McMillan on Options

Lawrence G. McMillan

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118045886
• Edition: 2
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Legendary trader Larry McMillan does it-again-offering his personal options strategies for consistently enhancing trading profits

Larry McMillan's name is virtually synonymous with options. This "Trader's Hall of Fame" recipient first shared his personal options strategies and techniques in the original McMillan on Options. Now, in a revised and Second Edition, this indispensable guide to the world of options addresses a myriad of new techniques and methods needed for profiting consistently in today's fast-paced investment arena. This thoroughly new Second Edition features updates in almost every chapter as well as enhanced coverage of many new and increasingly popular products. It also offers McMillan's personal philosophy on options, and reveals many of his previously unpublished personal insights. Readers will soon discover why Yale Hirsch of the Stock Trader's Almanac says, "McMillan is an options guru par excellence."

1

Option History, Definitions, and Terms

There are many types of listed options trading today: stock options, index options, and futures options are the major ones. The object of this book is to explore some of the many ways in which options can be used and to give practical demonstrations that will help the reader make money.

Options are useful in a wide array of applications. They can be used to establish self-contained strategies, they can be used as substitutes for other instruments, or they can be used to enhance or protect one’s position in the underlying instrument, whether that is stock, index, or futures. In the course of this book, the reader may discover that there are more useful applications of options than he ever imagined. As stated in the Preface, this book is not really meant for novices but contains all definitions to serve as a platform for the larger discussion.

UNDERLYING INSTRUMENTS

Let’s begin with the definitions of the simplest terms, as a means of establishing the basic building blocks. Before even getting into what an option is, we should have some idea of the kinds of things that have options. That is, what are the underlying instruments that provide the groundwork for the various listed derivative securities (options, warrants, etc.)? The simplest underlying instrument is common stock. Options that give the investor the right to buy or sell common stock are called stock options or equity options.

Another very popular type of underlying instrument is an index. An index is created when prices of a group of financial instruments—stocks, for example—are grouped together and “averaged” in some manner so that the resulting number is an index that supposedly is representative of how that particular group of financial instruments is performing. The best-known index is the Dow Jones Industrial Average, but there are indices of many other groups of stocks; indices with a large number of stocks in them are the Standard & Poor’s (S&P) 500 and the Value Line Index, for example. There are also many stock indices that track various groups of stocks that are in the same industry: Utility Index, Oil Index, Gold and Silver Index, for example. There are even indices on foreign stock markets, but they have options listed in the United States; these include the Japan Index, Hong Kong Index, and Mexico Index, as well as several others. Indices are not restricted to stocks, however. There are indices of commodities, such as the Commodity Research Bureau Index. Moreover, there are indices of bonds and rates; these include such things as the Short-Term Rate Index, the Muni Bond Index, and the 30-Year Bond Rate Index. Options on these indices are called index options. Appendix A contains a list of available index options.

Finally, the third broad category of underlying instrument is futures. This is probably the least-understood type of underlying instrument, but as you will see when we get into strategies, futures options are extremely useful and very important. Some people mistakenly think options and futures are nearly the same thing. Nothing could be further from the truth. The “dry” definition is a futures contract is a standardized contract calling for the delivery of a specified quantity of a certain commodity, or delivery of cash, at some future time. In reality, owning a futures contract is very much like owning stock, except that the futures’ price is related to the cash price of the underlying commodity, and the futures contract has a fixed expiration date. Thus, futures contracts can climb in price infinitely, just as stocks can, and they could theoretically trade all the way down to zero, just as stocks can. Moreover, futures can generally be traded on very small percentages of margin, so that the risk of owning futures is quite large, as are the potential rewards. We discuss futures contracts in more detail later, but this brief description should suffice to lay the groundwork for the following discussion of options terms. As might be suspected, options on futures contracts are called futures options.

