Episode 01

Explore the Options Market with JJ Kinahan

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Explore the state of the options market today with JJ Kinahan, Chief Market Strategist at TD Ameritrade, and guests.

Audio Transcript

JJ: This is Understanding Options. I'm your host, JJ Kinahan.

Victor: Hello, everyone. I'm Victor Jones, director of trading at TD Ameritrade. Here with JJ Kinahan, chief market strategist of TD Ameritrade. Welcome to JJ's podcast series, Understanding Options. Today, JJ and I are joined by Kevin Hincks, Scott Connor of our trader education team here, and Tom White from our affiliate advisory service, TradeWise.

JJ: Thanks, Vic. Welcome Kevin, Scott, and Tom. Thanks for joining us today to discuss today's topic, exploring the options market.

Victor: Yeah, today, JJ, we're going to talk about the changes that have taken place in the options market over the years and how it's evolved. So I'm kind of curious to start with you, JJ, how have you seen the business evolve over even just the last decade?

JJ: Well, I think, Vic, if you look at how the business has evolved from how I got started in options trading, which is similar to Tom, Scott, and Kevin, all of us started on the trading floor many years ago and we all joke that we probably wouldn't get hired today because the business has evolved from one of being on the floor having all the information yourself, to being more mathematically inclined where you're setting analytics and you're setting algorithms to make the trades, whereas we sort of made the trades ourselves.

So I think that all of us would agree that getting started in the business back then was a little bit of happenstance. All of us happened to know someone who gave you an opportunity. But just like any business, once you have the opportunity, you have to take advantage of it. When I first started trading, which was a similar time to Kevin and Scott, Tommy was a little bit later, the success rate was only about 25%. And I think that one of the things that we do every day with our education here is talk to people about learning how not to lose money.

Victor: What about you, Kevin? How have you seen the business change?

Kevin: Well, I mean, obviously moving from trading open outcry to electronic trading, I've seen it actually take place on two different floors. I saw it not only on the Cboe but on the Chicago Board of Trade as well as the grain markets moved to 100% electronic trading. So you know, I came up much like these guys. You start off as a clerk. You learn the business. I actually got a job then as a broker's clerk, and then moved into market making as a third stop. But yeah, it was always-- there was always an organic way to learn the business from being on the trading floor that frankly isn't there now, so you've got to take other avenues. Like TD Ameritrade, you've got to take other avenues to learn how to trade options.

Victor: And what about you, Scott? How have you seen it evolve?

Scott: Well, I hesitate to tell you when I started trading. JJ gave us a little bit of an idea of when we all started--

JJ: It got fun when they added electricity, didn't it, Scott?

Scott: We had to stop using the chisel, yeah, I know what you're saying. But I think one of the things that still sticks in my mind today is how efficient trading and markets have become. And that's a huge benefit for clients, like TD Ameritrade clients, they now have a lot of the technology we have available to them on a thinkorswim type trading software. So it's a big change.

Now some people, I think, would call that in these days a disruption. Because it was kind of like a disruption. They took this model of trading, and as archaic as it might sound in the trading pits were, and then made it much more efficient and effective. And that's, like I said, the fallout for that is that many of us ended up leaving the floor but we're still involved with education. But the principles of trading haven't changed, they've just become more efficient.

Victor: Great point, Scott. What about you, Tom?

Tom: Similar. I'm a little bit younger than all these old guys. I started a little bit later on the floor. But I think going back to the efficiency of the markets and how dynamic the markets have been when we started in the open outcry business, but then again, we've all traded through all the downturns in the market, all the big events that kind of changed the way that we trade. And we've evolved as traders, just like the markets have. And I think that's the biggest thing that I've seen over the years. I left the trading floor in 2007. But the markets don't change, they just become more efficient, which is better for the retail client, which is great.

But I think the experience of us trading through all those-- the dot.com bubble, the housing bubble burst, the Russian crisis, long term capital, all those things kind of shaped the way that we trade. And I think that's for the better even though they were big bumps in the market.

Victor: And just even over the last 10 years, the retail trader in general has become, I feel, more informed. As those markets become more efficient, they become much more informed and much more active in the options market than they were 10, 20 years ago.

Tom: Sure.

JJ: I think it's interesting, you know, Kevin, Scott, Tom all shared one sort of thread, and that is taking what they know and trying to help other people through that or relating what they had. And you know, I'll start, actually if you don't mind, Scott, you talked about that a lot. And you know, what you guys do every single day, I think makes a difference.

