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    Lawrence G. McMillan - Options As A Strategic Investment-Prentice Hall Press (2001) PDF

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    OPTIONS STRATEGIC INVESTMENT Lawrence G. McMillan | {= 23 ia NEW YORK INSTITUTE of SANE NEW YORK « TORONTO » SYDWE PORE NEW YORK INSTITUTE OF FINANCE [NYIF and New York Institute of Finance aré trademarks of Executive Tax Reports, Ine, used under license by Penguin Putnam Inc “Ths pblion dened to prove acute ands nforaton in od tothe ete covered hd with Haare ale pblcer not enol im endrng log accountng cher profesional eves lel adie or ‘Sherpa mote sve the seer ef «competent profes person shuld be wut ere of nai fly alped bya Cotes of a Anertcon Bar Asocation nd Comet of Publis ‘ed Amoco Copyright © 2002 by Penguin Putnam Tne, Prentice Hall i a registered trademark of Pearson Education, Inc. ‘llrightsreserved No pr of ths book may be reproducodin any form or by any meas, without per ‘hia ing ome publ formant a Library of Congress Cataloging-in-Publication Data MeMillan, L. G. (Lawrence G.) (Options asa stratogic investment / Lawrence G. MeMillan.~ 4th ed eon. Includes index. ISBN 0-7352-0197-8 (cloth) 1. Options (Finance) I. Tile. 1H1G6042.M35 2001 392,63'228—de21 00-058319 “Associate Publisher: Killen Schneid Coleman Production Editor: Mariann Hiutlak Interior Design’Formatting: Inkwell Publishing Services Printed in the United States of America w 9876543 ISBN 0-7952-0197-8 ‘Most NYIF and New York Institute of Finance books are available at special quantity discounts for Dull purchases for sales promotions, premiums, find-aising, or educational use. Special books, or ‘ook excerpts, can also be created to fit specific needs, ordeals write: Special Markets, Pnguin Putnam Ine. 75 Hudson Street, New York, New York 10014 Contents Preface 5 x Part I BASIC PROPERTIES OF STOCK OPTIONS Chapter 1 Definitions . .. oppo 3 Elementary Definitions 3 Factors Influencing the Price of an Option 9 Exercise and Assignment: The Mechanics 15 ‘The Option Markets. 2 Option Symbology 23 Details of Option Trading a Order Entry. 22 Profits and Profit Graphs : u Part Il CALL OPTION STRATEGIES Chapter 2 Covered Call Writing. The Importance of Covered Call Writing 39 Covered Writing Philosophy : 2 The Total Return Concept of Covered Writing ..... 45 Computing Return on Investment a Execution of the Covered Write Order 56 Selecting a Covered Writing Position, 58 Writing against Stock Already Owned. 62 Diversifying Return and Protection ina Covered Write 66 Follow-Up Action. coe 70 Special Writing Situations 7 Covered Call Writing Summary 93 Chapter 3 Call Baying 0 Why Buy? 95 Risk ond Reward for the Call Buyer 7 Which Option to Buy?..... oe OL Advanced Selection Criteria ce 103 Follow-Up Action. 107 A Farther Comment on Spreads ur Chapter 4 Other Call Buying Strategies ......... pooponoo5 ‘The Protected Short Sale (or Synthetic Put) : Follow-Up Action. The Reverse Hedge (Simulated Straddle) Follow-Up Action Altering the Ratio of Long Cals to Short Stock. Summary... Chapter 5 Naked Call Writing ............ ‘The Uncovered (Naked) Call Option Investment Required The Philosophy of Selling Naked Options Risk and Reward Summary Chapter 6 Ratio Call Writing ..... The Ratio Write Investment Required Contents v Selection Criteria. . 151 The Variable Ratio Write 155 Follow-Up Action. 7 158 An Introduction to Call Spread Strategies. 168 Chapter Bull Spreads .......0...060ccceceeeeeeeeaeeeeeeeeeceeeeee Degrees of Aggressiveness 15 Ranking Bull Spreads 176 Follow-Up Action. cone 179 Other Uses of Bull Spreads 180 Summary : 185 Chapter 8 Bear Spreads Using Call Options .............0...0005 ‘The Bear Spread 186 Selecting a Bear Spread. : 189 Follow-Up Action. 190 Summary 190 Chapter9 Calendar Spreads exganogscos ‘The Neutral Cal prea 192 Follow-Up Action 194 The Bullish Calendar Spread. 196 Follow-Up Action. 197, Using AU Three Expiration Series 198 Summary fen 199 Chapter 10 The Butterfly Spread. Selecting the Spread Follow-Up Action Summary Chapter 11 Ratio Call Spreads... : Differing Philosophies 213 Follow-Up Action : 217 Summary 221 Chapter 12 Combining Calendar and Ratio Spreads .....................,202 Ratio Calendar Spread : . 222 Choosing the Spread 225 Follow-Up Action , 226 Delta-Neutral Calendar Spreads... . cece 227 Follow-Up Action 229 Chapter 13 Reverse Spreads... ae Reverse Calendar Spre 230 Reverse Ratio Spread (Backspread) 12 232 Chapter 14 Diagonalizing a Spread..