OPTION TERMS

An option is the right to buy or sell a particular underlying security at a specific price, and that right is only good for a certain period of time. The specific items in that definition of an option are as follows:

• Type. Type describes whether we are talking about a call option or a put option. If we are talking about stock options, then a call option gives its owner the right to buy stock, while a put option gives him the right to sell stock. While it is possible to use options in many ways, if we are merely talking about buying options, then a call option purchase is bullish—we want the underlying stock to increase in price—and a put option purchase is bearish—we want the stock to decline.

• Underlying Security. Underlying security is what specifically can be bought or sold by the option holder. In the case of stock options, it’s the actual stock that can be bought or sold (IBM, for example).

• Strike Price. The strike price is the price at which the underlying security can be bought (call option) or sold (put option). Listed options have some standardization as far as striking prices are concerned. For example, stock and index options have striking prices spaced 5 points apart. Moreover stock options also have strikes spaced 2½ points apart if the strike is below 25. Futures option striking prices are more complex, because of the differing natures of the underlying futures, but they are still standardized for each commodity (1 point apart for bonds, for example, or 10 points apart for a more volatile commodity, like corn).

• Expiration Date. The expiration date is the date by which the option must either be liquidated (i.e., sold in the open market) or exercised (i.e., converted into the physical instrument that underlies the option contract—stock, index, or futures). Again, expiration dates were standardized with the listing of options on exchanges. For stock options and most index options, this date is the Saturday following the third Friday of the expiration month (which, by default, makes the third Friday of the month the last trading day). However, for futures options, these dates vary widely. More about that later. The most heavily traded listed options usually have less than nine months of life remaining, but there are longer-term options—called LEAPS options when one is referring to stock options or index options—that can extend out to two years or more.

These four terms combine to uniquely describe any option contract. It is common to describe the option by stating these terms in this order: underlying, expiration date, strike, and type. For example, an option described as an IBM July 50 call completely describes the fact that this option gives you the right to buy IBM at a price of 50, up until the expiration date in July. Similarly, a futures option described as the U.S. Bond Dec 98 put gives you the right to sell the underlying 30-year U.S. Government Bond futures contract at a price of 98, up until the expiration of the December options.

THE COST OF AN OPTION

The cost of an option is, of course, called the price, but it is also referred to as the premium. You may notice that we have not yet described how much of the underlying instrument can be bought or sold via the option contract. Listed options generally standardize this quantity. For example, stock options give the owner the right to buy (call) or sell (put) 100 shares of the underlying stock. If the stock splits or declares a stock dividend, then that quantity is adjusted to reflect the split. But, in general, stock options are spoken of as being options on 100 shares of stock. Index options, too, are generally for 100 “shares” of the underlying index; but since the index is not usually a physical entity (i.e., it does not really have shares), index options often convert into cash. We will describe that process shortly. Finally, futures options are exercisable into one futures contract, regardless of how many bushels, pounds, bales, or bonds that futures contract represents in terms of the actual commodity.

Only by knowing this quantity can you tell how many actual dollars an option contract will cost, since option prices are quoted in units. For example, if someone tells you that the IBM July 50 call is trading at 3 (and we know that the option is for 100 shares of IBM), then the actual cost of the option is $300. Thus, one option trading at 3 costs $300 and “controls” 100 shares of IBM until the expiration date.

It is a fairly common mistake for a beginner to say “I want to buy 100 options” when what he really means is he wants to buy one option (this mistake derives from the fact that if a stock investor wants to control 100 shares of IBM, then he tells his broker to buy 100 IBM common stock). This can result in some big errors for customers and/or their brokerage firms, or possibly even worse. You can see that if you told your broker to buy 500 of the above IBM options, you would have to pay $150,000 for those options (500 × $300); but if you really meant to buy 5 options (to “control” 500 shares of IBM), you thought you were making a $1,500 investment (5 × $300). Quite a difference.

