Options for Volatile Markets

P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford i P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford OPTIONS FOR VOLATILE MARKETS i P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford Since 1996, Bloomberg Press has published books for financial professionals on investing, economics, and policy affecting investors. Titles are written by leading practitioners and authorities, and have been translated into more than 20 languages. The Bloomberg Financial Series provides both core reference knowledge and actionable information for financial professionals. The books are written by experts familiar with the work flows, challenges, and demands of investment professionals who trade the markets, manage money, and analyze investments 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 authors Far From Random—Using 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 Writing—The Powerful Technique that Lowers Risk and Enhances Returns in Stock Investing by Richard Lehman and Lawrence G. McMillan (Bloomberg Press, 2003) Options as a Strategic Investment, Fourth Edition,byLawrenceG.McMillan (New York Institute of Finance, 2002) Profit with Options by Lawrence G. McMillan (John Wiley & Sons, 2002) ii P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford OPTIONS FOR VOLATILE MARKETS Managing Volatility and Protecting against Catastrophic Risk SECOND EDITION Richard Lehman Lawrence G. McMillan iii P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford 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 That Enhances Return and Lowers Risk in Stock Investing by Richard Lehman and Lawrence G. McMillan, was published in 2003 by Bloomberg Press. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-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 at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limitf o Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, 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 that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Lehman, Richard, 1948– Options 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 2011 332.63 228—dc22 2011012023 Printed in the United States of America 10987654321 iv P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford In memory of Roslyn Lehman January 6, 1928–September 24, 2010 v P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford vi P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford Contents Preface xi INTRODUCTION The “New Normal” in Equity Investing 1 CHAPTER 1 Option Basics 7 What Are Options? 7 Exercise and Assignment 14 Positions 17 How Options Are Traded 19 Options in Your Account 22 CHAPTER 2 Option Pricing and Valuation 25 Option Premium 25 Theoretical Value 27 Time Value 28 Volatility 31 Interest Rates 32 Dividends 32 Calls versus Puts 33 Option Skews and Anomalies 34 CHAPTER 3 The Basics of Covered Call Writing 37 Requirements for “Valid” Covered Writes 38 Risk/Reward of a Covered Write 39 Calculating Potential Returns 46 Major Factors Affecting Call-Writing Returns 48 vii P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford viii Contents Covered Writing as an Ongoing Strategy 54 Summing Up Covered Writing 57 CHAPTER 4 Implementing Covered Call Writing 59 Follow-Up Actions 59 Behavioral Issues 69 Differing Approaches 70 Selecting Calls to Write 77 Risks 80 Basic Tax Rules for Options 81 Summing Up Implementation 84 CHAPTER 5 Advanced Call-Writing Techniques 87 Writing Calls on “Hot” Stocks 88 Tax Deferral Strategies 89 Covered Writing on Margin 90 Covered Writing against Securities Other Than Stock 93 Partial Writing, Mixed Writing, and Ratio Writing 98 Put Writing 103 Expiration Games 106 Option-Stock Arbitrage 108 CHAPTER 6 Basic Put Hedging 111 Put Hedge Basics 111 Advantages 115 Disadvantages 116 Behavioral Implications 123 Put Hedge versus Covered Call 127 Hedging against Catastrophic Risk 129 CHAPTER 7 Advanced Hedging Strategies 131 Put Hedge Follow-Ups 131 Using Put Spreads to Hedge 137 Collars 145 Conclusions on Protective Option Strategies 151 P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford Contents ix CHAPTER 8 Options on ETFs 153 ETFs in a Nutshell 154 ETF Options 158 Covered Call Writing on ETFs 159 Our Put Hedge and Collar Study on SPY 162 Appendix: Partial List of ETFs with Listed Options 165 CHAPTER 9 Volatility and Volatility Derivatives 171 What Is Volatility? 171 Using VIX as a Market Indicator 173 Volatility Futures 179 Variance Futures 181 The Behavior of VIX Futures 183 VIX Options 191 VIX Option Strategies 199 The Future 204 Acknowledgments 205 About the Authors 206 Index 207 P1: OTA/XYZ P2: ABC JWBT522-fm JWBT522-Lehman June 20, 2011 11:55 Printer Name: Courier Westford x P1: OTA/XYZ P2: ABC JWBT522-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 the subject at this time. The answer to that is twofold: (1) because there have been material developments within the world of options—new durations, new rules, new volatility instruments, and (2) more important, because there have also been significant changes in the nature of the markets and the environment for securities investing. In the interest of brevity, we referred to the new environment in the title simply as volatile markets, but that understates how extensive we feel the changes are. What we are really saying (and we expound further on this subject in the Introduction) is that today’s financial markets harbor risk and uncertainties far beyond historically accepted norms, and that it is now more important than ever to manage the risks in investment portfolios on a continual basis. To that end, we still see listed options as the single most effective tool in the financial arsenal for dealing with such risk and volatility. We still believe covered call writing is an underutilized strategy that offers equity investors a highly effective tool for reducing volatility—much more so than simply relying on security diversification. But we also feel that volatility has become more of a factor in equity investing than ever before and that the downside risks of equity investing have expanded dramatically. These risks, which are an ever-present factor in equities markets, are growing rather than receding, and have reached a level that not only requires a more potent defense against risk than covered call writing by itself, but suggest that equity portfolios should adopt a virtually continuous risk-management strategy. Yet, as we concluded in our earlier work, the mainstream investment management industry remains sorely lacking in either using options themselves or in aiding investors in using them.

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