-.......00 0... ee cccceeeeeeeeeeee ss 236 ‘The Diagonal Bull Spread 236 Owning a Call for “Free”, . 239 Diagonal Backspreads 240 Call Option Summary : 241 Part 11 PUT OPTION STRATEGIES Chapter 15 Put Option Basics..... 0.0.0... eee ees eeeeeeaee Put Strategies Pricing Put Options , see AT The Effect of Dividends on Put Option Premiums... 28 Exercise and Assignment : - 950 Conversion , 253 Chapter 16 Put Option Buying. ... ponbtoe Put Buying versus Short Sale. Selecting Which Put to Buy Ranking Prospective Put Purchases Follow-Up Action Loss-Limiting Actions Equivalent Positions Chapter 17 Put Buying in Conjunction with Common Stock Ownership... Which Put to Buy ‘Tax Considerations . Put Buying As Protection for the Covered Call Writer No-Cost Collars Chapter 18, vii 261 262 267 270 271 273 275 =. 875 278 Buying Puts in Conjunction with Call Purchases ........... +++ 281 Straddle Buying Selecting a Straddle Buy Follow-Up Action. Buying a Strangle Chapter 19 The Sale of a Put .... ‘The Uncovered Put Sale. Follow-Up Action. Evaluating a Naked Put Write Buying Stock below Its Market Price ‘The Covered Put Sale Ratio Put Writing. Chapter 20 The Sale of a Straddle The Covered Straddte Write The Uncovered Straddle Write Selecting a Straddle Write Follow-Up Action. cece Equivalent Stock Position Follow-Up. Starting Out with the Protection in Place Strangle (Combination) Writing Further Comments on Uncovered Straddle and Strangle Writing, 282 285 285 288 302 302 307 308 312 313 31s: 318 viii (omens Chapter 21 Synthetic Stock Positions Created by Puts and Calls . Synthetic Long Stock Synthetic Short Sale. Splitting the Strikes Summary Chapter 22 Basic Put Spreads........... 329 Bear Spread. coe 329 Bull Spread 332 Calendar Spread 333 Chapter 23, Spreads Combining Calls and Puts. .. The Butterfly Spread Combining an Option Purchase and a Spread. A Simple Follow-Up Action for Bull or Bear Spreads Three Useful but Complex Strategies Selecting the Spreads. Summary : = 356 Chapter 24 Ratio Spreads Using Puts ...........+.+++ ‘The Ratio Put Spread. 358 Using Deltas. . 361 ‘The Ratio Put Calendar Spread. 361 A Logical Extension (The Ratio Calendar Combination). 364 Put Option Summary. . 366 Chapter 25 The Basics Pricing LEAPS. Comparing LEAPS and Short-Term Options. ard LEAPS Strategies. 375 Speculative Option Buying with LEAPS = 382 Selling LEAPS : 390 (Contents Spreads Using LEAPS Summary 403 409 Part IV ADDITIONAL CONSIDERATIONS Chapter 26 Buying Options and Treasury Bills... oacda5 66 “How the Treasury BillOption Stratezy Operates 413 Summary #1 Chapter 27 Arbitrage... ....-.seeeeece ween Basic Put and Call Arbitrage (Discounting? 23 Dividend Arbitrage : . coe 25 Conversions and Reversals. 428 More on Carrying Costs 430 Back to Conversions and Reversals 431 Risks in Concersions and Reversals. . : 493 Summary of Conversion Arbitrage cette 437 The “Interest Play 438 The Box Spread 439 Variations on Equivalence Arbitrage 443 The Effects of Arbitrage : 44 Risk Arbitrage Using Options 5 Pairs Trading 454 Facilitation (Black Positioning) = 455 Chapter 28 Mathematical Applications. . ++ 456 ‘The Black-Scholes Modal. 456 Expected Return 466 Applying the Calculations to Strategy Decisions. : 472 Facilitation or Institutional Block Positioning... 482 Aiding in Follow-Up Action 485 Implementation 488 Summary 489 Part V INDEX OPTIONS AND FUTURES Chapter 29 Introduction to Index Option Products and Futures. . = 493 Indices . ee 493 Cash-Based Options 500 atures voces . 506 Options on Index Futures . 512 Standard Options Strategies Using Index Options. vee BIB Put-Call Ratio 520 Summary. coeeeeee coe 523 Chapter 30 Stock Index Hedging Strategies. . soll Market Baskets 531 Program Trading 537 Index Arbitrage . cece AT Follow-Up Strategies oo S87 Market Basket Risk 560 Impact on the Stock Market. 561 Simulating an Index. 566 Trading the Tracking Error fee ord Summary 877 Chapter 31 Index Spreading Sie agg oo eegsue5noecoeoEo53054050009 Inter-Index Spreading Serer : 579 Summary vee 8B ‘Chapter 32 Structured Products . . Poereeeeeeeerers . 589 Part I: “Riskless” Ownership of a Stock or Index 590 The “Structure” of a Structured Product. 5 590 Cash Value, ae 593. The Cost of the Imbedded Call Option . 504 Price Behavior Prior to Maturity 595 SIS. 596 Computing the Value of the Imbedded Call When the Underlying Is Trading ata Discount 602 The Adjustment Factor 602 Other Constructs : 607 Option Strategies Involving Structured Products 613 Lists of Structured Products 618 Part II: Products Designed to Provide “Income” 618 PERCS, : 618 Call Feature : . 