<s> McMillanon Options
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A MARKETPLACE BOOK
McMillanon OptionsSecond Edition
Lawrence G. McMillan
John Wiley & Sons, Inc.
Copyright © 2004 by Lawrence G. McMillan. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108of the 1976 United States Copyright Act, without either the prior writtenpermission of the Publisher, or authorization through payment of the appropriateper-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive,Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressedto the Permissions Department, John Wiley & Sons, Inc., 111 River Street,Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008.Limit of Liability/Disclaimer of Warranty: While the publisher and author have usedtheir best efforts in preparing this book, they make no representations orwarranties with respect to the accuracy or completeness of the contents of thisbook and specifically disclaim any implied warranties of merchantability or fitnessfor a particular purpose. No warranty may be created or extended by salesrepresentatives or written sales materials. The advice and strategies containedherein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable forany loss of profit or any other commercial damages, including but not limited tospecial, incidental, consequential, or other damages.For general information on our other products and services, or technical support,please contact our Customer Care Department within the United States at 800762-2974, outside the United States at 317-572-3993 or fax 317-572-4002.Wiley also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic books.For more information about Wiley products, visit our web site at www.wiley.com.ISBN 0-471-67875-9Printed in the United States of America.10 9 8 7 6 5 4 3 2 1
Preface
When people learn that I have written another book, they usually askone of two questions: “Is this an update of your other book?” or“What’s the difference between this one and your other one?” Firstof all, this is most assuredly not an update of Options as a StrategicInvestment (OSI). This is a completely different, stand-alone bookthat relates option trading in actual examples. Second, there is a substantial difference between this book and OSI. This book is notintended to be a comprehensive definition of strategies—that is better derived from OSI, which is a reference work. This is a book inwhich the application of options to actual trading situations is discussed. There are plenty of actual trading examples, many of themderived from my own trading experience. In addition, there are anumber of stories—some humorous, some more on the tragic side—that illustrate the rewards and pitfalls of trading, especially tradingoptions. In addition, the content of this book covers ground that onedoes not normally find in books on options; that content will be discussed shortly.There is a continuous discussion of futures trading, as well asstock and index trading, herein. The futures markets offer manyinteresting situations for option trading and strategies. To that end,the basic definitions of futures options—and how they compare to,and differ from, stock options—are included in Chapter 1.While the book is not really meant for beginners, it contains allthe necessary definitions. Thus, serious traders will have no trouble atall in getting up to speed. In fact, many of the techniques described inthis book do not require familiarity with option strategies at all. Themore elementary option strategy definitions are not expanded upon
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at great length here, however, as my objective is to describe practicalapplications. For example, it is not my intention to detail the explicitcalculations of break-even points and explain follow-up actions forthese basic strategies. Readers who feel a need to better understandthe basics should refer to the aforementioned work, OSI, whichdescribes virtually all conceivable strategies in a rather large amountof detail.As for content, the book is basically divided into five major sections, spread out over seven rather lengthy chapters. The first part—Chapters 1 and 2—lays out the basic definitions and reviews optionstrategies, so that the framework is in place to understand and utilizethe material in succeeding chapters. Even seasoned option professionals should enjoy reading these introductory chapters, for thetrading tales that accompany many of the strategies are sure to elicitsome nodding of heads. Graphs and charts are liberally used. Sincethings are more easily seen in graphs than in tables, over 120 suchgraphs and charts are included in this book.The next three chapters—3 through 5—are intensive discussionsof some very important trading tactics, based on options. However,they are more of a basic nature and don’t require a theoreticalapproach to option trading. In fact, a stock or futures trader shouldbe able to absorb this information rather quickly, even if he doesn’thave a clue as to what the delta of an option is. Don’t get mewrong—I encourage every option trader to use a model via a computer program in order to evaluate an option before he actually buysor sells it. However, these chapters don’t require anything more theoretical than that.Chapter 3 contains material that is extremely important to alltraders—particularly stock traders, although futures traders will certainly benefit as well. I like to think of the information in this chapteras demonstrating how versatile options can be—they don’t have tobe merely a speculative vehicle. A basic understanding of the concepts involving using options to construct positions that are equivalent to owning stock or futures contracts is shown to be necessary formany applications. For example, it allows a futures trader to extracthimself from a position, even though the futures may be locked limitagainst him.
