This week on Traders’ Insight Radio, Steve Sosnick, Chief Strategist at IBKR speaks with Interactive Brokers Group’s founder Thomas Peterffy. In part one of this two part interview, they cover stories from Thomas’ early trading days and how technology entered the trading floor.
Options involve risk and are not suitable for all investors. For more information read the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or copy and paste this link into your browser: http://www.optionsclearing.com/about/publications/character-risks.jsp
Transcript -Traders’ Insight Radio Ep. 3: You Mean You Don’t Have to Know Anything to Do This?
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Good morning everybody. Thanks for tuning into Traders Insight Radio. I want to welcome the founder and chairman of Interactive Brokers, someone whose name should be instantly familiar to everybody.
Mr Thomas Peterffy. is joining us today from Sunny Florida, while I am in snowy Greenwich CT. Good morning Thomas.
Good morning, Steve.
One of the things that I’ve been so curious about is you’ve been in the markets since the early ‘70s and markets have changed…
I actually got my job as a commodities trading firm in 1969.
Ah OK, sorry I was dating it from the time you started on the Amex.
Oh no, so I got my job in 1969 as a computer programmer and that’s was the time when I first heard about put and call options. I soon acquired a friend who worked for an over-the-counter dealer because in those days put and call options were not listed yet.
So, I had this friend who worked for an over the counter options dealer and he told me one day that you know there are these people who buy these options and often before they expire they want to get out of them and he said some of them are very good buys and you should look into them.
And I thought that’s interesting, but I had no idea how to tell whether it’s a good buy or not. So, I started to think about how to value these, at that time, mostly in the money call options. And I eventually came up with a formula and I programmed.
I had a little home computer, and I programmed the computer with the formula. I could just put in the strike and the volatility and the expiration and it would give me the price.
So that’s how I came to fall in love with options. You know, they were done in ‘73. The options were listed in Chicago on stocks and in ‘75 on the Amex. And the Amex added put options to their goals in ‘77 and that I couldn’t stand it anymore.
So, I just quit my job and went down to the floor of the American stock exchanges and market maker in options.
That’s great. Now your model probably predates Black Scholes.
Well, I don’t know. Strangely enough I didn’t know about Black Scholes at all and on the Amex nobody else knew about any option model either. So, I was basically the only one there having my calculations. So every morning I went down with a printed sheet of various stock prices and the corresponding equivalent option prices.
And so I went from crowd to crowd and trying to look for options that looked interesting and that’s what I did. And then eventually I had an accident, and I couldn’t stand on the floor and I also wanted to make the operation bigger. And that’s when I decided to basically build a computer program and acquired a chip that was able to interpret the electronic impulses from the electronic ticker.
And I engineered that into the home computer. And so I had always up to date option prices in the computer. So I built a program that continuously was cycling through these prices and settled on option spreads that there seemed to be out of whack. The program would print out those spreads and now all we needed were members — exchange member employees who to whom we could convey those spread orders and they would go to the specialist and try to get them done.
But the specialist — I remembered from my floor days on the floor that the specialist really doesn’t want to pay attention to you except if you have something to do that he would really love to do. So, I know what to do and finally I came out with this ingenious idea that I would hire attractive young women to put them on the floor as members, and that’s what I did.
And lo and behold, the specialists were suddenly always paying attention to what the women wanted to do, and they didn’t really have to know anything.
But we put them through a two week course to teach them and then they became members of the exchange and we put them on these seats.
I had exactly 4 women at this point and one day I was going out for dinner with a friend of mine in a restaurant on the Upper East Side. And we walk into this restaurant and there are three people sitting there that my friend knew, three men who are all in show business and they invited us to sit with them, which we did.
So one of the guys, his name was Aaron Russo. He was at that time, Bette Midler’s manager, and this was in 1982 — ‘82 or ‘83. I think ’82. He was Bette Midler’s manager and he was also dabbling in movies. And the other fellow sat next to him was a black man by the name of Melvin Van Peebles. And there were one or two other guys. So we sat down and after a while Aaron turns to me and he said. So what do you do?
And I tried to explain to him what I do, and he says you mean that these women don’t really have to know what they are doing? They don’t know if they haven’t had years of experience? And I said no. No, they just tell them on the phone what they want to do and they go in there and they do it.