Of course, these sorts of things tend to balloon out of control at the worst times (Murphy’s Law is what they call it). When the market crashed 190 points on one Friday in October 1990 as the UAL deal fell apart, people were genuinely concerned. On Monday morning, a rather large stockholder had been reading about buying puts as protection for his stocks, so he put in a market order to buy something like 1,500 puts at the market. His broker was a little taken aback, but since this was a large stockholder, he put the order in. Of course, that morning, the puts were extremely expensive as people were fearful of another 1987-style crash. Even though the options had been quoted at a price of 5 on Friday night, the order was filled on Monday morning at the extremely high price of 12 because of fear that prices would crash further. Two days later, the customer received his confirm, requesting payment of $1.8 million. The customer called his broker and said that he had meant to buy puts on 1,500 shares, not 1,500 puts—a difference of roughly $1,782,000! Of course, by this time, the market had rallied and the puts were trading at only a dollar or two (one or two points, that is). I’m not sure how the lawsuit turned out.

The cost—in U.S. dollars—of any particular futures option depends, of course, on how much of the commodity the futures control. We have already said that a futures option “controls” one futures contract. But each futures contract is somewhat different. For example, soybean futures and options are worth $50 per point. So if someone says that a soybean July 600 put is selling for 12, then it would cost $600 (12 × $50) to buy that option. However, Eurodollar futures and options are worth $2,500 per point. So if a Eurodollar Dec 98 call is selling for 0.70, then you have to pay $1,750 (0.70 × $2,500) to buy it. We specify the terms for most of the larger futures contracts in Appendix B.

THE HISTORY OF LISTED OPTIONS

On April 26, 1973, the Chicago Board Options Exchange (CBOE) opened its doors and began trading listed call options on 16 stocks. From that humble beginning, option trading has evolved to today’s broad and active markets. We thought it might be interesting to review how option trading got to where it is today (nostalgic might be a better word for “old-timers” who have been around since the beginning). In addition, a review of the history of listed option trading might provide some insight for newer traders as to how and why the markets have developed the way they have.

The Over-the-Counter Market

Prior to listed option trading, puts and calls traded over the counter. In this form, there were several dealers of options who found both a buyer and a seller (writer) of a contract, got them to agree on terms, and executed a trade between them. The term writer arose from the fact that an actual contract was being “written” and the issuing party was the seller of the option. The dealer generally took a commission out of the middle of this trade: for example, the buyer might have paid 3¼ and the seller received 3. The remaining ¼ point was kept by the dealer as payment for lining up the trade.

Options of this type were generally struck at the current stock price; thus if the stock was selling at 46 3/8 when the contract was agreed upon, then that would be the striking price of the calls (or puts). This made for some very awkward calculations. Moreover, these over-the-counter options normally had expiration dates that were fixed time periods when they were issued: the choices were time periods of 6 months + 10 days, 95 days, 65 days, or 35 days. One other term that was unusual: dividends went to the holder of the call upon exercise. Thus, upon exercise, the striking price would actually be adjusted for the dividends paid over the life of the option.

Besides the relatively arduous task of finding two parties who wanted to take opposite sides of a particular trade, the greatest hindrance to development of the over-the-counter market was that there was virtually no secondary market at all. Suppose you bought a call on a stock with these terms: strike price 46 3/8, expiration date 35 days from trade date. Later, if the stock went up a couple of points quickly, you might theoretically have wanted to sell your over-the-counter call. However, who were you going to sell it to? The dealer might try to find another buyer, but the terms would be the same as the original call. Thus, if the stock had risen to 48¾ after 10 calendar days had passed, the dealer would be trying to find someone to buy a call that was 2 3/8 points in-the-money that had 25 days of life remaining. Needless to say, it would be virtually impossible for a buyer to be found. Thus, option holders were often forced to hold on until expiration or to trade stock against their option in order to lock in some profit. Since this was in the days of fixed commission rates, it was a relatively expensive matter to be trading stock against an option holding. Altogether, this was a small option market, trading less than 1,000 contracts daily in total.

The CBOE Beginning

This over-the-counter arrangement was onerous for all parties. So it was decided to put into practice the idea of standardizing things by having fixed striking prices and fixed expiration dates, and having all trades clear through a central clearing corporation. These solutions all came from the Chicago Board of Trade (CBOT), since standardization of futures contracts had proven to be workable there. The first president of the CBOE was Joe Sullivan, who had headed the research project for the CBOT.

However, since...