CNBC Pro Talks: Mike Khouw on the ins and outs of options trading 9/3/24

0:01This is CNBC Pro Talks, where we go one on one on one with Wall Street's top investors, smartest traders, and rising stars. We find out what makes them tick, what makes them money, and how you can follow in their footsteps.

0:16Welcome to another edition of CNBC Pro Talks. I'm Mike Santoli. In today for Dominic Chu. This month's guest is Michael Ko. Mike is co-founder and chief strategist of Open Interest Pro, a financial data analysis and investment strategy consulting firm. He's also the co-author of The Options Edge, a guide to understanding the value of options, volatility, and strategies for institutional and retail investors. We have him here today to discuss that very topic, broader markets, and to answer some questions from CNBC Pro subscribers. So, Mike, it's really great to have you here today. Let's start to get into it.

0:51I'd love to just, I guess, set the scene, if you could, with describing your background in this business, which I know stretches back, what, close to 30 years? Yeah, it's just under 30 years. I started in the business in the mid-1990s. I was first a member of the Philadelphia Stock Exchange. We traded options on stocks, cash settled indices at the time. This was sort of before ETFs really took off. And we traded statistical volatility arbitrage. Evertrage, I later transitioned to the American Stock Exchange in New York and ran a specialist unit there, trading options and a lot of new listings as, you know, basically the options market really started to expand then and it just has continued to explode ever since.

1:38I also was a member of the New York Mercantile Exchange, so I have some experience trading the energies and the precious metals, which was part of the COMEX at that time. So we traded options on oil and gas, the products, which would be things like New York unleaded and heating oil. Now we think about it more as diesel and jet. But I also have worked on the fundamental side as well. There's a hedge fund. It's now a family office. But at the time, it was called Ivory Capital. It was based in Los Angeles. Deep dive private equity approach to equity investing. Managed ultimately at one point about$5 billion.

2:13So, you know, did that. ran the derivatives trading business at Cantor Fitzgerald, where I was a partner for a number of years. And then most recently was running a long-only large-cap, actively managed, event-driven equity fund, where we tried to identify stocks going into catalysts like earnings. And oftentimes we used information that we gleaned from the options markets to help us make that set of decisions. But we were basically just trading stocks in the mutual fund portion at that time. Gotcha. And you kind of hit on multiple ways I think you can come at options in general and what they can be used for.

2:52You mentioned use them for an information source. What's the message of the market? Use them, I guess, straight some statistical elements of the market trade, actual volatility in a pure way, or express a fundamental view one way or another. I mean, if you had to try and explain it to somebody who is new to options or considering getting into trading options, What are they principally for in your mind? Well, as you just alluded to, I mean, they have myriad uses, really. You know, volatility itself is an asset class and derivatives are a key part of that, both listed and OTC. So you can trade volatility as an asset class.

3:32That's really important for a lot of institutional investors who are trying to manage the portfolio risk overall and may have cash flow requirements that don't allow them to take big drawdowns. You know, good examples of that would be insurance companies, pensions, public pensions, for example, need to manage those types of risks very carefully because they're paying out to beneficiaries of the pensions and the trusts. And you can't simply pay out a fixed income to a large number of beneficiaries, but have the asset pool draw down significantly in the midst of that because you're going to be selling assets at distressed prices.

4:09So managing volatility of a big fund like that is important for some institutional investors. I think it's important for retail investors as well, but maybe not quite as much unless they're already in retirement. But I think the most important thing to take away when you think about options is that they are essentially just a form of insurance. No matter how you structure it, ultimately it's a form of insurance on the underlying asset. And that could be, you know, whether it's a car or a house, stock, a bond, an index, a commodity, doesn't really matter. But if you think about it as a form of insurance, then you can better understand how you want to use them.

4:48And there are multiple ways you can make money doing that. You can speculate, you can hedge, or you can be the house, essentially, and sell insurance. That can also be profitable. But understand that, you know, you're not going to see the same kinds of risk reward relationships if you're selling options as you do when you buy them. You know, we have some subscribers who are interested, but maybe don't know exactly really even the terminology or when the right moment is to try and experiment or, you know, educate themselves about options. So let's bring it down to the real basics. What's a put?

5:23What's a call? How might you use those things? Yeah. Yeah, so options for the average investor really didn't come into the scene in the United States until the 1970s. And first, they listed call options. A few years later, they listed put options on a handful of securities. A call option simply gives the holder of the call option the right to buy the underlying asset. Usually, we're talking about stocks at a fixed price at some point between now and the future. So right now, NVIDIA is trading$123. You could buy a January 125 strike call option. And if you own that call, you have the right, but not the obligation, to purchase NVIDIA for$125 at some point between now and when that option expires.

6:12And of course, the attractiveness of that kind of an instrument is that if the stock rolls over and trades down to$70, you clearly don't want to buy it at$125. But if it runs up to$135,$140, that's more attractive. And then, of course, you can also buy a put option. A put option gives you the right to sell the underlying asset at a fixed price. So you could say a January 120 strike put option on NVIDIA would give you the right to sell it. So you're essentially buying, if you own the stock, a form of insurance. And you can use that either to insure a position. You can use it to speculate, which some people do.

6:50But understand that if the stock's trading$123 now, something has to happen for it to get above$125 by more than you pay for that call option or below$120 by more than you pay for that put option. So that's why we talk a lot about volatility, because how much an underlying asset moves around matters a lot to the value of an option. For sure. And so the whole thing is an exercise in trying to price out volatility and price out probabilities, really. Right. So kind of figure out what scenarios under which you might make money, what you might want to pay to participate in that. And of course, you can also be a seller of call or put options.