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Later in the same chapter, there is an extremely detailed discussion of how the expiration of options and futures affect the stockmarket. Several trading systems are laid out that have good trackrecords, and that can be used month after month. Finally, the use ofoptions or futures to protect a portfolio of stocks is also discussed insome detail. If we ever go into another bear market, these strategieswill certainly become very popular.Chapter 4 is my favorite—“The Predictive Power of Options.”Since options offer leverage, they are a popular trading vehicle for allmanner of speculators. By observing both option prices and optionvolume, you can draw many important conclusions regarding theforthcoming direction of stocks and futures. A large part of the chapter describes how to use option volume to buy stock (or sometimessell it) in advance of major corporate news items, such as takeoversor earnings surprises. However, another lengthy discussion involvesthe put–call ratio—a contrary indicator—as it applies to a wide variety of indices and futures. The work on futures’ put–call ratios is, Ibelieve, unique in the annals of technical analysis in that the techniques are applied to and rated on a vast array of futures markets.Several trading systems—from day-trading to seasonal patterns—with profitable track records are described in Chapter 5.Many traders, even those who are technically inclined, often overlook the power of seasonality. Moreover, the use of options in intermarket spreads is explained. Options give intermarket spreaders anadditional chance to make money, if applied in the ways shown.For those with a theoretical bent, Chapter 6 may be your favorite.The use of neutral option strategies is discussed, especially withrespect to predicting and trading volatility. One of my pet peeves isthat the term “neutral” is thrown around with such ease and, as aresult, is often applied to positions that have considerable risk. Theintent of Chapter 6 is to not only set the record straight, but todemonstrate that—while neutral trading can certainly be profitable—it is not the easy-money, no-work technique that some proponentsseem to be extolling. I am often asked how I base my decisions ontaking a position, rolling, and so forth, so the backspread example inChapter 6 is intended to be almost a diary of what I was thinking andhow I traded the position over the course of six months.
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The book winds up with a discussion of money management,trading philosophy, and some trading guidelines—all in Chapter 7.Some of my favorite trading stories and sayings are related in thischapter. I hope you enjoy them as well.My hope is that this book will bring more traders into the optionmarkets, as they realize that options can be used in many ways.Options don’t merely have to be treated as a speculative vehicle. Infact, you might be strictly a stock or futures trader but find thatoptions can give you valuable buy and sell signals. Those with a moretheoretical bent will find that volatility trading can be lucrative as well.
SECOND EDITIONAfter seven years, I felt a second edition was necessary because therehad been sufficient changes in the derivatives industry to justify arewrite with deletions and additions. For example, Chapter 1, whichis mostly definitions, now includes Exchange Traded Funds, ElectronicTrading, Single Stock Futures, and Volatility Futures. The main purpose of the second edition is to weed out material that no longer isviable—either because products had become delisted or illiquid orbecause strategies had become exploited—and to include new tacticsand strategies that I apply in my own trading and analysis.Chapter 3, which discusses various option special applications,now includes a discussion describing how a stock can be “pinned” toa striking price at expiration—what causes it, why it happens, andwhen to expect it. Furthermore, as options have become more popular as a hedging vehicle for stock owners—particularly professionalstock owners—new strategies have developed. They are included inthis new edition. One is the use of the newly listed volatility futures,and another is an expanded use of the “collar” strategy with listedoptions. New examples are included to describe both applications.In the revised Chapter 4, one major addition is the inclusion ofput–call ratio charts and theory on individual stocks. In the first edition, I had felt that there was too much insider trading in stockoptions and that such activity would distort the usefulness of put–callratios on individual stocks. But, as time passed, I came to feel thatlarge, well-capitalized stocks were less susceptible to manipulation
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and insider trading and that their put–call ratios could indeed provideanother good sentiment-based indicator for traders. Another majoraspect of put–call ratios included in this edition is weighted put–callratios. This method, which incorporates the price of the option aswell as its trading volume, is a highly effective improvement on thebasic theory of using put–call ratios as indicators. On another relatedtopic—using the volatility indices as a market predictor—we havedone a good deal of research over the years, and much of that is nowincluded in Chapter 4. This research not only includes the analysis ofpeaks and valleys in the VIX chart itself, but also shows how the comparison of implied and historical volatilities is an important indicator.Chapter 5 still covers trading systems and strategies. One majorchange that has taken place in the markets in recent years is the lossof effectiveness of the New York Stock Exchange (NYSE) advance–decline figures. This is due to decimalization for the most part. As aresult, we have adapted another method of looking at breadth—the“stocks only” approach. This adaptation is applied to some of oursystems, and the improvement is significant. The section on intermarket spreads has been updated as well. For some spreads, this isnothing more than bringing charts up to date. But for others—notably, the January effect spreads—significant changes in the pattern of the spread have taken place; and, thus, changes in strategyfor trading the spread are necessary as well. This also includes theway that intermarket spreads are implemented. There is less relianceon futures and more reliance on Exchange Traded Funds (ETFs),which are much more popular now than they were when the first edition was published. Finally, the seasonal trading systems are updated,and one more has been added—the late-January seasonal buy point.The systems presented in this chapter remain some of my favoritespeculative trading vehicles; and with this new, up-to-date information, they should prove to be useful for all readers.A more advanced approach to option trading is once again presented in Chapter 6. A significant amount of new information isincluded, most in the area of statistics and probability, that is, applying statistics to trading decisions. The concept of expected return isexplained and illustrated, as is the concept of the Monte Carlo probability simulation. These concepts and tools allow the theoreticallybased trader to be more disciplined in his approach to the markets.
