cover & table of contents - options for volatile markets (2nd edition)

P1: OTA/XYZ P2: ABCJWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford

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OPTIONS FORVOLATILEMARKETS

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Since 1996, Bloomberg Press has published books for financial professionalson investing, economics, and policy affecting investors. Titles are written byleading practitioners and authorities, and have been translated into more than20 languages.

The Bloomberg Financial Series provides both core reference knowledgeand actionable information for financial professionals. The books are writ-ten by experts familiar with the work flows, challenges, and demands ofinvestment professionals who trade the markets, manage money, and analyzeinvestments in their capacity of growing and protecting wealth, hedging risk,and generating revenue.

For a list of available titles, please visit our Web site at www.wiley.com/go/bloombergpress.

Other books by the authorsFar From RandomUsing Investor Behavior and Trend Analysis to Forecast

Market Movement by Richard Lehman (Bloomberg Press, 2009)McMillan on Options by Lawrence G. McMillan (John Wiley & Sons, 2004)New Insights on Covered Call WritingThe Powerful Technique that Lowers

Risk and Enhances Returns in Stock Investing by Richard Lehman andLawrence G. McMillan (Bloomberg Press, 2003)

Options as a Strategic Investment, Fourth Edition, by Lawrence G. McMillan(New York Institute of Finance, 2002)

Profit with Options by Lawrence G. McMillan (John Wiley & Sons, 2002)

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OPTIONS FORVOLATILEMARKETSManaging Volatility andProtecting against Catastrophic Risk

SECOND EDITION

Richard LehmanLawrence G. McMillan

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Copyright 2011 by Richard Lehman and Lawrence G. McMillan. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

A previous edition of this book, New Insights on Covered Call Writing: The Powerful Technique ThatEnhances Return and Lowers Risk in Stock Investing by Richard Lehman and Lawrence G. McMillan, waspublished in 2003 by Bloomberg Press.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form orby any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except aspermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the priorwritten permission of the Publisher, or authorization through payment of the appropriate per-copy fee tothe Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax(978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission shouldbe addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Lehman, Richard, 1948Options for volatile markets : managing volatility and protecting against catastrophic risk / Richard

Lehman, Lawrence G. McMillan. 2nd ed.p. cm.(Bloomberg financial ; 143)

Includes index.Rev. ed., previously published under title: New insights on covered call writing by Bloomberg Press

in 2003.ISBN 978-1-118-02226-9 (cloth); ISBN 978-1-118-10264-0 (ebk);ISBN 978-1-118-10265-7 (ebk); ISBN 978-1-118-10266-4 (ebk)1. Stock options. 2. Investments. I. McMillan, L. G. (Lawrence G.) II. Lehman, Richard,

1948= New insights on covered call writing. III. Title.HG6042.L44 2011332.63228dc22 2011012023

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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http://www.copyright.comhttp://www.wiley.com/go/permissionshttp://www.wiley.com


In memory of Roslyn Lehman

January 6, 1928September 24, 2010

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Contents

Preface xi

INTRODUCTIONThe New Normal in Equity Investing 1

CHAPTER 1Option Basics 7What Are Options? 7Exercise and Assignment 14Positions 17How Options Are Traded 19Options in Your Account 22

CHAPTER 2Option Pricing and Valuation 25Option Premium 25Theoretical Value 27Time Value 28Volatility 31Interest Rates 32Dividends 32Calls versus Puts 33Option Skews and Anomalies 34

CHAPTER 3The Basics of Covered Call Writing 37Requirements for Valid Covered Writes 38Risk/Reward of a Covered Write 39Calculating Potential Returns 46Major Factors Affecting Call-Writing Returns 48

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Covered Writing as an Ongoing Strategy 54Summing Up Covered Writing 57

CHAPTER 4Implementing Covered Call Writing 59Follow-Up Actions 59Behavioral Issues 69Differing Approaches 70Selecting Calls to Write 77Risks 80Basic Tax Rules for Options 81Summing Up Implementation 84

CHAPTER 5Advanced Call-Writing Techniques 87Writing Calls on Hot Stocks 88Tax Deferral Strategies 89Covered Writing on Margin 90Covered Writing against Securities Other Than Stock 93Partial Writing, Mixed Writing, and Ratio Writing 98Put Writing 103Expiration Games 106Option-Stock Arbitrage 108

CHAPTER 6Basic Put Hedging 111Put Hedge Basics 111Advantages 115Disadvantages 116Behavioral Implications 123Put Hedge versus Covered Call 127Hedging against Catastrophic Risk 129

CHAPTER 7Advanced Hedging Strategies 131Put Hedge Follow-Ups 131Using Put Spreads to Hedge 137Collars 145Conclusions on Protective Option Strategies 151


Contents ix

CHAPTER 8Options on ETFs 153ETFs in a Nutshell 154ETF Options 158Covered Call Writing on ETFs 159Our Put Hedge and Collar Study on SPY 162Appendix: Partial List of ETFs with Listed Options 165

