same but you have a directional bias. But if I buy a straddle, every single day that I hold that straddle, I lose money. I lose money on time decay because those options get worthless a little every day. Now when people say that the only way to make money is by selling them, that's what they're looking at and it's an oversimplification. What they're ignoring is the idea that you also have this thing called positive gamma. And what positive gamma allows for is that it allows for when the market goes higher and you're making money, you make money at an increasing rate. And with a straddle, you also make money when the market goes lower and you make money at an increasing rate. Now again, I said, the same holds true even if you just say buy a call. If you buy a call because of positive gamma, when the market goes higher and you're making money, again you make it at that increasing rate. It's an exponential return you're getting. When the market goes lower, granted you lose money, but you lose money at a slower and slower rate the further the market goes down. And that's beneficial too and that's basically the benefit that you get for the detriment of accepting time decay. Now, there's another way we can look at it as well and that's in terms of implied volatility. Implied volatility is this volatility component that's in the pricing of every option and it fluctuates. So if you buy when the implied volatility level is high, it can decline and you can lose money even if the market goes your way.
Tim Bourquin: So the idea then is to constantly monitor these and make adjustments. I mean that's another one of the things that I've heard that traders don't do enough of. It's that they put on a position then just leave it there until it's done. And I guess the more professional option traders are constantly adjusting that position; selling half of it, buying different strike prices, different months out, that sort of thing. Is that correct?
Dan Passarelli: Oh, man absolutely. You know options require traders to be a little bit more active. They're not the kind of investment where you buy a call one day and then three years later you say, "Martha whatever happened to those calls we bought back in 2010?" You know it doesn't work that way. They have an expiration date first of all and second of all there's a lot of moving parts. And time is an important factor that can help you or hurt you and so you've got to be monitoring it all the time to see what the changes that affect the value of that option are doing to it.
Tim Bourquin: What do you recommend to people in terms of what options market they should be in? Should they be trading currency options or index options, what do you recommend?
Dan Passarelli: Well, I've been around the block. I mean I've traded equity options on the floor. I've even traded grain options on the floor and index options and I've traded a lot of stuff. And the reason why I've made a couple of moves here and there going into different markets is because sometimes some markets are better than others and sometimes it kind of flip flops a little bit back and forth. So here's what you want. You want to look for options that have high liquidity. A robust market means that the bid and the ask spread are tighter. That is an important cost in doing business. People spend so much time worrying about trying to save 35 cents in commissions, but they're willing to lose $100 on the bid-ask spread because they're trading something that's too wide. And that's really the primary thing that people have to focus on. It's trading something that's liquid, that's a robust contract where they're not giving too much up to the market. And as far as whether it's volatile or if it's not volatile or if it's an uptrend or a downtrend, that doesn't matter because options are versatile. Whatever the stock is doing or the commodity or whatever it is, is doing, you can find an option strategy to capitalize on that as long as you're not giving up too much to the bid-ask.
Tim Bourquin: So it sounds like you've got to be willing to go to whatever market is the hot market right then and trading well and it has that narrow spread?
Dan Passarelli: Yeah. Yeah. Liquidity is king. That's what makes the difference. If you're a smart option trader, even if the stock is not moving at all, it's the most boring stock in the world. You can find a strategy to make money on it.
Tim Bourquin: One of the things I've heard traders say is they get into it because they see options as an inexpensive way to trade because maybe they see something that's $1, $1.30 a contract or even those lower ones. You'd find those ones that are way out of the money, 30 cents or something along those lines. But then they also read these books like the Black Scholes' method or what not and it seems pretty complicated once they get in there and try all these different strategies. How should somebody start in terms of what to do? Is it as simple as covered calls or what should they be doing?
Dan Passarelli: Well the first step is to get some education, okay? And I realize that that sounds like a little bit of a copout answer at first but here's the thing. You need to be very, very prepared to trade options. The people who are making money are the people who understand the product. And even when you start out, you'll probably start out with some fairly basic trades, like maybe going out and simply buying a call or it may be a covered call like you mentioned. But because like you said traders need to know how to adjust and that's what the good successful traders do is they know how to make those adjustments. You've got to understand options more than just a simple strategy you're putting on now because you might adjust it and make it a little bit more complex.
Tim Bourquin: So is every trader's edge different or is there one edge that you need to find in option trading?
Dan Passarelli: Well, there's one methodology that I teach all my traders. Now I teach them slightly different given their personality and given their background and what they already know and what they need to know. But I'll give you a little bit of an insight into my trading path that I lead all my traders down. I teach them how to analyze the technicals to get edge. I teach them how to analyze fundamentals in order to get edge and I have a very straightforward approach at that. And then most importantly, I teach them how to analyze volatility and get a volatility edge.
Tim Bourquin: Explain what you mean when you say, get a volatility edge.
Dan Passarelli: Sure. Well, this goes back a little bit to what we were talking about before, about buying low volatility and selling high volatility. A lot of traders out there, you know they kind of know that volatility has something to do with options. But in general I found that most of the people who come to me looking for education really don't understand volatility. And they don't really understand all the power that it has in order to help you get edge and in order to help you buy cheaper options and sell more expensive options. Now let's look at just simply buying a call again. Let's back up for one second. If I buy a call at two bucks, maybe my goal is to sell it at $2.50 because the market - you know I'm bullish. Maybe I want to make 25% or maybe even 50%. Now what if I told you that you could make an extra, oh I don't know let's just be conservative and say 2% on every single trade you make. And let's say on your losers, you'd lose 2% less on every single trade you make. Now there's a lot of people out there who are pretty happy to beat the market, and there are some people who are a little bit more aggressive who want to maybe double what the market's doing, you know the S&P 500. I'm being very, very conservative by saying if you use volatility to gain edge on every trader, your winners will be bigger and your losers with be smaller on every trade. Now you're going to have winners and you're going to have losers but that edge adds up over time. It's much the same way that a casino thinks. I'm teaching you to stop being a gambler and to start being basically like a casino. I want you to be in the business of statistics, not just in the business of trying to take a chance and get lucky.
Tim Bourquin: All right. Well, we've obviously just barely scratched the surface here. So, what you can do is scroll down just a little bit on this page here and you'll see a link to Dan's site and we'll send you over there and you can check out all that he has to offer. Dan thanks very much for spending some time on the phone with me and talking about options. I know it's a big interesting subject for a lot of people, there's a lot to learn. So, thanks for your time.
Dan Passarelli: Thank you Tim. I love doing interviews like these and talking to people.
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