Dan Colarusso chatted with Alex Jacobson of International Securities Exchange on TSC Chats, Tuesday, Jan. 16 at 5 p.m. EST.

TSC_Dan:

I'm Dan Colarusso,

TSC's

old options writer. I've learned a ton from Alex Jacobson, one of the industry's best teachers.

TSC_Alex:

I'm Alex Jacobson of the

ISE

(International Securities Exchange). I'm anxious to answer your option questions.

chat-guest26:

Could you explain to us what an option is exactly and what you do with them?

TSC_Alex:

An option is a right to buy or sell a specific security at a specific price within a specific period of time. Options can be bought or they can be sold.

TSC_Dan:

Call options are bought to express a bullish idea about a stock, as kind of a proxy for the actual shares; put options, on the other hand, are used to express the opposite sentiment.

chat-guest448:

What options are attractively priced right now?

TSC_Alex:

All options are fairly priced at any point in time. They represent a current valuation of risk/reward based on current views in the market. Many users look to buy/sell cheap or expensive options. In reality, options are only cheap or expensive when you have a view of FUTURE price action.

TSC_Dan:

Right now, options on tech stocks seem more expensive because the underlying stocks are very volatile.

chat-guest448:

How do you determine whether an option premium is expensive or cheap?

TSC_Alex:

The common method of viewing an option as expensive or cheap is to compare it to some historical measure. We call this historical measure historical volatility. Many people would view options as expensive if current volatility is higher than historical volatility. This, however, is really a bad measure. A better measure would be to compare current volatility. Current valuation to expected valuation.

If a stock was $80 a few weeks ago and it's $40 today, is it expensive or cheap. It is clearly cheaper than it was, but it still might be expensive if your view of future valuation was lower.

TSC_Dan:

McMillan Analysis has a

Web site that provides some of these numbers on historical and current volatility.

chat-guest651:

Trading just options, I have "saved" a call, as the market fell by buying a lower call and waiting for the market to reverse. Is this a sound strategy?

TSC_Alex:

The concept of rolling down an option position is only sound if you remain very bullish on the underlying stock. Rolling down is a lot like running up a down escalator. You get hurt if the ride stops.

TSC_Dan:

And if you're aware of the transaction costs, which can be prohibitive if this becomes a habit.

chat-guest651:

Can you recommend any good books on day trading or short term trading OEX options?

TSC_Alex:

A good book that just came out and the name escapes me at this moment was authored by

Tony Saliba

... one of the most successful traders ever at the

CBOE

(Chicago Board Options Exchange). It literally just came out last week, and I'm confident you can find it by searching under the author ... Saliba (

The Options Workbook : Proven Strategies from a Market Wizard

).

TSC_Dan:

For overall options, you can always pick up

TheStreet.com's Guide to Smart Investing in the Internet Era

. I wrote the options chapter, with the help of people like Alex.

chat-guest643:

Hi Dan. Regarding your ALLR heads-up today, can you explain how an options mm hedges himself on a large call purchase in a low volume stock? Doesn't he want to be long common with the call buyer in an equal amount? Thx.

TSC_Alex:

The MM wants to Delta hedge if they can. Delta hedging is buying the equivalent number of shares of common that the options represent. This method of hedging works well if there are no price gaps over the life of the trade. If the MM delta hedges and the prices gaps up one morning, the MM would lose a lot of $$.

TSC_Dan:

A problem can be that buying the shares may run the stock up, putting the MM in a tougher position.

chat-guest448:

Hello guys -- I've been trading options on and off for the past 2 years. I've made some nice hits and had some expire worthless. I need some fine-tuning, any good books that you can recommend?

TSC_Dan:

Options for the Stock Investor

, by

Jim Bittman

is one of my favorites. It's simple and really helps you relate options strategies to your investment ideas.

chat-guest229:

Alex, what is the best method to trade inside the spread on liquid options? The MM just will not execute against paper that improves the bid/ask.

TSC_Alex:

Make your broker "book" the order so that the entire community sees it. I suspect your broker is not acting as aggressively as might be possible, especially if you trade decent size.

chat-guest229:

Alex, how much volume is ISE getting vs. floor-based exchanges now?

TSC_Alex:

ISE already has about 4% of the total marketplace. We only trade about 200 total option names so far, so that in those names we actually already do about 8% of the total volume. Only about 10%- 20% of the brokerage community is connected to the ISE so far. So your broker may not be able to access us yet.

chat-guest479:

Alex, how many stocks does the ISE currently trade options contracts on? How many do you intend to offer in the future? How soon?

TSC_Alex:

200 stocks currently, 600 when we complete connection, probably by year-end.

chat-guest78:

Is there a good reason to write a naked option?

TSC_Alex:

The only reason for an individual investor to write a naked option would be writing a naked equity put.

TSC_Dan:

Remember, naked options are ones sold without owning the underlying stocks.

TSC_Alex:

To buy stock below the current market.

TSC_Dan:

But writing puts is dangerous, you have to love the stock.

TSC_Alex:

Individual investors REALLY ought to avoid naked index options.

TSC_Dan:

It's difficult to pick, I think, the selling point because if you feel like a stock may fall in the short term but be strong over time, you may not be able to predict how far or how long.

chat-guest479:

Alex, I am currently managing a small hedge fund. How fast can I execute large orders on the ISE? For example, how fast could I expect to execute 50 or 500 contracts of a MSFT option?

