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The World According to Larry McMillan

Lawrence McMillan is the author of Options as a Strategic Investment, the most popular derivatives book ever published. The book has sold more than 200,000 copies since its first edition in 1992. He is also president of McMillan Analysis Corp., which publishes a newsletter ("The Option Strategist”) and whose web site (www.optionstrategist.com) focuses on equity, index and futures options. He spoke with editor Joe Kolman in April.

Derivatives Strategy: What's the basic concept behind volatility trading?

Larry McMillan: It's all about trying to buy volatility near the low of its trading range and selling it near the high. How you actually do that is a little esoteric.

The first thing I look at, when buying volatility, is the current implied level of volatility—and I compare it to the past level of implied volatility. I usually look for options that are in the 10th percentile of cheapness. When options in general are really expensive—and there are a lot of very expensive options these days—I will be looking up to the 20th percentile for cheap options.

DS: How do you define a cheap option?

LM: It is in a low percentile of its applied implied volatility over the last 600 trading days.

DS: Why do you select that particular range of days?

LM: Six hundred is not really a fixed amount, but it's more than two years of trading. It gives you a healthy distance. You can do some studies on the data and feel pretty comfortable that you've got a good historical pattern.

DS: Do you find that things break out of that pattern in uncertain ways? You're relying quite a bit on history.

LM: This is only the first step. Things change, but options just don't suddenly become cheap. They drift into cheapness. If a takeover rumor surfaces, options can move from cheap to expensive overnight, but there aren't many news items—a confirmed takeover would be one—that would change an option from expensive to cheap overnight. I like to see implied volatility near its historic lows—and for no particular reason. That indicates to me that buyers are bored and sellers are aggressive.

In certain ways, volatility trading is a contrarian form of investing. It's like trading sentiment. Other people are making the options whatever price they are, and you're betting that they are going to be wrong at the major turning points. You don't know why the options are cheap or why people are selling them. They may have some axe to grind. They may be selling calls against their position, or a specialist may be doing his arbitrage function or whatever.

At my firm, once we identify a cheap option, we bring historic volatility into the picture because we still need to evaluate whether the stock could make moves of the size that we need to make a straddle purchase profitable.

DS: That's your most common strategy—straddle buying?

LM: Yes. There are on two ways to trade volatility. You can be a short-term volatility trader and look for volatility to revert quickly to some kind of mean. In that case, you would want to hedge yourself so you just had vega risk, so you are only exposed to volatility. Then you hope volatility will pop back up to a reasonable level so you can get out of your position. That's pretty hard to do. That happens sometimes, but a lot of times these options get cheap and stay cheap, even after the stock starts to move.

The other way to play volatility is to take a position to hold—for example, buying straddles, which gives you two ways to make money. Either volatility can revert to some higher level or the underlying stock can make a move and you can make money even if volatility doesn't help you out.

We use a proprietary probability model, which has a non-lognormal distribution built into it. Trading volatility from the long side gives you an extra bonus. Occasionally, when you get moves that are crazy, such as when an earnings surprise kills a stock on the downside or a takeover bid makes it jumpon the upside, or evenwhen there's simply insane volatility like we had recently —anything that falls way outside the normal range of what people would think of as stock price movement—that's to our advantage.

"Options just don't suddenly become cheap. They can move from cheap to expensive overnight, but there aren't many news items that would change an option from expensive to cheap overnight.”

The third step of our approach is actually to look back at the chart of the stock and see how often it has been able to move the required distance. It has to tell us that we have an 80 percent chance of making money, or we won't take the trade.

So if the options satisfy all three tests, and if there is no fundamental reason why volatility is low, then we will buy. We can pretty much make money about 80-odd percent of the time with these trades, and the risk is limited because we own the options. When we lose, we generally try to cut the loss to a maximum of 60 percent of the straddle price. Sometimes, when you win, you win real big, so you make multiple times your original investment.

DS: What are the risks of this kind of strategy?