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He can concentrate on situations where options are mispriced(volatility skews, for example), solid in the knowledge that a consistent investment in positions with above-average expected returnsshould eventually produce above-average results.Much of the data and tools necessary for the modern optiontrader can be found on the Internet, and there is some discussion ofwhere to find data and tools in Chapter 7. I would, of course, bepleased to see readers visit our web site, www.optionstrategist.com,where a great deal of free information is presented. We also have asubscriber area, The Strategy Zone, on that web site, where more indepth reports and data are available, along with a daily market commentary.There is no doubt that options and other derivatives now hold amajor place in the investment landscape, but it is disconcerting to seehow many people still don’t seem to understand options. In fact, theyare quick to place blame on derivatives when things go wrong. Onlyby dissemination of the kind of information in this book can we hopeto overcome such negative and uneducated attitudes. When we haveanother bear market, option traders will probably do very well—whether they use options as a protective device or as a speculativeone. Some have even gone so far as to predict that angry investors,who do not understand derivatives, will attempt to blame that bearmarket and its concomitant losses on options and other derivatives.That would be ludicrous, of course, but if we can convince more andmore people of the viability of option trading, then affixing anyfuture blame will be a moot point.I’ve been in this business so long now that there are literally hundreds of people I could thank for helping me get to this point. However, in the interest of space and time, I will limit my kudos to thosewho specifically helped with this book and with the concepts behindit: Shelley Kaufman, who did all the graphics work in this book andwho is an invaluable confidant on all matters; Peter Bricken, whofirst came up with the idea of monitoring option volume as a precursor of corporate news events; Van Hemphill, Mike Gallagher, andJeff Kaufman, who provided information on expiration activity that isnonpareil and who have helped me to clarify my thinking on strategies regarding expiration; Chris Myers, who convinced me to writethis book; Peter Kopple, off whom I can constantly bounce ideas;
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and Art Kaufman, who convinced me that I could go into business formyself. Finally, a special thanks to my wife, Janet, who puts up withmy crazy hours, and to my children, Karen and Glenn.LAWRENCE G. MCMILLANRandolph, New JerseyAugust 2004
Contents
List of Figures1 Option History, Definitions, and TermsUnderlying Instruments 1Option Terms 3The Cost of an Option 4The History of Listed Options 6The Over-the-Counter Market 6The CBOE Beginning 7Index Options 9Exchange-Traded Funds 10Futures Options 10Today’s Over-the-Counter Market 11Option Trading Procedures 12Electronic Trading 14Exercise and Assignment 15Mechanics of Exercise and Assignment 19Futures and Futures Options 24First Notice Day 25Single Stock Futures 26Volatility Indices and Futures 27Futures Options Terms 28Influences on an Option’s Price 32Volatility 33How the Factors Affect the Option Price 36Delta 37
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CONTENTSWhat Affects Delta? 39Technical Analysis 42
2 An Overview of Option StrategiesProfit Graphs 45Outright Option Buying 47Using Long Options to Protect Stock 52Buying Puts as an Insurance Policy for Long StockBuying Calls to Protect Short Stock 55Buying Both a Put and a Call 57Selling Options 59Covered Call Writing 60Naked Option Writing 62Naked Put Writing 64Naked Call Writing 69Straddle and Combination Selling 73Spreads 77Vertical Spreads 77Calendar Spreads 85Diagonal Spreads 88When Spreads Are Attractive 89Ratio Strategies 91Ratio Writing 91Ratio Spreads 92More Complex Constructions 99Using an Option Model 102Summary 103