CHAPTER 9Volatility and Volatility Derivatives 171What Is Volatility? 171Using VIX as a Market Indicator 173Volatility Futures 179Variance Futures 181The Behavior of VIX Futures 183VIX Options 191VIX Option Strategies 199The Future 204

Acknowledgments 205

About the Authors 206

Index 207


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P1: OTA/XYZ P2: ABCJWBT522-bpreface JWBT522-Lehman June 18, 2011 9:13 Printer Name: Courier Westford

Preface

Because our previous books covered the gamut on option theory and strategies,one might reasonably ask why we felt the need to publish a new book on thesubject at this time. The answer to that is twofold: (1) because there havebeen material developments within the world of optionsnew durations,new rules, new volatility instruments, and (2) more important, because therehave also been significant changes in the nature of the markets and theenvironment for securities investing. In the interest of brevity, we referred tothe new environment in the title simply as volatile markets, but that understateshow extensive we feel the changes are. What we are really saying (and weexpound further on this subject in the Introduction) is that todays financialmarkets harbor risk and uncertainties far beyond historically accepted norms,and that it is now more important than ever to manage the risks in investmentportfolios on a continual basis. To that end, we still see listed options as thesingle most effective tool in the financial arsenal for dealing with such riskand volatility.

We still believe covered call writing is an underutilized strategy that offersequity investors a highly effective tool for reducing volatilitymuch more sothan simply relying on security diversification. But we also feel that volatilityhas become more of a factor in equity investing than ever before and thatthe downside risks of equity investing have expanded dramatically. Theserisks, which are an ever-present factor in equities markets, are growing ratherthan receding, and have reached a level that not only requires a more potentdefense against risk than covered call writing by itself, but suggest that equityportfolios should adopt a virtually continuous risk-management strategy. Yet,as we concluded in our earlier work, the mainstream investment managementindustry remains sorely lacking in either using options themselves or in aidinginvestors in using them. The events of 2008 and the flash crash of 2010should have awakened professional managers in a big way to the need tohedge equity portfolios with options, but for a variety of systemic reasons,those changes have been slow to emerge. Our aim with this book is to help

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both individuals and money management professionals recognize that risk isvery definitely a controllable entity.

In 2003, we published New Insights on Covered Call Writing because wefelt that vast improvements in online tools, data, and discount brokerageservices coupled with changes in options availability and reduced transactioncosts had significantly changed the landscape for individual investors withregard to writing covered calls in stock portfolios. At the same time, the full-service wire houses were discouraging their reps and clients from using optionsand professional money managers continued to live in a stock picking worldthat simply didnt embrace options in a serious way. For the most part, theseconditions persist. Yet, had you adopted covered call writing in the beginningof 2004 in a well diversified portfolio, you would not only have significantlyreduced your volatility compared to that of the S&P 500 over the ensuing sixyears, you would also have handily outperformed it. Between the years 2004and 2009, the S&P Total Return index (S&P 500 with dividends reinvested)returned 13.36 percent, while, according to the CBOE, its Buy-Write index(BXM) returned 20.54 percent for the same period.

The basic practice of covered call writing reduces volatility quite nicely(about one-third according to studies on the BXM index), but more advancedforms of option writing coupled with more powerful hedging strategies such aspurchasing puts may be necessary in todays environment. Put hedging satisfiesthe downside protection requirement, but can be prohibitively expensive andhas other drawbacks. In this book, we discuss variations of both strategies indetail as well as the use of both together to deal with todays markets. Finally, weexamine the new vehicles that allow investors to actually trade volatility itself.

The first five chapters in this book represent an updated and condensedversion of the basic options and covered call writing content from New Insightson Covered Call Writing . (Chapters 1 and 2 are very elementary and areincluded so those who have never used options before can start from scratch.Those already familiar with options may want to jump in at Chapter 3 for thebasics of covered call writing.) Chapter 6 focuses on put hedging and Chapter 7combines call writing and put hedging into collar strategies. Chapter 8 appliesthese option strategies to the rapidly growing field of exchange-traded funds(ETFs), and Chapter 9 explains how to utilize the new volatility instrumentsthat are now available.

The book is addressed to the broad audience of equity investors, bothindividual and professional. We feel that every investor in listed equities,whether managing a portfolio themselves, or paying a broker, money manager,or mutual fund manager to manage it for them, should at least recognize that


Preface xiii

there are tools available to effectively reduce risk and volatility, and to eitherlearn how to use those tools themselves, or find a professional who does. Inparticular, we hope, for the sake of millions of hardworking Americans, thatthe people responsible for pension and retirement assets in this country takenote, as trillions of dollars in retirement assets are woefully unhedged againstanother calamity like 2008 or worse.

RICHARD LEHMANLAWRENCE G. MCMILLAN

P1: OTA/XYZ P2: ABCJWBT522-babout JWBT522-Lehman June 20, 2011 9:49 Printer Name: Courier Westford

About the Authors

Richard Lehman is the founder of RHL Capital, a Registered InvestmentAdviser and an Instructor of Behavioral Finance and Options at UC BerkeleyExtension. He also publishes a weekly investment newsletter on technicalanalysis called The Channelist. His financial career spans more than 30 yearsin Product Management, Marketing, Sales and Investment Management,beginning with an 11-year-stint on Wall Street with EF Hutton, ThomsonMcKinnon, and the New York Stock Exchange.