7:30So you can kind of be a provider of that insurance, although I guess that's different in terms of your potential payoff and how much you can gain or lose. Well, that's right. I mean, imagine if you've been a longtime holder of NVIDIA and you are now starting to think that, you know, we've had enormous growth since the company started trading publicly. And you might be saying to yourself, is it possible that the company which had experienced two consecutive years of about 360 % plus top line growth, is that achievable over the long term? And of course, the law of large numbers would suggest that it isn't.

8:13So you could say, well, I've really benefited from the run-up in the stock price, but I don't know that there's as much potential gains over the course of the next five years as there was over the last five, which would be asking a lot for any appreciated stock. So you could start selling call options against the stock holdings that you have and take in the income that people who are willing to speculate that it could run further covered essentially by the stock that you already own. So therefore, you don't have to sell the stock that you have. And you can, we'll say, milk a little bit of premium out of it if you wanted to.

8:49Right. And so if the stock were to go up and those call options go in the money, you would effectively have sold at a higher level. Yeah, that's right. That's the thing. You're giving the potential for a massive upside move to somebody else by selling a call against your stock. But you still participate to a degree. And if it doesn't run up to those high levels and you just continue to collect the premiums, then that's kind of that best case scenario. But, you know, that's why when we say you sell options, you're selling volatility. So you could also sell puts and potentially have the risk of owning the stock at a lower price.

9:24But big moves are not your ally if you're short options. Big moves are what you want if you buy them. Exactly. Yeah. It's a bet on stability in a sense if you're a seller of options. Walk through your, I guess, your approach to making a decision, making a trade. Where does it typically start? Are you looking for some kind of anomaly? Are you starting with a fundamental view on a stock or an index and then deciding how to implement that with options? So, you know, as I indicated, you know, we use options in a couple different contexts. Some of it is trading volatility, which tends to be a little bit quanti.

10:01But when it comes to using it for the regular investment process, generally what we're looking at is we look at the underlying burst. So that's going to be a combination of factors. Do we like the stock? Do we not? Is there an upcoming catalyst? That's one of the first things that usually get me looking at something in the first place. So every publicly traded company in the United States has to report their earnings four times a year. that's four times a year that we know a stock has the potential to move much more than it does on any normal trading day so I'm looking for those events I'm also going to look for things like conferences and presentations those are potential market moving events and of course you know things that can move the market more generally so we're always interested in Fed announcements we're interested in inflation data we're interested in employment data because those can have an implication for for publicly traded equities so once I've done that, I often will then take a look at technical factors.

11:00So if you're going to look at what is going on for an underlying stock, I care a lot about fundamentals. But fundamentals don't tend to drive stock prices in the short term. It's trite to say it. I'm sure a lot of people that you've spoken to say this all the time. In the long term, the equity markets are a weighing machine. But in the short term, they're a voting machine. And so we can't ignore momentum. We can't ignore money flows. And there's actually fundamental drivers that could be causing that. If you have institutional selling going on in the stock, regardless of what you happen to think about the fundamentals, until that resolves itself, the stock's probably going to be remaining under some pressure.

11:40So we're looking for catalysts. We want to look at stocks, how we feel about them fundamentally. We're going to look at the technicals. And then once we do all of those things, we'll take a look at the price of the options and say, OK, do the options look like a good buy, given what we think about these things, or a good sale? We can do both. Before we get into maybe the current market view and essentially some subscriber questions and some individual trades, I'm wondering about your thoughts about, you mentioned how options trading has proliferated so much over the decades. It's gone nothing but up way more than volumes in the overall equity market.

12:15And now, of course, we have so much attention on the zero data expiration option flow. So basically every day of the week, there are some options that are simply going to expire by the end of that day. And, you know, people either consider it to be somehow a market moving influence or just some noise around the edges. Has it changed anything about the market rhythms? And do you find that they're either useful or not? So I don't trade zero DTE options myself, and we haven't done that on an institutional level other than, you know, I would say, of course, we did. Anytime you trade on expiration day, you're trading a zero DTE.

12:53So now every day is an expiration day for some underlines. I think they have a great utility. I particularly like them for things like macroeconomic announcements, trading SPX options, for example. So when I'm thinking about the broad market, I typically look at SPX index options. For people who aren't trading that much money, SPY options are sort of a kissing cousin, if you will. will. SPX index options have an advantage from an institutional user's point of view, and that is that they are European, which means they can only be exercised when they expire, and they're cash settled, which means that basically you establish the level of the index relative to the strike, and there's just a money flow at the end of that.

13:38And operationally, if you're running a big book, that tends to be a little bit easier. It's also a very institutional product. You can trade it in huge size. There's massive amounts of liquidity. It's the most liquid options market in the world. So for institutions, they tend to use SPX. But I think the zero DTEs are really helpful because it also helps you identify how the options market is thinking about catalysts. You can see which options are really elevated in value. For example, we can look out to the options that are expiring in early November, and we can see that between the 5th and the 6th of November, options become 7 % more expensive from one day to the next.

14:18Right. Well, why is that? I think we all know the answer. Election is coming and the markets think that's going to be an important day. For sure. All right, well, let's get a little more granular here about the market outlook and some individual questions. But first, we do have to end the free portion of this Pro Talks And if you want to hear Mike talk a little bit more about options trading, answer some questions from some subscribers as well, please head on over to CNBC dot com slash pro. CNBC Pro Talks is a monthly interview series that's part of CNBC's premium subscription service, CNBC Pro.

14:56To hear the full Pro Talk interview, including specific stock picks and investment strategies, listeners can subscribe to CNBC Pro at CNBC dot com slash pro talks. That's also where subscribers can submit questions for upcoming guests or pro members can email those questions to askprotalks at CNBC dot com.