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3 The Versatile Option105Options as a Direct Substitute for the Underlying 105Equivalent Short Stock 108Single Stock Futures 111Defending against a Limit Move in Futures Contracts 112Options as a Proxy for the Underlying 116Option Buying as a Short-Term Stock Substitute 116Option Buying as a Long-Term Stock Substitute 117Using LEAPS Puts instead of Calls 118The Effect of Stock Index Futures on the Stock Market 119Index Arbitrage 120Portfolio Insurance 124
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Program Trading 127The Effect of Index Futures and Index Option Expiration onthe Stock Market 129Games People Play 132Open Interest Implications 135A Hedged Strategy 137Speculation Early in Expiration Week 143Trading with the Arbs 148The Postexpiration Effect of Futures onthe Stock Market: A Trading System 149Expiration’s Effect on Individual Stocks 155Options as an Insurance Policy 157The Collar 168Using LEAPS as Collars 170Hedging with Over-the-Counter Options 174Using Volatility Futures as Portfolio Insurance 177The Contract Details 178Strategies for Protecting a Portfolio of Stocks withVX Futures 180What Can Go Wrong? 183Options on VX Futures 184Summary 1854 The Predictive Power of Options187Using Stock Option Volume as an Indicator 187How Much Is Too Much? 188The Analysis 190Analysis in Real Time 200Examples 202Profitability 223Further Considerations 226Using Stops 229When Option Volume Is Not a Good Predictor 235Using Option Prices as an Indicator 237Expensive Stock Options May Predict Corporate News 238Analyzing Implied Volatility for Speculative Trades 241Implied Volatility Can Predict Trading Gaps 248Some Strategies for Trading the Volatility Gap 253Implied Volatility Can Predict a Change of Trend 256Covered Call Writing When Volatility Increases 258
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CONTENTSImplied Volatility of Index Options 262A Case Study: The 1994 and 1995 Markets 268Another Case Study: 1997–1999 272The Seasonality of Volatility 277Trading Volatility Directly 281Further Observations on Index Volatility 282The Put–Call Ratio 283The Data 286Interpreting the Ratios 289Sector Index Options Put– Call Ratios 308Using Put– Call Ratios to Trade Individual Stocks 312Futures Options Put–Call Ratios 318Futures Options Volume 340Put– Call Ratio Trading Summary 341On Moving Averages 341Summary 350
5 Trading Systems and StrategiesIncorporating Futures Fair Value into Your Trading 351Day-Trading Vehicles 353The TICKI Day -Trading System 355The Intraday Market-Reversal Corollary 363A Short-Term Trading System 366Monitoring the Oscillator Intraday 369Problems with the Advance–Decline Line 374Intermarket Spreads 378European Options 381The HUG / HOG Spread 389The January Effect 399Gold Stocks versus the Price of Gold 408Oil Stocks versus the Price of Oil 414Utility Stocks and 30-Year T-Bonds 419Similar-Sector Index versus Futures Intermarket SpreadsPairs Trading 424Other Seasonal Tendencies 425August: The Dull Month— Or Is It? 425September–October: A Very Tradeable Time Periodfor the Stock Market 430Late-October Buy Point 434Late-January Buy Point 436Summary 439
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6 Trading Volatility and Other Theoretical ApproachesVolatility 442Delta Neutral Trading 445Keeping a Position Neutral 450Other Forms of Neutrality 452Predicting Volatility 455Comparing Historical and Implied Volatility 457Trading Implied Volatility 461Selling Volatility 461Buying Volatility 471The “Greeks” 483The Model 484Delta 486Vega 491Theta 493Rho 493Gamma, Revisited 495Gamma and Delta Neutral 498Even More Advanced Constructions 514Summary 516Trading the Volatility Skew 516Price Distributions 521Trading the Positive Skew 525Trading the Negative Skew 530Put Ratio Spread 547A Volatility Skew Biases a Position 550Finding Where Volatility Skewing Exists 553The Aggressive Calendar Spread 555Using Probability and Statistics in Volatility Trading 558Expected Return 564Summary 567
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7 Other Important ConsiderationsSupport Activities 569Order Entry 569Brokers and Brokerage 572Data Vendors 576Software 580Trading Methodology and Philosophy 584Managing Your Money 584Speculative Trading Procedures 592