LM: The biggest problem when you take an intermediate-term approach is that you start acquiring some delta risk right away. Of course, you are always taking on vega risk, the risk of volatility. One other important risk is time decay—theta. It doesn't manifest itself right away. A six-month straddle is not going to decay much—at least not until the last month or so. The other important risk is the price risk. Say you buy a straddle for 10 points. If the stock moves up five points and implied volatility moves up five points, implied volatility is still low and you haven't made any money yet. But you've acquired a positive delta. Your position is now delta-long because the stock moved up five points. Now if the stock moves down five points, back to your starting point, you're going to lose money because you're back where you were and some time will have passed. So the biggest risk is monitoring the price risk and deciding what to do with it.

DS: What other kinds of volatility trading do you see in the market?

LM: Floor traders will try to look for volatility to revert to some sort of a mean. They will see one order that is priced at the wrong volatility and try to snap it up. Suppose they know that a certain stock's options generally trade at a volatility of 45 percent. Now if someone suddenly comes in looking to sell volatility at 40 percent, a volatility trader on the floor would buy that volatility immediately and then offer it back at 45 percent, because that was where it had been trading, and hopefully make a little bit of money there.

That is a professional, non-commission-paying floor-trading strategy. You can almost do that from upstairs, but it is harder to see everything. Of course, if you sell it, you have to hedge it. That's what a market-maker has to do anyway. If he acquires a position that he cannot immediately sell for a profit, then he has to hedge it and still leave himself room to make money if volatility went back to 45 percent.

DS: You're not much of a volatility seller.

LM: People think volatility selling is easy. If you look at a chart of implied volatility, you often see that when it's trading near its lows, it is pretty well-defined. But the highs are sometimes spiky peaks. If you could sell one of those spiky peaks in volatility and then buy it back later, in theory, you'd have a nice trade.

But I always remember something the lead market-maker in Microsoft once told me. "Invariably, an overpriced option deserves to be overpriced.” In other words, somewhere down the line, you will found out why that guy was bidding that much for that option. He knew something you didn't. It is a tough game. But there are some professional ways to hedge it.

"I always remember something the lead market-maker in Microsoft told me. "Invariably an overpriced option deserves to be over-priced.”

DS: Like what?

LM: One common way that still leaves you some room to make money is selling credit spreads. You sell a credit put spread way out-of-the-money. That's a bullish spread. And maybe you buy a credit call spread out-of-the-money. That's a bear spread. So you're hoping that the stock doesn't go to either side.

DS: I think the people who tried that with fixed-income spreads got blown out of the water by the Russian crisis.

LM: That's why I am not a big fan of that strategy. You are selling an expensive option and you are hedging it by buying an expensive option. So what are you really gaining? But a lot of people do it.

DS: Of course, you can choose not to hedge it.

LM: I have done of lot of naked option-writing over the years. I am profitable on it, but its wearing on your stomach lining. I prefer to sell the options naked, way out-of-the-money and take my chances—rather than do the credit spreads, because at least if volatility drops, I will make some decent money.

In either case, with the credit spreads, your risk is limited, but it's large in comparison with what you can make. So if markets move all the way through both of your strikes, as they did in the Russian crisis, then you have your maximum risk staring you in the face. You've sold something for half a buck and you have to buy it back for five. Five may be your risk limit, but that is still a big chunk of change, compared with what you were going to make.

That invariably happens to naked option writers or credit spreaders—you make money for about nine or 10 months and everything is going along fine and all of a sudden you hit one bad month and it costs you your profits for the last nine or 10 months and you almost have to start over again.

DS: What are the most common mistakes you see institutional traders making about volatility?

LM: I think a lot of institutional investors tend to think that selling options is a great moneymaker, because of time decay. In reality, the portion of an option that is not intrinsic value eventually does wear away because of time. But it's really most heavily influenced by changes in volatility, until the option gets quite near to the end of its life.

You read about this all the time. Somebody will say, "Do this because you collect the time premium while you're waiting.” Sure, but meanwhile you're at huge risk to volatility. If the market goes up and the guy has a covered write in place, he says "That's OK, I made money.” But maybe he really gave away a small fortune. He could have a lot more money if he hadn't sold that option. So I think even institutional approaches that are being used for hedges should be looked at more significantly under volatility microscopes.

But of course, institutional investors don't do that. And that's why we make money.