He says “you mean anybody could do this?” I said well theoretically anybody could do this. So he puts his hands on Melvin’s shoulders and he says, “you mean, Melvin here, who I was sitting next to, could do it just as well?”
And I said…
I’ll interrupt for one second just to say that Melvin, for the listeners who don’t know who Melvin Van Peebles is or was, he passed away. He was an independent film director. He had some success with some of what they now called “Blaxploitation” movies. But at this point it was a couple years after that. So he had some name recognition, sorry.
Well, I don’t know how much recognition yet because I had never heard of him. But subsequently I found out that he indeed made a couple of movies in which he starred. So anyway, he said you mean Melvin here could do this and I said, yeah, I think he could. He says, “You know what, I’ll make you a $10,000 bet”. In those days, $10,000 was like $50,000 today. So it was something and I said, “Well, ok, $10,000” and he said. “Well, you hire Melvin, and he works for you for a year and if you can sustain him for a year I pay you $10,000.”
And so I hired Melvin and he went through our two week training course and then we sent him down to the floor and he was a very charming guy. Everybody loved him and many people of course knew about the movie he made, and so he was very popular and he did a fantastic job and.
A year later, Aaron, I got together and he says, “Well, you know, Melvin is done here and we’re ready for him to do something else. But here is the $10,000.” And I said, well, thank you very much. And that was it. And then, about a year later, suddenly Aaron comes out with this movie called “Trading Places.” So that’s where he really made his $10,000 back many, many, many, many times.
You told me this story recently after we did our first podcast, and I was hysterical. I hope the listeners enjoy it. Let me just clarify for the listeners: #1 the bet was not $1.00 as it was in the movie. It was a substantial amount of money. And #2, there was no insider trading involved as there was in the movie just a very good model.
Let me let me clarify that. It’s obviously dramatic license.
That so I want to be clear not to paint you as the villain here. This is just a great story. Since so much has changed in the business over time, much of it as a result of technological changes that you were behind, what do you still see as being the same?
Well, everything is basically exactly the same, it just happens much quicker. The price differences are which we negotiate for are much smaller. So in those days, you know whether an option cost…first of all options were trading in eights and quarters, not in pennies, so you know the minimum bid offer spread was an eighth and then later on it went to a sixteenth and then went to a nickel and then went down to 1 cent.
So, option commissions where something like 30…the lowest was $30 a contract and then it went on. And some brokers were charging $200 in commission per contract, so it was completely different. For that reason, and because there was chaos on the floors all the time because the rules called for time and price priority, but nobody knew who came first and what is the best price.
So that’s why I kept pushing for automation, but the specialists basically didn’t want to hear about that, and the floor members didn’t want to hear about it because they figured that they made most of their money on the chaos.
Because nobody knew what was going on, so it was easy to change and eighth here and there and scam.
And my point was always but look guys, we could do 10 times or 100 times as many trades, even though we would make much less money on each contract. But they somehow didn’t see it that way. And indeed we needed a new generation of people who were more technologically oriented to finally start to adopt electronic technology to trading.
And therein lies, I guess, what allowed the change. You mentioned the $10,000 was worth 50 today. You started with about $200,000, which is just under $1,000,000 today and within about six years you were the probably the largest market maker around. Was this the result strictly of your better technology and better-looking women or was…?
Well, no, it was. It was strictly the idea. So my idea was always that given that I know what the number should be, and nobody else did, I could…I was more certain that my numbers were right so I could bid a little bit higher and offer a little bit lower than my competitors because I knew exactly the price which was between my bid and offer. And I trusted it.
So basically I was competing on price. And that is basically still true today, so I know lower transaction cost people are all … the fact of the matter is that if you pay high transaction costs eventually you will lose money even if you happen to be right most of the time.
So you need very, very low transaction costs in order to make money, and that’s what we have always believed. And that’s what we always built on.
And so build a better mousetrap is part of it and the other part being if you want more of something, make it cheaper. Make it free.
We all know that there were various crises in the markets in the time you’ve been involved. Which do you figure have been the biggest, most dangerous ones and how did you avoid the pitfall?