Scott: Yeah, absolutely JJ. One of the questions we get asked all the time when we go to different events, and that would be, Scott, I know all of you had experience on the floor, but what are some of the key takeaways that might help me as a trader and investor? So a retail client, they oftentimes ask that question. And we try to incorporate that into all the different kinds of educational offerings we have here. But some of those takeaways that came from the floor, I think, JJ, we just learned from people who stayed with us for 20 years plus.

You know, what were they doing? What trading factors did they kind of have in common? And oftentimes those things kind of boiled down to just a couple of things. One is having defined risk in their trading. I would say also taking advantage of the high probability that is offered through options trading. And then third, learning about time decay and keeping that on your side. So those are just three of the takeaways I think I learned as a member of the exchange.

JJ: And Kev, you know, you do Swim Lessons every day in here. And one of the things that I think is interesting is how you've kind of progressed since you've been here in the last three years, talking to the world from a market maker point of view to talking to the world now as a retail trader.

Kevin: Right.

JJ: Just like everybody you're talking to. So what do you see is kind of the difference in how you're approaching the world that way?

Kevin: Well, you've got to talk to people differently. First, you've got to find out are they a trader. Are they someone that can make money on the downside and the upside as stocks go up and down? Or are they an investor? Someone who likes to just long term invest. So are they doing covered calls? Or are they doing daily strategies to try to make income? Things like that. That's what I like to talk about to people about and see what their overall game plan is. And then fit our education to their game plan. Some people are just investors. Right, there just buying dips.

And then we teach them how to sell covered calls and educate them on how to do better things. But some people are now full time traders. You talk to people at shows and when we go out in public that are now full time trading options. So they're looking for ideas both sides, not just to be an investor but an actual trader.

JJ: And Vic, before I go to Tommy for an old floor trader point of view, yeah, I'm calling you old now Tom, how do you see it as somebody who learned the business from a different end, even as to how things have progressed over the last few years?

Victor: Yeah, you know it's funny, JJ, because I listen to you guys and your stories about how the structure of the market has changed. And for me, the structure really hasn't changed in the time that I've been in the markets. It's always been electronic. It's been fairly efficient. Technology has been decent, but what's changed, I think, is the mentality that people have towards wanting to understand how to diversify their toolbag. Like I think one of the most interesting analogies I ever heard was, if you had a doctor and the doctor only had a scalpel, would you want that person to do surgery on you?

Or if you're a trader and you only know one trick in your toolbag, versus you understand the full capabilities and the tools at your disposal to trade in up, down, and sideways markets, you're a little bit more prepared. And I think people, what I've seen, is the appetite for the education change over the last 10 years, even though the structure of the market hasn't changed for me much or the technology. So I think that's the biggest change that I've seen.

JJ: That's really interesting. And Tommy, how about you? What trends are you seeing or have you seen over the last few years, especially as Victor brought up the importance of education?

Tom: I think the main point is the diversity of all the education that we offer at TD Ameritrade. Scott kind of mentioned talking to clients at shows, and that's what we do. And I just did it this past year, a lot. And what we're seeing is that clients are saying, oh, I want this. I want that. It used to be when you invested, you went in a few different paths. You were a long term investor. You were a short term investor. You were growth. You were not growth.

And I think the diversity and the amount of products that we offer at TD Ameritrade, whether it's the website, books and articles that JJ writes, videos that we're doing, the Swim Lessons that Scott's doing, the clients are out there and they want something different. And they all want a different item to kind of focus on. And I think TD Ameritrade by far offers the best range of educational products out there. And we continue to expand those.

JJ: And I love, Victor, you mentioned the tool box because I think one of the things that the education does, one of the things you guys do all day on Swim Lessons is give people the power to have more tools and understand-- I love the toolbelt analogy because I like knowing I have a 3/8 socket wrench at home. I won't really use it much but when I need it, I want to know it's there. And the education becomes key to fully understand how the options work, the potential benefits and risk, and the tools that you can use. And the entire-- I have to give our industry-- I always compare the options industry a little bit to hockey players.

We're just happy when people talk to us. And so I think the industry has started to come out more, providing a lot more educational material over the years. Firms like ourselves, the exchanges, the Options Industry Council, OIC, et cetera, have done a really good job with that overall.

Victor: And also the subject matter. Before it used to be, click on A, B, or C. Education was more product-focused instead of practical application. And now you have a lot of things we're talking about here, what Scott and Kevin do, is walk through a trader mentality from a to b and explain how they think about risk and reward, those types of things.