620 A PERGS Is a Covered Call Write. 622 Price Behavior : 623 PERCS Strategies : 625 PERCS Summary .....0.00.04+ : 636 Other Structured Products 7 Structured Product Summary 640 Chapter 33 Mathematical Considerations for Index Products......... Arbitrage 641 Mathematical Applications cites 644 Chapter 34 Futures and Futures Options ..... 652 Futures Contracts 653 Options on Futures 660 Futures Option Trading Strategies. 2674 Commonplace Mispricing Strategies ce 653 Summary 695 Chapter 35. Futures Option Strategies for Futures Spreads . wee ee es 696 Futures Spreads. 696 Using Futures Options in Futures Spreads... 704 Summary 720 Part VI MEASURING AND TRADING VOLATILITY Chapter 36 The Basics of Volatility Trading. ........6.0.ccee00eeeeeeeeee 727 Definitions of Volatility 728 Another Approach: GARCH 731 Moving Averages 732 Inilied Volatility 732 The Volatility of Volatility . . 734 Volatility Trading ce TAB Why Does Volatility Reach Extremes?. TH Summary : 748 Chapter 37 How Volatility Affects Popular Strategies ..... ea) Vega : 2.749 Implied Volatility and Delta 753 Effects on Neutrality 755 Position Vega 187 Outright Option Purchases and Sales 787 ‘Time Value Premium is a Misnomer 762 Volatility and the Put Option. . 765 Straddle or Strangle Buying and Selling . 766 Call Bull Spreads 767 Vertical Put Spreads 6 Put Bear Spreads . : m7 Calendar Spreads . 778 Ratio Spreads and Backspreads 780 Summary . 782 Chapter 38 The Distribution of Stock Prices ...........++ ween 783 Misconceptions about Volatility 753 Volatility Buyer's Rule! 7 ‘The Distribution of Stock Prices 769 What This Means for Option Traders 795 ‘Stock Price Distribution Summary 796 The Pricing of Options. : . 2798 ‘The Probability of Stock Price Movement .... cece 798 Expected Return . 809 Summary : 5 810 Chapter 39 Volatility Trading Techniques .......-..0eeeeeeeeeeeeeeeeee BIZ ‘Two Ways Volatility Predictions Can Be Wrong : 813 ‘Trading the Volatility Prediction . su Trading the Volatility Skew : 837 Volatility Trading Summary ce su Chapter 40 Advanced Concepts . e = 846 Neutrality 6 The “Greeks” 848 Strategy Considerations: Using the “Greks” 866 ‘Advanced Mathematical Concepts. so1 Summary 07 Chapter 41 Taxes......+. oe History Basic Tax Treatment. cee : = 910 Exercise and Assignment . foe 913 Special Tax Problems : : 922 Summary oo 925 ‘Tax Planning Strategies for Equity Options oe 985 Summary : : epreco 930 Chapter 42 The Best Strategy? ..... General Concepts: Market Attitude and Equivalent Positions = 932 What Is Best for Me Might Not Be Best for You 934 ‘Mathematical Ranking. . 996 Summary 5 cece 937 Postscript... Part VIL APPENDICES ‘Appendix A Strategy Summary Appendix B Equivalent Positions Appendix C Formulae .. Appendix D Graphs. + -957 Appendix E Qualified Covered Calls... +961 Glossary. ‘ 963 Index : 983, Preface ‘When the listed option market originated in April 1973, a new world of investment strategies was opened to the investing public. The standardization of option terms and the formation of a liquid secondary market created new investment vehicles that, adapted properly, can enhance almost every investment philosophy, from the con- servative to the speculative. This book is about those option strategies ~ which ones work in which situations and why they work. Some of these strategies are traditionally considered to be complex, but with the proper knowledge of their underlying principles, most investors can understand them, While this book contains all the basic definitions concerning options, little time ‘or space is spent on the most elementary definitions. For example, the reader should be familiar with what a call option is, what the CBOE is, and how to find and read option quotes in a newspaper. In essence, everything is contained here for the novice to build on, but the bulk of the discussion is above the beginner level. The reader should also be somewhat familiar with technical analysis, understanding at least the terms support and resistance. Certain strategies can be, and have been, the topic of whole books — call buy- ing, for example. While some of the strategies discussed in this book receive a more thorough treatment than others, this is by no means a book about only one or two strategies. Current literature on stock options generally does not treat covered call ‘writing in a great deal of detail. But because it is one of the most widely used option strategies by the investing public, call writing