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CONTENTS
Actual Trading Examples 597Option Trading Philosophy 609The Biggest Mistake 615Summary 616Appendix A: Listed Index and Sector OptionsAppendix B: Futures Options Terms and ExpirationsAppendix C: Option Models
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Index
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List of Figures
1.11.22.12.22.32.42.52.62.72.82.92.102.112.122.132.142.152.162.172.182.192.202.213.13.24.14.24.34.44.5
Exercise and Assignment of Stock or Futures Options 20Exercise and Assignment of Cash-Based Index Options 23Call Purchase 46Put Purchase 48Long Stock / Long Put 53Long Call/ Short Stock 56Straddle Purchase 58Combination (Strangle) Purchase 59Covered Call Write 61Naked Put Write 65Naked Call Write 71Short Combination 74Short Straddle 74Bull Spread 78Bull Spread Comparison 79Bear Spread 81Calendar Spread 86Ratio Call Write 91Call Ratio Spread 93Put Ratio Spread 95Call Backspread 96Put Backspread 98Butterfly Spread 100The Collar as Insurance 159VIX Volatilities 185Southern Pacific Railroad 202American Cyanamid 204Gerber—Option Volume 206Chipcom 208U.S. Shoe 210xix
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LIST OF FIGURES
4.6U.S. Shoe—Option Volume 2124.7Motorola 2134.8Sybase 2174.9Syntex 2194.10 Bethlehem Steel 2314.11 ADM, 12/27/95 2324.12 Grupo Tribasa 2344.13 U.S. Surgical, 7/20/95 2354.14 Gerber—Implied Volatility 2404.15 Gensia Pharmaceuticals 2514.16 Liposome Technology 2544.17 IBM, 8/92–10/94 2594.18 Telefonos de Mexico (Telmex) 2614.19 CBOE’s Volatility Index ($VXO)—Entire History 2644.20 $OEX Movements after Low $VIX Readings 2664.21 Volatility Index—VIX 2694.22 OEX 2704.23 $VIX and $OEX: 1997–1999 2734.24 $VXO Composite Spread: 1989–2003 2794.25 Put–Call Ratio 2854.26 55-Day Index Put–Call Ratio 2904.27 OEX during 1987 2924.28 55-Day Equity Put–Call Ratio 2934.29 21-Day QQQ Put–Call Ratio with QQQ Overlay 2964.30 Standard Put–Call Ratio 2994.31 $OEX: 1999–2000 3004.32 Weighted Equity-Only Put–Call Ratio: 1999–2000 3034.33 Standard Equity-Only Put–Call Ratio 3054.34 Weighted Equity-Only Put–Call Ratio 3054.35 $MSH Put–Call Ratio 3094.36 $MSH Weighted Put–Call Ratio 3114.37 Nasdaq-100 Trading Stock (QQQ) 3114.38 MSFT: 1999–2000 3134.39 Standard MSFT Put–Call Ratio 3144.39A Weighted MSFT Put–Call Ratio 3154.40 Standard INTC Put–Call Ratio 3174.41 Weighted INTC Put–Call Ratio 3184.42 21-Day Gold Put–Call Ratio 3194.43 Continuous Gold Futures 3204.44 Continuous Live-Cattle Futures 3234.45 21-Day Live-Cattle Put–Call Ratio 323
LIST OF FIGURES4.464.474.484.494.504.514.524.534.544.554.564.574.584.594.604.614.624.634.645.15.25.35.45.55.65.75.85.95.105.115.125.135.145.155.165.176.16.26.36.46.5
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Continuous T-Bond Futures 32421-Day T-Bond Put–Call Ratio 32521-Day S&P Put–Call Ratio 325Continuous Sugar Futures 32621-Day Sugar Put–Call Ratio 327Continuous Coffee Futures 32821-Day Coffee Put–Call Ratio 328Continuous Cotton Futures 32921-Day Cotton Put–Call Ratio 329Continuous Live-Hog Futures 33121-Day Live-Hog Put–Call Ratio 332Continuous Natural Gas Futures 33321-Day Natural Gas Put–Call Ratio 33321-Day BP Standard Put–Call Ratio 33421-Day BP Weighted Put–Call Ratio 33521-Day JY Weighted Put–Call Ratio 33621-Day SF Weighted Put–Call Ratio 33721-Day EC Weighted Put–Call Ratio 33821-Day SI Weighted Put–Call Ratio 339Oscillator: 1998–2004 373NYSE Advance–Decline Line 376Heating Oil/ Unleaded Gas Composite Spread: 1992–2003 391HOG/ HUG 1993 Contracts 392HOG/ HUG 1992 Contracts 393HOG/ HUG 2000 Contracts 393HOG/ HUG 2001 Contracts 394HOG/ HUG 2002 Contracts 395HOG 397Value Line/S&P 500 Composite: 1989–2003 400Value Line Index Minus S&P 500 407$XAU Divided by Dec Gold Futures 410$XOI Divided by Dec Crude Oil Futures: 1992–1995 415$XOI Divided by Dec Crude Oil Futures: 1993 416$XOI Divided by Dec Crude Oil Futures: 1992–2003 418$UTY Divided by Dec T-Bond Futures 420PD Divided by Dec Copper Futures 423Naked Straddle Sale versus Naked Strangle 463Strangle Sale 464Call Ratio Spread 465Straddle Buy 472Retail Index (RL