JJ: Absolutely. And you know, some of it can be, shall we say, information overload. People get kind of bogged down because there is a ton of information out there right now. And so you know, people often say, well, how can I not be overwhelmed by it? And I would say that it's-- and Kevin, I think you just talked about it. A, try and figure out where you're at.

Kevin: Right.

JJ: And b, just do a little bit at a time. I think we can all-- you know, it reminds me of somebody who goes on a diet and their first thing is, I'm just not going to eat. You're not going to be successful.

Kevin: J, I was talking to someone just this past few weeks ago in Las Vegas. And when I told them that I started out trading options, trading one stock, one. And I traded a lot of options in one name, they looked at me, they couldn't believe that. And I go, I got good at one, then I moved two. Then I got good at two, then I moved to three. And I did it really slowly. And that's how I got into trading. I wanted to be good at the ones underlying that I was trading, not necessarily all over the place, but just get good at that one thing and then expand your universe.

Scott: And as well, I'll add to that, maybe also your sizing. So when you're starting off with a new strategy, it's not something we're going to dive in and do 10 or 20 options, well start small. So you start with a small amount, like Kevin said, learn a strategy and build from there. Once you start gaining experience and you see how those strategies behave in different market conditions.

JJ: And I think that one of the things that people after they first learn strategies and stocks, and Kevin I love that you just said try one at a time because again, as human nature, I think we all just want to go crazy on everything we do rather than work in slowly. And so you know, keeping things simple helps a lot. When we all started on the floor, there wasn't any electronic trading. Electronic trading was considered when you went from the phone call, taking five minutes to taking 30 seconds. And we had tickets, paper tickets, basically.

Now you can do it so fast. And it's just being careful about how you place those orders is really important. You know, one of our colleagues, Frankie Walsh, always says something about make sure you're really double check the order. And I think sometimes people get so ahead of themselves they want to do it really quickly.

Victor: And so I'm curious to that point. Like Tom, you educate a lot of people on a regular basis. And there's usually a point when somebody goes from thinking about how much money they can make to how much risk do I actually have on the table. And that's almost like a light bulb for a lot of people. I wonder if you could, to JJ's point as he's talking about starting to place orders, you know, how do you think about it and how have you educated people when they get to that point where they understand reward versus risk.

Tom: Yeah, you know, you make a great point, Vic, because that is one of the first things I tell people. As a trader, I always went home and put on a trade and thought, how much can I lose on this trade? Well, everybody else, the investor, the general public always thinks about, how much can I make on this trade? You know, that's a natural reaction. But as a trader and been through these market environments that we have been, I always stress to clients, even our clients, I say, you know what? Start small.

You know, trade a little bit more but trade small. I mean, as long as you've defined your risk and know your downside, and I always use this analogy with our clients. Hey, I like to sleep at night, you should too, when you put on a position, using options, or any product for that matter. You should know your downside before entering into any position.

JJ: What you probably really are alluding to is people who are new investors. Because I think Kevin brings up a good point about people who are more experienced. Many times we're willing to say, you know what, if we go down-- I'm going to hold this stock for 15 years. If we go to 8%, I'm buying. I'm not selling. You know, Potter's not selling. Potter's buying.

Tom: Yeah, JJ makes a good point. As we're all retail investors at this point, we're all self-directed retail investors. And I think more that trader mentality was when I first started out as a market maker down there, so yeah, I think for any retail trader you should get comfortable and get experience trading these products before you start ramping up your size to what you're comfortable with as far as risk goes.

Victor: JJ, to your point about placing orders, Scott, one thing I hear you talk about is layering in your trades. You know, you're not necessarily putting them all on at one time. I wonder if you could elaborate on that.

Scott: Sure. Yeah, we discuss that quite a bit. We call that layering in or scaling. You probably hear that described two different ways. So basically what that means instead of jumping in and saying let's say I have 10 options I want to purchase on a particular stock, maybe I'll put in five, Victor, just to start off with, see what happens from there. If the stock moves down a little bit, maybe I can add to that position at a little bit lower price. And so what basically what I'm trying to do is sort of dollar cost average the price of that.

Now, you can always dive in first and jump all in there at once. But then if the stock moves adversely you'll wish, ah, I might have had an opportunity to actually get a slightly better price on that. And it's not just getting in, Victor, sometimes it's getting out of those trades as well.

JJ: I think one of the other things that's interesting as we sort of just segue to maybe a different topic that I think might be kind of interesting, is when you start talking to people who are newer-- and Tommy, you've talked a lot about the trading mentality-- but as we think about-- and Vic, maybe you start us there-- the difference between buying and selling stocks and buying and selling options. So you know, what do you see there when people-- how should they think about it when they're new?