TSC_Alex:

TheStreet Recommends

1.2 seconds electronically.

chat-guest872:

Is there much of an advantage to trading via a broker that specialized in options vs. someone like e-trade?

TSC_Dan:

Brokers which specialize in options can sometimes work the order a little more aggressively, but that will cost you a little more than going through an online broker. But it's important to remember that the eighths you may have given up in stocks are more significant when trading options, that makes execution very, very important.

chat-guest479:

Alex, what is the largest number of contracts that will be executed automatically on ISE? Does the ISE try to always have the most competitive bid/offer?

TSC_Alex:

By definition any exchange that fills a customer order must do it at the most competitive bid/offer. The options industry currently has the bar set to 50 contracts for instant execution. The ISE allows your broker to route 50 or less automatically and provides an electronic block trading facility for orders over 50 contracts. The block takes a maximum of 30 seconds.

chat-guest92:

Considering various market conditions, do you trade options differently than you would stocks?

TSC_Alex:

Yes. Because options are derivatives of the stock in very fast and volatile markets, options will be more difficult to trade. Meaning wider bid/offer spreads. Accordingly, I would use limit orders in options more frequently than I would in stocks.

TSC_Dan:

In these current market conditions, for instance, I'd be more likely to buy calls than actual stock because I'd have less capital at risk.

TSC_Alex:

Good point. In very volatile markets it makes more sense to buy an option. That may appear EXPENSIVE than buying a stock that can gap down 10 or 20 points.

chat-guest821:

Either Dan or Alex, I came on late, so apologies if I missed this, but what experience do each of you have as options traders?

TSC_Dan:

I have no trading background, but I've written about the options market for about three years; we're not allowed to trade individual stocks or options at

TSC

.

TSC_Alex:

In the early 80s I was top producing options broker at

Merrill Lynch

. I left there to run the country's 2nd largest option portfolio. I'm a founding member of the CBOE's options institute and have 20 years + of options experience.

chat-guest229:

Alex, how can a retail investor know the size of the market on ISE? Or are you saying you can do a 50 lot at the market?

TSC_Alex:

Your broker can see size of the market on their screen and shortly, when enough quote capacity becomes available, you'll be able to see a size quote in options.

chat-guest651:

How does one trade options on the ISE?

TSC_Alex:

Through a member broker same as you would the CBOE or Amex, but recognize that not everyone is hooked up yet. You want to ask your broker if they have ISE access already and if not, how soon?

chat-guest24:

How does volatility affect whether or not you should buy options?

TSC_Dan:

High volatility can inflate the price of an option, so that you may be right about how the stock may perform, but not get a big enough move in the option to justify the risk you've taken.

TSC_Alex:

Volatility is critical to the short-term option user. You definitely would want to buy options if you thought volatility would increase.

TSC_Dan:

The volatility is priced in.

TSC_Alex:

You might avoid buying options if you thought volatility would decline. Also understand that volatility has the biggest impact on out-of-the-money options.

TSC_Dan:

Like in earnings season or when a takeover rumor has been hanging around for too long, that makes volatility higher.

TSC_Alex:

If you bought an OTM option, say a call, and the stock went up with declining volatility the call would fall in price.

chat-guest643:

Are there rules for options mms honoring a displayed bid or offer? Or does the mm have sole discretion whether to fill at a particular price?

TSC_Alex:

There are rules that require an MM to stand up to their quotes. Make certain your broker makes certain the MM stands up to their market.

chat-guest77:

Is it easier to trade options successfully when a market appears to be either steadily rising or falling instead of volatile?

TSC_Alex:

Not really. It's best to trade options when you have a good view of what the underlying will look like going forward.

TSC_Dan:

Volatility gives you more opportunities but also creates more potential disasters.

TSC_Alex:

In markets with increasing volatility -- options should be bought in markets with decreasing volatility -- option buying should be avoided in most cases.

chat-guest229:

Alex, is it ever going to be feasible for retail traders to get a look at an electronic book like we have with Nasdaq Level II?

TSC_Alex:

Yes. It is just a matter of regulatory relief and having enough quote bandwidth. The ISE currently shows size internally to its dealers.

chat-guest77:

What is the average "shelf life" of an option?

TSC_Dan:

It can expire anywhere between 1 day and 3 years, essentially.

chat-guest197:

Bought some call LEAPS, but have now turned against me. I still have out to '02, so is there a strategy you can suggest?

TSC_Alex:

Do you still like the underlying stock? If so, just wait, the erosion on 2002 leaps is still pretty moderate. If you no longer like the underlying long term, I wouldn't continue to hold the leaps. Many people advocate selling short-term options against leaps that have gone bad, but I just don't see it.

chat-guest643:

Regarding delta hedges, how would a MM hedge puts in a non-borrowable stock? Thx again.

TSC_Alex:

The MM can't hedge puts in non-borrow mstock. They would trade small with huge bid/offer spreads.

chat-guest651:

My broker allows a straddle to be placed as one transaction. Isn't it better/more flexible to leg into a straddle so you can control the exit on each side?

TSC_Alex:

Absolutely not. The market in the combined piece is usually better than the individual two options. If you really want to leg into a position that is fine, but you'll pay two bid/offer spreads.

TSC_Dan:

That's about all the time we have; Alex and I would like to thank everyone for their questions.

TSC-RealMoneyLaura:

Thanks so much for joining us this afternoon. Please join us tomorrow.

Dave Gaffen

and

Brett Fromson

and

Christopher Edmonds

will be on hand to discuss the Bond Market, the day's action and of course Energy! We'll see you then.

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