Well, obviously the greatest crisis I remember was the ‘87 crash. The problem was that, you see, people didn’t realize — and often still today they do not realize — that when you sell something short, there is no limit. That if you have to close it out, a potential seller can charge you [anything] if he doesn’t have competitors, and in the ‘87 crash things were so chaotic and many people were basically bankrupt. And their clearing brokers we’re forcing them to cover.
As a matter of fact, the clearing brokers often send down their own brokers to take over the position and cover it. I never forget this this situation, in which there was [something] that fell…somebody was short just five puts, just five put contracts on a $25 stock.
And the broker had to cover the contracts and he comes and he says where can I buy five of these? And he said $25 for a $25 stock.
So nobody said anything and he said OK, $25. Nobody said it. See, he said $30. Nobody said anything…$35. Finally, somebody sold him that the five contracts at $40.00 each on a $25 stock. The five puts.
So the issue is that when you are short an option and there is complete chaos, there is no rational price at which it’s available to you in the chaos. And that was that is the same story with basically GameStop when it went to $500.
So shorting things is when there isn’t an exact offset that you can guarantee to be able to lay your hands on. That’s a very dangerous game.
Yeah, I know. And one thing I’ve learned that was I had just started in the business at that point and I remember being in the morning meeting at Salomon Brothers at the time and they had said basically the specialist system was broke. The clearing firms were hanging on by a thread and that was later what got them as you know, let’s say the first of the massive liquidity injections from the Fed. Which I guess is a topic for a later podcast.
But that lesson stuck with everybody. And I know that when we were trading options, the model was set up to never be short disaster puts basically for that for that reason.
At least at our firm.
Yes, no, no. I can’t speak for others.
I know what we did and that was never be short disaster puts and it paid off a lot of times too as I saw it in action.
And we lost money on it, but overall, we always made sure that we’ll be alive and we will never default on anybody.
Yeah, I think back to the to the long term Capital Management crisis. You know and even though we had done nothing wrong and even though we had the disaster puts, the LEAPS were getting marked against us and that was a fairly hairy time not of our own making. And we had the right position, and even then…
That’s right, I mean, even in the ‘87 crash we had the situation where we are making markets and options on all the US exchanges, and one of the exchanges that traded index options was at that time the New York Stock Exchange futures exchange, called the NYFE.
They traded index options on stocks, the NYSE NYFE index. And they were basically commodities, so they weren’t cleared by the Options Clearing Corporation. They were cleared by a subsidiary of the Options Clearing Corporation called NYFE clearing.
So it just so happens that we while we were long delta in stock options, we were short delta on the NYFE. So while we had huge losses on the crash, we had huge losses on the stock options, we had more than offsetting gains on the futures exchange. Here comes the problem.
The OCC came to collect the losses at 9:00 AM and was paying the gains at 10:00 AM. And so we said, we can’t pay the losses. And they said, well, if you can’t pay the losses, you are in trouble.
We have to close you down. I said, why don’t pay yourself. You have bones among the short positions. They said, well, you’re not authorized to do that because there are new rules. So for three days we were suspended and after the third day, the FCC gave OCC a special permission to pay itself on our behalf from one pocket to the other, and so that was a very tricky time.
Let me just ask this, this is more of a personal question. Have you ever thought of writing an autobiography? I’m happy to get these stories for our podcast, but have you ever thought of putting them down?
Oh, of course I will. One day when I will have nothing to do, I will do it.
Fair enough, I don’t know when that day will happen because clearly you’ve been engaged day-to-day. You’ve stepped back from the CEO role and as you said in your message to the firm, the New Year’s message, you’ve been nothing but pleased with that. Any comments you want to make about transitioning away from CEO?
I mean, yeah, I mean it’s wonderful because Milan [Galik, CEO] basically takes all the things that I had. I was beginning to have difficulty keeping everything in my head.
You know, as you grow older, it becomes a little more difficult, and so it’s wonderful that that he is incredibly competent. And we can all rely on his leadership and I can contribute wherever I can. And I still work 8-9 hours a day, seven days a week and I love it. But I don’t have to take care of everything. It’s a great need.
For someone who’s as engaged as you, that sort of counts as retirement, I guess to a certain extent.
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Disclosure: Options Trading
Options involve risk and are not suitable for all investors. For more information read the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or copy and paste this link into your browser:
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