Victor: Yeah. The difference for me early on was-- and that was what I started trading, just stocks straight up.

JJ: Which most do.

Victor: Yeah, exactly. And I think what I learned is that, of course, once you buy a stock, the next tick can either be up or down. Of course, you can have tick it could stay the same, but you're going to have that next tick you're most likely up or down on your decision making. With options, there was some gray area, which I liked the ability to potentially put on trades and have the ability to be away from the market where the market just had to stay above a certain break even. It didn't necessarily need to go in a certain direction one way or the other. And so for me, again, that was another lightbulb to say, hey, I can utilize these instruments to trade not just buy stock and wait for the market to go up, I can now have a little bit more flexibility in my timing for a trade as well as the direction, whether it's up, down, or neutral. So that was the biggest thing for me.

JJ: And Kev, what would you be-- what would you say to somebody who's new about the difference between stocks and options?

Kevin: Well, I think we teach a lot on Swim Lessons how you can use options to better leverage. What I love about options is smaller accounts can trade options that can't trade stocks. I've always said, you give me a strategy and I'll show you an option strategy that can get you where you want to go for less money. Because buying stock, 100 shares of Apple today will cost you $16,000. Well, you can trade options and be bullish on Apple for a couple of hundred dollars. So smaller accounts, educating--

The great way-- I actually think if you were the really smart investor, you'd flip that. The smaller investor should start with options and learn that because of the lesser risk and less dollars invested. And then grow your account, because buying stock is sometimes expensive.

JJ: And I think it's interesting that you say less risk with options. You can make them risky if you'd like to.

Kevin: Exactly, but learning the risk is important.

JJ: But I think one of the great things you guys do every day on Swim Lessons is you say, OK, here's a way to define. That's what's the best part about options. The risk can be clearly defined up front so you know exactly what can happen.

Kevin: Right. I mean, you know, there's risk. Whenever you take your foot off first base and go out there and trade, there's some risk. You have the ability to still limit that and control the amount of risk you put out.

Victor: What you said is so important. I'm a millennial. So a lot of people my age are looking at the stocks that tend to be in the news. We're talking $1,000 stocks, or $500, $200 stocks. And those are things that some people in my age bracket just can't invest in a meaningful way.

Kevin: Right, what am I going to buy, 10 shares?

Victor: Exactly.

Kevin: You don't feel like an investor when you're buying 10 shares.

Victor: Yeah, so it's not even about, necessarily, leverage, but it's just about participation.

Kevin: Right.

Victor: So they provide an avenue for participation in stocks and names that you know but you wouldn't otherwise be able to trade effectively.

JJ: And you guys are talking about buying and selling stocks. So you know, what is the difference between buying and selling a stock. And maybe I'll start with Vic since you said you brought up the figure. You started with stocks and went to options. Between buying and selling stock and buying and selling options, how do you think about it?

Victor: Well, and I'll kind of pass this on to Tom, but I would say it helped me to start thinking in terms of probabilities. When I was trading stocks, I was just I was trying to be a stock picker. When I started trading options, it was more about understanding how to put probabilities in my favor, how to understand volatility, understanding statistics. And that totally changed my mind frame around trading. Instead of being a stock picker, it was about the strategy I was using on the underlying stock.

Because I could be wrong in the stock that I picked, and as long as I'm picking a decent strategy, it's potentially giving me the ability to be right even if I'm wrong about direction.

Tom: Yeah, I think that's one of the important points that we teach our clients when we're talking about trading strategies and using options, instead of stock for taking a directional bias. I mean, Vic, you made a great point. You can do four different options strategies for that same bullish stance that you had buying Apple shares, but that would cost you a lot more. And what we try to do is break that down in a risk-defined manner for our clients to simplify it when we're talking about directional trades or simple option strategies.

But being able to sleep at night when you still have that position on, because if you buy Apple for $160 a share, it's going to cost you a lot more as far as capital goes. But also, the event risk that something comes out negative in Apple and the stock goes down 10%, that's a big hit to your capital exposure. But if you do option strategies on a directional bias and you're doing it in a risk-defined manner, you can really allow yourself to sleep at night, be comfortable with that same bias, but on a smaller scale as far as capital involved and risk tolerance on that.

Victor: In some cases, Scott, it's not about choosing stock versus options, right? If you're a stock trader, there are ways to use options to enhance, or potentially look to enhance yield or generate income on existing stock portfolios. So it's not even a question about choosing one or the other. Sometimes it's a question about looking to enhance yield.