Lawrence G. McMillan is the founder and President of McMillan Analy-sis Corporation. He authors Daily Volume Alerts, a unique daily servicethat selects short-term stock trades by looking for unusual increases in equityoption volume. McMillan manages option-oriented accounts for individ-ual investors and also publishes The Option Strategist, a derivative productsnewsletter covering equity, index, and futures options.

As one of the foremost experts on options, McMillan has taught optionscourses at the New York Institute of Finance, and has spoken on optionsstrategies at many seminars and colloquiums in the United States, Canada,and Europe. He was formerly senior vice president in charge of the EquityArbitrage Department at Thomson McKinnon Securities, Inc.

The authors web sites contain additional material, product and service refer-ences, and links to related sites:

www.RHLCapital.comwww.OptionStrategist.com

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http://www.RHLCapital.comhttp://www.OptionStrategist.com

P1: OTA/XYZ P2: ABCJWBT522-babout JWBT522-Lehman June 20, 2011 9:49 Printer Name: Courier Westford

About the Authors

Richard Lehman is the founder of RHL Capital, a Registered InvestmentAdviser and an Instructor of Behavioral Finance and Options at UC BerkeleyExtension. He also publishes a weekly investment newsletter on technicalanalysis called The Channelist. His financial career spans more than 30 yearsin Product Management, Marketing, Sales and Investment Management,beginning with an 11-year-stint on Wall Street with EF Hutton, ThomsonMcKinnon, and the New York Stock Exchange.

Lawrence G. McMillan is the founder and President of McMillan Analy-sis Corporation. He authors Daily Volume Alerts, a unique daily servicethat selects short-term stock trades by looking for unusual increases in equityoption volume. McMillan manages option-oriented accounts for individ-ual investors and also publishes The Option Strategist, a derivative productsnewsletter covering equity, index, and futures options.

As one of the foremost experts on options, McMillan has taught optionscourses at the New York Institute of Finance, and has spoken on optionsstrategies at many seminars and colloquiums in the United States, Canada,and Europe. He was formerly senior vice president in charge of the EquityArbitrage Department at Thomson McKinnon Securities, Inc.

The authors web sites contain additional material, product and service refer-ences, and links to related sites:

www.RHLCapital.comwww.OptionStrategist.com

206

http://www.RHLCapital.comhttp://www.OptionStrategist.com

OPTIONS FORVOLATILEMARKETSContentsPrefaceINTRODUCTION The New Normal in Equity InvestingCHAPTER 1 Option BasicsWhat Are Options?Exercise and AssignmentPositionsHow Options Are TradedOptions in Your Account

CHAPTER 2 Option Pricing and ValuationOption PremiumTheoretical ValueTime ValueVolatilityInterest RatesDividendsCalls versus PutsOption Skews and Anomalies

CHAPTER 3 The Basics of Covered Call WritingRequirements for Valid Covered WritesRisk/Reward of a Covered WriteCalculating Potential ReturnsMajor Factors Affecting Call-Writing ReturnsCovered Writing as an Ongoing StrategySumming Up Covered Writing

CHAPTER 4 Implementing Covered Call WritingFollow-Up ActionsBehavioral IssuesDiffering ApproachesSelecting Calls to WriteRisksBasic Tax Rules for OptionsSumming Up Implementation

CHAPTER 5 Advanced Call-Writing TechniquesWriting Calls on Hot StocksTax Deferral StrategiesCovered Writing on MarginCovered Writing against Securities Other Than StockPartial Writing, Mixed Writing, and Ratio WritingPut WritingExpiration GamesOption-Stock Arbitrage

CHAPTER 6 Basic Put HedgingPut Hedge BasicsAdvantagesDisadvantagesBehavioral ImplicationsPut Hedge versus Covered CallHedging against Catastrophic Risk

CHAPTER 7 Advanced Hedging StrategiesPut Hedge Follow-UpsUsing Put Spreads to HedgeCollarsConclusions on Protective Option Strategies

CHAPTER 8 Options on ETFsETFs in a NutshellETF OptionsCovered Call Writing on ETFsOur Put Hedge and Collar Study on SPYAppendix: Partial List of ETFs with Listed Options

CHAPTER 9 Volatility and Volatility DerivativesWhat Is Volatility?Using VIX as a Market IndicatorVolatility FuturesVariance FuturesThe Behavior of VIX FuturesVIX OptionsVIX Option StrategiesThe Future

AcknowledgmentsAbout the AuthorsIndexOPTIONS FORVOLATILEMARKETSContentsPrefaceINTRODUCTION The New Normal in Equity InvestingCHAPTER 1 Option BasicsWhat Are Options?Exercise and AssignmentPositionsHow Options Are TradedOptions in Your Account













































AcknowledgmentsAbout the AuthorsIndex

cover & table of contents - options for volatile markets (2nd edition)

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