is the subject of one of the most in- depth discussions presented here. The material presented herein on call and put buying is not particularly lengthy, although much of it is of an advanced nature — especially the parts regarding buying volatility ~ and should be useful even to sophis- ticated traders, In discussing each strategy, particular emphasis is placed on showing why one would want to implement the strategy in the first place and on demonstrat nv vii Prefoce are made for using the computer as a tool in follow-up action, including an example printout of an advanced follow-up analysis. THIRD EDITION There were originally six new chapters in the third edition. There were new chapters on LEAPS, CAPS, and PERCS, since they were new option or option-related prod- ‘ucts at that time. LEAPS are merely long-term options. However, as such, they require a little different viewpoint than regular short-term options. For example, short-term inter- est rates have a much more profound influence on a longer-term option than on a short-term one. Strategies are presented for using LEAPS as a substitute for stock ownership, as well as for using LEAPS in standard strategies. PERCS are actually a type of preferred stock, with a redemption feature built in, They also pay significantly larger dividends than the ordinary common stock. The redemption feature makes a PERCS exactly like a covered call option write. As such, several strategies apply to PERCS that would also apply to covered writers, Moreover, suggestions are given for hedging PERCS. Subsequently, the PERCS chapter was enveloped into a larger chapter in the fourth edition. ‘The chapters on futures and other non-equity options that were written for the second edition were deleted and replaced by two entirely new chapters on futures options, Strategists should familiarize themselves with futures options, for many prof- it opportunities exist in this area. Thus, even though futures trading may be unfamil- iar to many customers and brokers who are equity traders, it behooves the serious strategist to acquire a knowledge of futures options. A chapter on futures concentrates ‘on definitions, pricing, and strategies that are unique to futures options; another chap- ter centers on the use of futures options in spreading strategies. These spreading strategies are different from the ones described in the first part ofthe book, although the calendar spread looks similar, but is really not. Futures traders and strategists spend a great deal of time looking at futures spreads, and the option strategies pre- sented in this chapter are designed to help make that type of trading more profitable, A new chapter dealing with advanced mathematical concepts was added near the end of the book. As option trading matured and the computer became more of an integral way of life in monitoring and evaluating positions, more advanced tech- niques were used to monitor risk. This chapter describes the six major measures of risk of an option position or portfolio. The application of these measures to initialize positions that are doubly or triply neutral is discussed. Moreover, the use of the com- puter to predict the results and “shape” of a position at points in the future is described. Preface xix ‘There were substantial revisions to the chapters on index options as well. Part of the revisions are due to the fact that these were relatively new products atthe time of the writing ofthe second edition; as a result, many changes were made to the prod- ucts — delisting of some index options and introduction of others. Also, after the crash of 1987, the use of index products changed somewhat (with introduction of circuit breakers, for example. FOURTH EDITION Once again, in the ever-changing world of options and derivatives, some new important products have been introduced and some new concepts in trading have come to the forefront. Meanwhile, others have been delisted or fallen out of favor. ‘There are five new chapters in the fourth edition, four of which deal with the most important approach to option trading today — volatility trading, ‘The chapter on CAPS was deleted, since CAPS were delisted by the option ‘exchanges. Moreover, the chapter on PERCS was incorporated into a much larger and more comprehensive chapter on another relatively new trading vehicle — struc- tured products. Structured products encompass a fairly wide range of securities ~ ‘many of which are listed on the major stock exchanges. These versatile products allow