Options as a Strategic Investment: Fifth Edition 5th Edition
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Just a few things I have learned from this book:
- The inner workings of the options market, including what happens behind the scenes when an option expires or gets exercised.
- The best explanation I've ever read of time value decay and how it relates to volatility of the underlying stock
- Why you probably should trade short term options instead of long term
- How to calculate a realistic estimate of risk vs. reward of a potential option play
- Different ways of writing covered calls depending on how aggressive or conservative you want to be
- How to compare different options from the available expiration dates and strike prices
- The pros and cons between writing an in-the-money option or an out-of-the-money option.
- How dividends can increase the risk of being assigned when writing a call option
- How to roll down a covered call option to maneuver your way out of a losing stock position.
I've learned all of this in the first 60 pages, and this book is over 1,000 pages. This book has paid for itself already with what I learned. Despite being jam packed with information, it is actually very approachable for anyone with the most basic knowledge of options trading.
I'm not kidding, buy this book!
Having read the 4th edition and two subsequent publications, I did not find any significantly new material in this 5th edition. About 85% of the book repeats information in the 4th and possibly earlier editions. The new material includes a chapter on mathematical applications (pages 447 - 477) and an expanded discussion of volatility (pages 767 - 947). The mathematical applications give a good overview of an option's theoretical value. If you want to learn how to calculate theoretical values, however, you should also read Options, Futures, and Other Derivatives (4th Edition) (Hull, 2011).
Although new to this book, much of the information on volatility was previously published in McMillan 2004 (pages 241-568) and McMillan 2011 (pages 171 - 204). For example, Figures 41-2 (p 872) and 41-3 (p 878) in this book are identical to Figures 9.1 and 9.9 in McMillan 2011. Also, much of the volatility - related text and several of the tables in this book are similar to those in McMillan 2004 and 2011. While one might criticize McMillan for repackaging the same material in different books, on the positive side: If you buy this book, you do not need to buy the other two.
I am disappointed that this 5th edition still uses hypothetical examples, rather than actual trades. While hypothetical examples are useful in explaining how to construct a position or to illustrate a position's sensitivity to individual variables (i.e., the Greeks: delta, gamma, vega and theta), they often do not give one a practical sense of whether the trade would be profitable or even feasible. Moreover, the hypothetical examples are mathematically rigged to give simple outcomes that do not occur in real trades.
Throughout the book McMillan advises his readers to construct option positions that are insensitive or "delta-neutral" to changes in the price of the underlying stock (e.g. Chapters 6, 11, 12 and 13). In his example of a neutral calendar spread (page 215) he buys 7 April 45 calls and sells 8 July 45 calls. The ratio of calls bought to calls sold was calculated from an unrealistic delta ratio of .7/.8. Actual delta values are expressed to at least four decimal places. A neutral position based on deltas rounded to the nearest tenth would be far from neutral.
Chapter 40 explains how to create a position that is neutral with respect to both gamma and delta and would profit at a specific rate (vega) if implied volatility increases or decreases (pages 835 - 836). Theoretically, such a position would be insensitive to changes in the stock's price but would profit with changes in implied volatility (IV). The example trade sells volatility; i.e. it would profit by $238.00 for every 1% drop in IV. To construct such a position for the hypothetical "XYZ" stock, one must buy 100 April 50 calls, sell 173 April 60 calls and short 1,759 shares of XYZ stock. In my opinion, this is an extremely large position just for the sake of making a profit when implied volatility drops.
I constructed two delta / gamma neutral spreads in a simulated account using the same math and methods that McMillan used in his example. One spread on Apple Computer (AAPL) would profit if implied volatility drops, and another spread on General Electric (GE) would profit if implied volatility rises. Unlike McMillan's example, the only way I could come close to achieving a delta / gamma neutral position was to specify a more modest return from vega e.g. -100.00 < position vega < 100.00. The position vega in McMillan's example is 278.00. Like McMillan's example, these were extraordinarily large positions; so large that the 500,000.00 cash balance in my simulated account did not provide sufficient margin to execute either trade. If anyone wants to see the specifics of these simulated trades, leave a comment or send me an email.
McMillan 2004 (page 505) includes a similar example of a huge position (555 contracts) that is delta/gamma neutral with limited vega risk. Later (page 516) McMillan concedes that this is a "theoretical example", but in this book, McMillan appears to be advising his readers to actually make these large trades. I wonder who he had in mind? Perhaps the London Whale made these types of trades until Jamie Dimon fired him.
