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By Lawrence G. McMillan

The fifth edition of the best-selling book, Options As A Strategic Investment was released today, August 7th.   An updated version of the Study Guide has also been released. The first edition was released in late 1979 with a 1980 copyright.  Further editions followed in 1986, 1993, and 2002.  Hence, it has been ten years since the last update.  Each of the previous editions was primarily spurred by a new major class of option products: 2nd edition: index options,  3rd edition: LEAPS, 4th edition: volatility trading, and now in the 5th edition: volatility derivatives.  Of course, there were many more changes and updates in each edition as other important changes took place in the option industry.  

Excerpt from the Preface to the Fifth Edition:

McMillan OSI 5 The largest addition to the book in the fifth edition is the lengthy chapter on Volatility Derivatives.  This new asset class – Volatility – is going to be one of the largest innovations in listed derivatives trading.  It is still in its infancy, but there is no denying that the ability to trade and hedge volatility is an extremely important component to any portfolio manager, as well as to any speculator. 

At the current time, there are listed futures, options, and ETNs on primarily one major volatility index – the CBOE’s Volatility Index (VIX).  However, steps are already being taken to introduce volatility derivatives on many stocks, futures, and indices.  In the future, it will mostly likely be the case that most entities with listed options will trade puts, calls, and volatility options (not to mention volatility futures, as well).  The CBOE has already described VIX options as the single most successful product launch in its history.

The new content spends a good deal of time explaining volatility futures, for they are effectively the underlying instrument for cash-based volatility options.  Hence, it is important that traders understand the volatility futures – even if they are not planning to trade them – if they are planning to trade volatility options.  Various strategies involving this new asset class are explained, much in the same manner as stock option strategies were explained.  The use of this new asset class as portfolio protection is fully explained as well.

Another major change in this edition involves The Option Symbology Initiative (OSI), completed in 2010, which necessitated a welcome change to the way option symbols are displayed.  This affects many of the examples and definitions.  The examples have also been updated for the currently lower commission rates and for decimalization.  One particular outgrowth of the OSI is that LEAPS options are now merely long-term options, identified by their expiration date.  However, the options industry is still using the term LEAPS, so it continues in use in this text as well.  The reader should understand, though, that a LEAPS option is not really anything different from any other listed option.

Other changes include an expansion of the section on how option activity at expiration and at other times may affect the stock market.  This involves not only “circuit breakers” but the actual effect of arbitrage on expiration day.  Separately, Portfolio Margin is described in Chapter 4 when margin is first discussed, and a new Appendix F has been added with the current portfolio margin rules.  However, the vast majority of examples in the book continue to be from the viewpoint of a trader using customer margin, not portfolio margin.  

The application of certain strategies has been expanded, often because of the nuances available from the generally more volatile markets that have existed in the past decade.  These include enhancements to the covered writing strategy (the partial extraction), the collar strategy, naked put writing, put ratio spreads, dual calendar spreads,  and an expansion of the discussion of butterfly-style strategies – specifically condor and iron condor spreads.  The section on ETFs has been expanded to include futures-based ETFs.

The chapter on mathematical applications has an addition as well: the way that I compute and identify a volatility skew in any entity’s options.  This is useful to volatility traders, of course, for many volatility strategies are based on identifying and exploiting either a horizontal or vertical skew (or both – diagonal).

A deletion involves the section on PERCS, the discussion of which has been removed from the book.  While there continue to be structured products being offered over-the-counter, primarily from the major brokerage firms to preferred customers, there are not nearly as many listed structured products any longer.  Some discussion of structured products remains in this text, but those wanting a full strategic analysis of PERCS are directed to read the 4th edition of this book.  I suspect there are not many who are interested currently.

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