INTERVIEW
Trading Chaos
Options Volatility With
Lawrence McMillan
Lawrence McMillan's interest in the options business started in 1973, when the first listed option started trading. He has written two best-selling books on options, including the classic Options As A Strategic Investment, and both books are recognized as essential resources for any serious options trader's library.
As president of McMillan Analysis Corp., Larry McMillan pens the "Daily Volume Alerts" newsletter and edits and publishes "The Option Strategist," a derivative products newsletter covering equity, index, and futures options.
McMillan is recognized as an options trading industry expert, and serious investors have relied on his insights, observations, and recommendations for years. Recently, he was inducted into the Traders' Hall of Fame. STOCKS & COMMODITIES Editor Jayanthi Gopalakrishnan spoke with McMillan late last year.
When you buy low volatility, time is your only enemy. But if you sell expensive volatility, there are a lot of bad things that can happen.
Tell me about the new edition of Options As
A Strategic Investment.
The new edition of Options will be the fourth, and should be published in early 2002. I've added four chapters on volatility trading: I discuss the uses of volatility, and also include a discussion on how volatility affects regular positions. A lot of people don't understand how volatile markets affect a normal options position, like a bull spread or a bear spread, so there's some discussion about that as well.
Since 1996 we've been in a pretty volatile market. It's apparent to me that options aren't behaving the way most people thought they would. People can't quite get how volatility affects them. Too many people just think an option wastes away with time and there's nothing more to it. Well, it does waste away eventually, but if you take a six-month option, the time decay will probably be on average four or five cents a day, whereas the volatility component - vega - or its delta can be 10 times that much. So time is really not a big deal for an option with even three months to run.
I don't know about you, but I'm not in a position for three months.
Well, if you are in a position for three months, of course, time comes into play. But most people are not going to be in an option for three months, and they really should be looking more at volatility, especially those who are going to sell options. Usually they sell an option and think it's going to expire worthless. They just expect that to happen without doing any serious analysis on what volatility might do to their positions. The four new chapters in the new edition mostly discuss volatility trading, but there is some discussion of the applications of volatility to other strategies as well. I have also added a new, fairly long chapter on structured products, which is another component of options and is a whole 'nother ball game.
What are structured products?
They're products that behave like index funds with options attached to them. They're traded on most of the major exchanges now and there are quite a few of them. Other than that, all the other material is pretty much updated. There's quite a bit of new material in the book.
Why don't you tell us about the concept behind volatility trading?
Well, the concept goes back a long way. It's an old notion in the option market, but it's always been difficult to put in practice. You find options that are not priced correctly, and you try to take advantage of their mispricing, without regard for the potential price movement of the underlying stock - that is, you don't have to predict the direction of the underlying stock. In the old days, we used to just try to find underpriced and overpriced options, but those were nebulous terms; in modern parlance it's called volatility trading because we measure the implied volatility of the options. From that, we decide whether we're looking at cheap options or expensive options.
...Continued in the February 2002 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the February 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.
Return to February2002 Contents