The book exaggerates the potential profits and low cost of adding a collar to a long stock position. According to Table 17-3 (page 264), a collar made by the sale of 2 ½ year out-of-the-money (OTM) calls and the purchase of 2 ½ year at-the-money (ATM) puts allows a 30% - 70% profit with a small risk. The text states, "Thus one should consider using 2.5 year LEAPS options when he establishes a collar because the striking price of OTM calls (that are sold) can cover the costs of ATM puts." I checked the price of adding a 2 ½ year collar to NKE, IBM, JPM and AAPL and found that the sale of any OTM call would not cover the cost of an ATM put. To break even, one would have to sell at least two calls for every put purchased. Note that in "Options for Volatile Markets" (McMillan 2011) McMillan recommends a different collar strategy: buy six-month puts and sell one month calls with strike prices approximately 2% OTM (page 149).
I stumbled on a few errors that while insignificant, should not exist after six editions:
* The text states, "Figure 37-8 shows just two cases - implied volatility of 30% and implied volatility of 80%." (page 731) The two curves in Figure 37-8 are both labeled IV = 30%.
* The short "240 January 70 calls" (p 841) should have a negative delta, gamma and vega, and a positive theta.
* The text states, "Since 1986, long-term and short-term capital gains rates have been equal." (page 953). As long as I can remember, tax rates on long-term capital gains has been lower than on short-term. For tax year 2013 the maximum long-term rate is 15% and the maximum short-term rate is 35%.
This long review focuses on a very small portion of this very long book. Generally, this is a good book and it is reasonably-priced. Just keep in mind that the book is not perfect and contains information that was previously published.
Top international reviews
But the following are the issues I have seen with the book...
1. Although it has tons of strategies, the key strategies used by traders these days are missing...e.g. Iron Fly, Jade lizard, unbalanced strangle etc.
2. Overall emphasis is on defined risk strategies. That is fine in US market where you can dramatically reduce your margin requirement using defined risk strategies. But in India that does not work. Sebi in her infinite wisdom has decided to ask for same margin even if risk is lot lower in defined risk strategies. So for iron condor (defined risk strangle) and strangle (undefined risk) will need almost same margin. In India you have no advantage using defined risk strategies from return of capital standpoint. Keep this in mind while reading this book. Adapt to Indian market conditions.
3. If you are option seller like me then you may want to get hold of the book that focuses only on option selling. Because you get tired of reading only about option buying. Option buying is low probability trade.
4. The author had trashed straddle as high risk trade and covered it in few pages. If people are trading straddle ( or options are being traded at strikes same as CMP) then those traders are not idiot. There must be some risk-reward that encourages traders to trade those options. The actual quantitative research on straddles is eye opening. Look at actual data and then decide not because some book says straddle is to be avoided.
5. Important variable for the option seller is current IV with respect to past history. This is not highlighted in strategies. One reason is author has not focused on option writing.
6. No advice or suggestion on managing profits and trade. The option traders hardly wait to get last paisa or wait till the last day of epiry to take the profits or take the loss. The option trading is very volatile and it has its own best practices discovered by veteran option traders over the years. The author does not touch this important topic.
7. Although this book covers tons of strategies the professional option traders only trade few profitable ones. And few of those are missing in this book. In Indian context it is even more important. In Indian context you may rely on 3-4 strategies max. So you may want to be selective while reading his book because otherwise you may spend lot of time reading something which you may never use in life. Use this book as reference book only. Do not read from first page to last page.
Looking at such weaknesses it is clear that, based on this book you cannot successfully trade the options. You need to learn from the practitioners the nuances of option trading like managing profits, stop-loss, entry criteria etc.
But you can get the theoretical underpinning of different strategies though from this book. That is why I said it is good place to start your journey.
Missing pictures everywhere.
Missing volatility and time effect in option charts.
Missing best entry (exit) points as that matters Most, as it creates pnl. Theory is nice, but credit received at entry with higher credit at exist is a loss no matter the strategy profile show its still in "profit zone" based on underlying price.
For each strategy, you have commissions, huge bid ask spreads, volatility, decay or huge margin against you. In the end, you still have to be "right" like when purchasing stock. That's why I completely miss the timing of trades, and stock charts.
Although it's from year 2012,it feels outdated when talking about big strike differences, skipping weeklies.
So far read the parts about option strategies, will update.