Scott: Absolutely. Blending the two strategies oftentimes does make sense. I mean, we can even use options-- Victor, in a strategy we call cash secured puts-- for someone who's just building a portfolio, someone who's young. You mentioned millennials. What's the way that I can actually if I wanted to get 100 shares of a stock, but I just didn't want to potentially buy it here. Maybe if it dips to a lower price. Well, there is a strategy there that can potentially set up a situation where you can buy stock at a lower price if that stock drops on expiration day for that particular strategy.

So no, there's absolutely great, great potentials to combine the two. The second one you mentioned was enhancing a portfolio. There's a strategy called a covered call strategy. I know we're not going to get deep in anything here, but that can be applied to an entire portfolio of stocks on a thinkorswim trading platform to a process of what we call beta weighting. So yeah, there's lots of things to learn. And not just each strategy by themselves, but by potentially combining both of them.

Victor: What about you, JJ? When you think about the differences between buying and selling stock versus buying and selling options, what are the differences that stick out for you?

JJ: I think there's a couple of things. First of all, Kevin mentioned something really important early, and that is not trying to learn everything at once. Because as Scott said, when it comes to options, the amount of strategies are fairly limitless, if you will, through combinations of them. The reason I'd primarily like options over stock is because with stock I can buy or sell. I'm right or wrong. There's a 50/50 on every trade. As you said, Vic, with options you can put, you know, theoretically you can put the probabilities in your favor.

The other thing about it is, I really like to know how much money I can possibly lose on every trade right when I go in. Yes, you could say, well, the stock could go to zero. In most cases, that's not really a realistic probability. But you could probably lose more than you think. By doing spreads, and I really like the spread part of options, doing them at limits, one thing I would discourage clients from doing is just throwing market orders out there because when things get crazy, particularly you're never quite sure where you're going to get filled. If you're put in a limit order, you can't get filled worse than that limit, you can get filled better than that limit. So again, you're defining everything upfront.

One of the things that we've all probably been guilty of, I know I have and I'm pretty sure everyone at this table has been, is saying, well, I know this is where I said I was going to go out, but this time is different. And then we all learn, the only thing that's different is this the most money we're ever going to lose. Whereas by doing spreads upfront and options, you've pretty much defined where you're getting out if things go against you. So it forces discipline on you.

Victor: How important is technology when you're talking about options? In terms of trading and placing orders, how important is it to have a good piece of technology that can serve up whether it's volatilities or probabilities?

Kevin: I mean, as electronic trading started, we all learned the difference between good technology and poor technology, or great and good. So that was always obviously, obviously the best technology is what you're looking for. You always want that innovative, the next best thing. That's all.

JJ: And one of the things I was just going to add really quickly and we're talking about doing fills, and Tommy, I know this is something you talk about a lot, is I talked about spreads. And Tom, I know up at TradeWise you talk about trying to stay as close to the theoretical value as possible.

Tom: Yeah, and I think you make a great point there as far as technology goes. And the products and tools that we have at thinkorswim and TD Ameritrade is that usually when you're going into a spread, you get that theoretical value or that midpoint to the price of that spread, and the platform allows you to do that. It takes over a lot of the calculations that you might have to-- that we made ourselves before, whether it was on Greeks or something a little bit more complicated. But as far as order entry, trading in as close to that theoretical value as possible because the platform allows you to pick that out is really important, because getting into the trade might be easy but getting out of it might be a little bit more difficult, so you want to stay in those liquid products.

And the platform allows you to pick that price that you think is fair and work around that to get your best possible fill.

JJ: Yeah, because I mean, there is a risk of that being filled. Let's be honest. But it will be a good trade when you do. And that's what I kind of prefer is making good trades by staying as close to theoretical value as possible. In a quick wrap, guys, we've all seen it every day. You know, compared to when we all started, the self-directed individual investor has an amazing set of tools and resources. And it's not just true for options. Yes, it probably is more pronounced in options because of the combinations that we talked about and probabilities, but for all investing in general.

Anyway, that's all for today's show, be sure to tune into our next podcast on the importance of breakevens. Big thank you to Kevin, Scott, Tom, and of course Vic for keeping the conversation moving along. Great to have you guys all here. You can find more on options education at essentialoptionstrategies.com. And as always, you can find me on Twitter at @TDAJJKinahan. And as always, most of all, thank you to our listeners. We really appreciate everybody listening to us today. It's always fun to make these with this crew. And good trading, everyone.

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