for many attractive, derivative-based applications — including index funds that have limited downside risk, for example. Many astute investors buy structured prod- ‘ucts for their retirements accounts. Volatility trading has become one of the most sophisticated approaches to option trading, The four new chapters actually comprise a new Part 6 ~ Measuring ‘And Trading Volatility. This new part of the book goes in-depth into why one should trade volatility (its easier to predict volatility than it is to predict stock prices), how volatility affects common option strategies — sometimes in ways that are not initially obvious to the average option trader, how stock prices are distributed (which is one of the reasons why volatility trading “works”), and how to construct and monitor a volatility trade, A number of relatively new techniques regarding measuring and pre- dicting volatility are presented in these chapters. Personally, I think that volatility buying of stock options is the most useful strategy, in general, for traders ofall levels — from beginners through experts. If constructed properly, the strategy not only has a high probability of success, but it also requires only a modest amount of work to monitor the position after it has been established. This means that a volatility buyer ccan have a “life” outside of watching a screen with dancing numbers om it all day. Moreover, most of the previous chapters were expanded to include the latest techniques and developments. For example, in Chapter 1 (Definitions), the entire area of option symbology has been expanded, because of the wild movements of x Preface stocks in the past few years. Also, the margin rules were changed in 2000, and those changes are noted throughout the book Those chapters dealing with the sale of options ~ particularly naked options ~ have been expanded to include more discussion of the way that stocks behave and how that presents problems and opportunities for the option writer. For example, in the chapter on Reverse Spreads, the reverse calendar spread is described in detail because - in a high-volatility environment — the strategy becomes inuch more viable. Another strategy that receives expanded treatment is the “collar” ~ the purchase of a put and simultaneous sale of a call against an underlying instrument. In fact, a similar strategy can be used — with a slight adjustment — by the outright buyer of an option (see the chapter on Spreads Combining Puts and Calls) Lam certain that many readers of this book expect to learn what the “best” option strategy is. While there is a chapter discussing this subject, there is no defin- itively “best” strategy. The optimum strategy for one investor may not be best for another. Option professionals who have the time to monitor positions closely may be able to utilize an array of strategies that could not possibly be operated diligently by public customer employed in another full-time occupation. Moreover, one’s partic- ular investment philosophy must play an important part in determining which strat- egy is best for him. Those willing to accept little or no risk other than that of owning stock may prefer covered call writing. More speculative strategists may feel that low- cost, high-profit-potential situations suit them best. Every investor must read the Options Clearing Corporation Prospectus before trading in listed options. Options may not be suitable for every investor. There are risks involved in any investment, and certain option strategies may involve large risks The reader must determine whether his or her financial situation and investment objectives are compatible with the strategies described, The only way an investor can reasonably make a decision on his or her own to trade options is to attempt to acquire a knowledge of the subject, Several years ago, I wrote that “the option market shows every sign of becom ing a stronger force in the investment world, Those who understand it will be able to benefit the most.” Nothing has happened in the interim to change the truth of that statement, and in fact, it could probably be even more forcefully stated today. For example, the Federal Reserve Board now often makes decisions with an eye to how derivatives will affect the markets. That shows just how important derivatives have become. The purpose of this book is to provide the reader with that understanding of options. | would like to express my appreciation to several people who helped make this book possible: to Ron Dilks and Howard