Options for Volatile Markets: Managing Volatility and Protecting Against Catastrophic Risk

good book

PRAISE: First and foremost, I confidently assert that this book is the single best resource now available that is focused primarily on the subject of covered calls investing. To those who have read the 1st Edition of this book (titled “New Insights on Covered Call Writing”), this 2nd Edition is a substantial improvement. It is written with great clarity throughout and is worthwhile reading for anyone (from novice to expert) interested in covered calls and other closely-related hedging strategies. Some of the best features are:
1. Excellent definitions and explanations of options terminology; and especially insightful discussions of important topics such as time value decay, skews, implied volatility, and historic volatility.
2. A very good explanation of why a fear common to many newbie covered calls investors, namely early exercise, is largely unwarranted.
3. Thorough discussions related to position management (the authors call this “follow-up actions”), including various types of “rolling”.
4. The section on “Basic Tax Rules for Options” is the best concise description I’ve seen anywhere on this topic.
5. Why it is critically important that investors develop knowledge of how “risk” and “volatility” should inform our investment decision-making process. Consideration of specific “traps” to be avoided is another especially strong feature of this book.
6. For investors interested in modifications to the basic covered calls strategy, hedging with protective puts, collars, and option spreads are also presented. Thankfully, the authors present these alternatives in a well-balanced manner, taking time to present both the pros and cons of each strategy.

CONCERNS:
1. I share the concern of some other reviewers that the revised title of this 2nd Edition is overly generic and therefore somewhat misleading. A more appropriate title would be something like “Covered Calls and Related Hedging Strategies”.
2. Figure 6.4 is a very nice, visual way to portray the “Behavioral Impact of Covered Call Writing”. But the stock price ranges are incorrect: “Good decision offset…” should be <$47, etc., etc.
3. Weekly options now exist for over 100 equities/ETFs and they continue to grow in both availability and popularity. Including commentary on the possible role of weeklies in the several instances when expiration timeframes are addressed throughout the book would definitely enhance the readers' overall understanding.

MAJOR FLAW: On pages 162-164, the authors present results from their own study of four strategies during 2007-2010. The results are summarized in Table 8.3. Unfortunately, there are errors in the "Total Period" column which will cause naïve readers to falsely conclude that the collar strategy provides substantially better returns than the other three strategies. Two of these errors are:
* The actual overall performance of SPY over these 3 3/4 years was -13.1%, not -17.3%.
* The +15.2% return claimed for the collar strategy defies basic common sense when compared with the returns presented for its related component parts, that is a covered calls return of +3.1% in combination with a put hedge return of -5.2%. We can also conclude that the +15.2% is also clearly inaccurate from a different viewpoint, since a time-weighted average of the flat period (+5.8%), down period(+0.4%), and up period (+16.7%) is much closer to +8.4% — but definitely not +15.2%.
This major flaw should be corrected prior to the next edition of this book. Further, to improve the validity of the results, the current 3 3/4 years backtest should be extended to a more rigorous minimum of 20 years.

I was surprised, when I got the book, that the first edition’s title had actually been “New Insights on Covered Call Writing” — a more accurate title, since about half the book is about covered calls. Did I, an experienced options investor, need a refresher on the simplest, most conservative strategy, covered writing?

Turns out, when the author sharing insights is McMillan, that, yep, I do (his co-author, Lehman, must be about as good a writer, analyst, and money manager — that’s high praise). I’ve learned a lot from this book; the excellent writing made it a real pleasure to go through the studying (shouldn’t take long — it’s a short 200-pages book).

The book is suitable for beginners, starting with summaries of option basics, pricing, covered writing — experts should not skip these early chapters, which offer many insightful observations. It gets even better when implementation details are dissected, then advanced variations (put writing, ratio writing, diagonals, …). The short coverage of put-call parity (titled “option-stock arbitrage”) is the best concise treatment I’ve seen.

The book moves on to hedging (put buying, follow-ups, spreads, collars, …), including a superb concise treatment of the psychological side of various forms of hedging; optionable ETFs; and, finally, VIX derivatives, in a 30-page final chapter which, again, is the best concise treatment of the subject I’ve ever seen — full, like the rest of the book, of tips, insights, real-life examples well presented with tables and graphs and masterfully discussed, actionable advice on VIX futures and options (only one related ETN, VXX — such ETNs are exploding in numbers and varieties, a detailed analysis would take another book this size).

In short, I can’t recommend this book highly enough to anybody — beginner, intermediate, or expert — with any interest in options, or, indeed, in the stock market.

This is not book on how to get rich with options, but rather how options can limit your losses on stocks. Following a brief overview of option basics and pricing, Lehman and McMillan dedicate over a third of their book to the covered call. They explain the advantages of writing near-term calls whose strikes are close to the stock’s purchase price. Next, about a fifth of the book discusses the hedged put and how collars (buy ITM put, write OTM call) can offset the price of the puts. The final two chapters apply the three strategies to exchange-traded funds (ETFs) and explain how call options on the CBOE volatility index (VIX) can protect portfolios from sudden market downturns. They briefly mention debit spreads but only in the context of protecting a long stock position. Credit spreads are not discussed nor any other option strategy that does not include the purchase of the underlying stock.

Although most books on option trading discuss these basic strategies, this one provides a much deeper perspective on how they should be implemented. For example, the authors use actual data or back testing to discuss the pros and cons of writing calls or buying puts with different strikes and different expirations. The data are thoughtfully presented in tables and figures that can help traders understand the relationship between risk and profit (e.g., Table 7-2, page 140). I also liked their analogy to an insurance policy. The more you invest in these protective options (aka the insurance premium), the less you will loose on your stock (aka the lower your deductible).

On the negative side, I found two errors and have one comment neither of which should discourage anyone from buying this book. Table 4.6, Options Taxed as Separate Securities (page 83), should have calculated capital gains as $175 – 45 rather than $175 – 0. And the values plotted on the Y axis of Figure 9.10 (VXX Divided by VXZ, page 196), are about a factor of 100 higher than the actual quotient. Also, as an options trader, I would have liked a more detailed discussion on the advantages of combining ratio spreads with long positions on the underlying stock. To my knowledge, ratio spreads are generally traded without purchasing the stock.

Perhaps the worse I can say about “Options for Volatile Markets” is that the title misleads readers to expect more than what they will find. As I stated earlier, most of the book focuses on three option strategies, the covered call, the hedged put and the collar. In my opinion, these strategies work no better in volatile markets than in flat markets. The authors admit as much when they state, “During a relatively flat period, all three option strategies performed quite adequately, with call writing expectedly being the best.” (page 162). However, in an earlier and more widely read publication (McMillan on Options, 2004), McMillan tells his readers not to write covered options during volatile markets:

“In summary, then, covered writing is a strategy designed to do best when stock prices are stable or moderately rising. If the underlying stock is, or becomes, volatile, this is not an attractive strategy because you cannot participate in large moves on the upside, but you will suffer the results of any move to the downside.” (page 62).

In view of the volatile markets that we have had over the past three years, I expect the authors chose their title to sell books rather than to preview the actual content or to be consistent with a past publication. Nevertheless, I still recommend this book to beginning and advanced traders.