How to Trade Options - Book Review - Lawrence G. McMillan, McMillan on Options

Larry McMillan is an iconic Hercules of the options world.  Few option titans have the depth and range of grounded insights to devote 630+ pages to a publication.  Do not be overwhelmed by what initially appears as a titanic chronicle.

McMillan commits extensive effort to clarify the proper use of misused trading terms.  He rectifies inaccurate practices by applying the mechanics of the math that is material and helps you visualize this with graphically rich worked examples.  Every chapter has its own summary, emphasizing specific techniques to refine your own trading methods.

There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.

The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number.  The percentages represent how much each chapter makes up of the 630 pages in total, excluding appendices.

1  Option History, Definitions, and Terms.  44, 6.98%.
2  An Overview of Option Strategies.  60, 9.52%.
3  The Versatile Option.  82, 13.02%.
4  The Predictive Power of Options.  164, 26.03%.
5  Trading Systems and Strategies.  90, 14.29%.
6  Trading Volatility and Other Theoretical Approaches.  128, 20.32%.
7  Other Important Considerations.  48, 7.62%.

Focus on chapters 4, 5 and 6, which makes up about 61% of the book. These chapters are relevant for practical trading purposes.  Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective.

4 The Predictive Power of Options. Within this chapter, focus on these sections: Using Stock Option Volume as an Indicator, Implied Volatility Can Predict a Change of Trend and The Put–Call Ratio.  

Here, you are taught to spot trading opportunities where the daily total option volume is more than double the average option volume. For highly liquid Index products, a higher ratio is required.  There are filters to validate the use of volume speculation.  These filters include ruling out the impact of arbitrage, total volume concentrated in too few strikes that are not identifiable as block trades, spread trades concentrated in just two series of strikes and over concentration of daily volume in ITM strikes that does not have the percentage leverage of ATM/OTM strikes.

The section on Implied Volatility evaluates the treatment of IV as it moves between its expected ranges towards extreme boundaries.  IV Mean Reversion is involved. Implied Volatility must leave from where it is currently trading at (be it IV for ITM, ATM or OTM strikes), to converge at zero on expiration date.  Though, price can go anywhere (up, down or stay flat).  The boundary analysis of IV is applied to covered call writing, index options, the seasonality of volatility and trading volatility directly using the VIX.  Other volatility companion measures should be used in combination with the VIX, namely the VXO, QQV and VXN as sentiment gauges.

McMillan differentiates between a “standard” put-call ratio versus the “dollar-weighted” put-call ratio. There is further refinement on the applicability of specific ratios to equity only put-call ratios, distinct from index put-call ratios and futures put-call ratios.  Weighted ratios accentuate the extremities of overbought/oversold conditions when sentiment has reached its peak or valley to signal impending changes, which is overlooked in using a standard ratio that is not weighted.  Sentiment needs to be sensitized with the weightage.

5 Trading Systems and Strategies. Pay attention to these sections, which make up about 68% of the chapter: Intermarket Spreads and Other Seasonal Tendencies.

The section covers European options that do trade at a discount to parity, spread differentials between heating oil futures and unleaded gas futures, small-cap outperformance with the January effect, spread differentials between gold stocks versus the price of gold, spread differentials between oil stocks versus the price of oil, the relationship between the utilities sector and 30-year bonds, other relationships between sector indexes/futures and Pairs Trading.  There is convergence and divergence at work in these specific products and asset classes identified. For a unique set of relationships, McMillan clearly explains why some relationships must be treated as cross-correlated dependencies versus independent treatment of non-correlated mutually exclusive events. There is also clarity on how to design your trading system to collectively control the diversification of risks across these distinct linear relationships and inverse interplays.

The section on Other Seasonal Tendencies challenges August as a dull month with muted volatility in the pits, alerts you to September-October as months to be long puts but short futures and identifies cyclical periods of rallies in late October and late January. McMillan confronts the conventional reasons for seasonal nuances. For example, the traditional leave periods of floor traders/market makers/institutions who move 85+% of exchange volume does not dampen volatility in the pits and there is no slack during the Labour Day holiday period. He blends the business cycle in with the use of seasonality. For example, companies that are stock components of the S&P 500 with cash rich balance sheets will need to periodically slim down their current asset holdings and redeploy cash into longer-term investments. Firms must maximize shareholder’s equity and cannot just sit on cash.  McMillan explains when and how to position your trades in view of the common market practice of “window dressing”, in context of cash flow contraction and the velocity of money during these periods of fiscal adjustments to the books of corporations.

6 Trading Volatility and Other Theoretical Approaches.

In brief, the themes covered are: volatility’s role in pricing options, controlling directional risk with delta neutral trading, predicting volatility based on forecasting IV from its current percentile, comparing historical and implied volatility to confirm trading ranges in percentile terms, trading implied volatility recognizing the trade off between being short premium versus long decay, reaffirming the relevance of the Black Scholes model with application of the Greeks, aligning a spread’s strike construction for trading the volatility skew, the aggressive calendar spread that expires within 10 days versus conventional inter-month calendars, using probability and statistics in volatility trading to rank the risk to reward profile of trades and expected return metrics to measure risk per $1 allocated.

Of all the focus chapters, Chapter 6 is the heaviest on the use of numerical reasoning. Though, is not beyond anyone who is comfortable with Statistics 101.

To complete the review, here’s the background of the author.  Larry is the President of McMillan Analysis Corporation, founded in 1991.  From 1982 to 1989, he headed up the Equity Arbitrage Department at Thomson McKinnon Securities, Inc. He traded the firm's own money primarily in advanced option spreads and risk arbitrage strategies.  Between 1989-90, he was in charge of the Proprietary Option Trading Department at Prudential-Bache Securities. He traded primarily convertible Euro-bonds and Japanese warrant arbitrage strategies.  Prior to these roles, he was the retail option strategist at Thomson McKinnon from 1976 to 1980, and traded the firm's proprietary account beginning in 1980.  He initially worked at Bell Telephone Laboratories from 1972 to 1976.  He holds an M.S. in applied mathematics and computer science.

In conclusion, McMillan on Options exposes you to the full gamut of how to trade options and the essential methods required to build a sustainable and consistent trading system. Intermarket spreading and Implied Volatility forecasting are clearly the cornerstones of a solid trading system.

This is not a criticism of the book but a personal observation. To complete the construction of a total trading system requires the metrics for portfolio diagnostics. I have written a separate article, entitled “Book Review -  Kenneth L. Grant, Trading Risk” that deals with portfolio management.