Lehman and McMillan, Options for Volatile Markets

We live in volatile times. Long gone is the decade that saw the first plastic Coke bottle, an immunization vaccine for polio, and passenger jets. The historical 100-day volatility on the S&P 500 index “is now running at almost double the average volatility of the 1950s.” What’s an individual investor or a portfolio manager to do? In this second edition of Options for Volatile Markets: Managing Volatility and Protecting against Catastrophic Risk (Bloomberg/Wiley, 2011) Richard Lehman and Lawrence G. McMillan offer a variety of strategies that can be easily executed and managed and that help mitigate portfolio (as well as individual stock or ETF) risk.

After a brief introduction to the basics of options in general and covered call writing in particular the authors move on to the meat of the book—when to put on and how to manage strategies that can smooth out portfolio returns and sometimes even augment those returns.

The first set of strategies is the family of covered call writing and advanced call-writing. Covered call writing can be an incredibly easy, set it and forget it, strategy: at expiration the call either expires worthless or is exercised. Or the investor can monitor his position and make decisions prior to expiration: he can close part or all of the position or can roll the short call up, down, or out. In the “smart people can sometimes do stupid things” department the authors warn against selling the stock and hanging on to a naked short call position. This warning might seem to be unnecessary, but I heard about a Connecticut family that ended up in the hospital because, in the wake of Hurricane Irene, they ran a generator inside their house. They seem to have been oblivious to the dangers of carbon monoxide poisoning.

The authors provide one of the best accounts of covered call writing I have come across, although those who are familiar with their New Insights on Covered Call Writing (2003) will recognize it as an updated and condensed version of the material presented in their earlier book. They offer tips on choosing strike price and expiration month, they identify potential traps and risks, and they outline basic tax rules for anyone not trading in an IRA.

Going beyond basic covered calls, the authors describe such strategies as the margined covered write; partial, mixed, and ratio writing; and the “call-on-call” covered write or what most of us know as calendar call spreads or diagonal spreads. They also discuss put writing which is, of course, the synthetic equivalent of covered call writing.

Since covered calls can expose the investor to substantial downside risk, what alternatives does the investor who wants to manage risk have? There’s the basic put hedge and more flexible and less costly hedging counterparts such as debit spreads, ratio spreads, butterflies, and calendars. Collar strategies, even those that are passive, can outperform stock-only portfolios. A study looking at performance over 122 months, from April 1999 through May 2009, compared the QQQ to a simple passive collar strategy. The collar outperformed handily on the metrics of return, standard deviation, and maximum drawdown. The authors are encouraged by the results: “if the strategy is effective as implemented in a totally automated manner, just imagine how much we may be able to enhance the results through additional refinements and an overlay of active management.” (p. 151)

Another set of versatile strategies uses VIX options. The authors devote only one chapter to a very complicated subject, but they do an excellent job of sorting things out. They suggest two strategies. First, a perpetual long OTM call strategy on VIX which made money between 3/21/2006 and 6/15/2010 (though its beginnings were not promising). “This,” they write, is “a unique finding, as we are not aware of a single other entity on which a call purchase executed month after month would generate a profitable result over time." (p. 199) The second strategy is to protect a stock portfolio with VIX calls rather than, say, SPX puts. Their reasoning is compelling.

Lehman and McMillan put a lot of flesh on the bones I’ve laid out here. I consider this an important book for anyone who’s finally starting to think about how to manage volatility and protect his portfolio against risk.