Whitman, who brought me into the bro- Preface rxi erage business; to Art Kaufman, whose broad experience in options helped to erys- tallize many of these strategies; to Peter Kopple for his help in reviewing the chap- ter on arbitrage; to Shelley Kaufman for his help on the third and fourth editions in designing the graphs and in the massive task of proofreading and editing; to Ben Russell and Fred Dahl for their suggestions on format and layout of the intial book; and to Jim Dalton (then president of the CBOE) for recommending a little-known option strategist when the New York Institute of Finance asked him, in 1977, if he had any suggestions for an author for a new book on options. Special thanks go to Bruce Nemirow for his invaluable assistance, especially for reading and critiquing the original manuscript. Most of all, I am grateful to my wife, Janet, who typed the orig- inal manuscript, and to Karen and Glenn, our children, all of whom graciously with- stood the countless hours of interrupted family life that were necessary in order to complete this work. LawRENCE G. MCMILLAN Pai Basic Properties of Stock Options INTRODUCTION Each chapter in this book presents information in a logically sequential fashion Many chapters build on the information presented in preceding chapters. One should therefore be able to proceed from beginning to end without constantly refer- ring to the glossary or index. However, the reader who is using the text as a refer- ence — pethaps scanning one of the later chapters ~ many find that terms are being ‘encountered that have been defined in an earlier chapter. In this case, the extensive slossary at the back of the book should prove useful. The index may provide aid as. well, since some subjects are described, in varying levels of complexity, in more than one place in the book. For example, call buying is discussed initially in Chapter 3: and mathematical applications, as they apply to call purchases, are described in Chapter 28. The latter chapters address more complex topics than do the early chapters Definitions The successful implementation of various investment strategies necessitates a sound working knowledge of the fundamentals of options and option trading. The option, strategist must be familiar with a wide range of the basic aspects of stock options ~ how the price of an option behaves under certain conditions or how the markets function. A thorough understanding of the rudiments and of the strategies helps the investor who is not familiar with options to decide not only whether a strategy seems desirable, but also — and more important ~ whether itis suitable. Determining suit- ability is nothing new to stock market investors, for stocks themselves are not suitable for every investor. For example, if the investor's primary objectives are income and safety of principal, then bonds, rather than stocks, would be more suitable. The need to assess the suitability of options is especially important: Option buyers can lose their entire investment in a short time, and uncovered option writers may be subjected to large financial risks, Despite follow-up methods designed to limit risk, the individual investor must decide whether option trading is suitable for his or her financial situa- tion and investment objective. ELEMENTARY DEI ONS A stock option is the right to buy or sell a particular stock at a certain price for alim- ited period of time. The stock in question is called the underlying security. A call option gives the owner (or holder) the right to buy the underlying security, while a put option gives the holder the right to sell the underlying security. The price at ‘which the stock may be bought or sold is the exercise price, also called the striking price. (In the listed options market, “exercise price” and “striking price” are synony- mous.) A stock option affords this right to buy or sell for only a limited period of times 4 Part ts Basic Properties of Stock Options thus, each option hasan expiration date, Throughout the book, the term “options” is always understood to mean listed options, that is, options traded on nation] option exchanges where a secondary market exists, Unless specifically mentioned, over-the- Counter options are not included in any discussion, DESCRIBING OPTIONS Four specifications uniquely describe any option contract 1. the type (put or call), 2. the underlying stock name, 3. the expiration date, and 4. the striking price. -r”rt—“

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