TDI Podcast: Winning Options (#929)

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1:02The last trading for this contract is July 17th. The Disciplined Investor is all about you, your money, and the markets. Sit back and get ready for this edition of The Disciplined Investor Podcast.

1:18Larry McMillan:This episode of The Disciplined Investor is sponsored by Horowitz & Company. If you're looking for a portfolio manager, look no further. Horowitz and Company. From seed through harvest, cultivating financial success.

1:37Aha, the OBAR is signed into law. Letters are going out with new deadlines for tariffs, and we're coming up on earnings season. JP Morgan, in fact, reporting on the 15th next week. And our guest, Larry McMillan, the option strategist. All this and much more on episode number 929 of the Disciplined Investor Podcast.

2:15And a great hello to you. Welcome to another episode of the Disciplined Investor Podcast. I'm Andrew Horowitz. I'm your host, the founder of Horowitz and Company, an investment advisory firm right here downtown Fort Lauderdale, where actually our studios are also located, where we produce this show and DH Unplugged each and every week for the last, I think it's 17 years or so, which we love doing. So what's been going on? A flurry, I think it's a flurry, of stuff. This whole, the crazy chaotic manner that we're getting used to, aren't we though? Seems that the VIX has been rather complacent. We'll talk about that a bit.

2:58We saw that the OBAA, the One Big Beautiful Bill Act, we have to have an acronym. There's actually, I think, a chief of acronyms for the U.S. government. Somebody that says, you know what, no matter what bill, whatever legislation we have, whatever happens, the legislation has to have an acronym. And that's the acronym for this OBAA. You're going to hear it time and time again. Now, it was signed into law last week, and now we have to, well, I figure it out. the idea that there is no tax on tips, not exactly true. No tax on Social Security, definitely not true. No tax on overtime, not true either.

3:31Yes, we have some things like all babies that are born seem to have a new account with$1 ,000 that's going to put into them. We have to figure out how that goes. Only till 2028. A lot of these things that have been put into this legislation are only until 2028. Then they have to be voted on, et cetera. Obviously, why 2028? You know why. It's all political. It's all for the face value of, hey, look what we got during our tenure. And if you want to go back and vote against this by not renewing it, well, you're doing a big disservice. And who knows what party is going to be in power in the next term.

4:16So that's a big issue right now. So we looked at a lot of different measures that could be impactful. Some are, some aren't. Like the deduction you get for the tips, it's not, again, it's not no tax. It's a deduction. $25 ,000 maximum, depending on where your income is, between$150 ,000 and$300 ,000, depending on if you're single or married, there's a deduction there. Only part is excluded. There's a maximum household threshold. but the good news is that if you are a service worker and or get tips somehow some way the potential is depending on your income level let's say you're about earning 50 60 70 000 you could be getting about a 28 to 3 000 tax savings over the next number of years pretty good and the better part of that really cool is that it's retroactive to 2025 tax year so this tax year Even though it was voted in now, you don't have to wait till 2026.

5:13In other words, when you file your 2025 in 2026, you're going to get the tax break. So you don't have to wait a whole year. Very cool. Overtime workers will see some benefit as well. Not as much. And a friend asked me, oh man, wait, you know what, second. I put this on Twitter, by the way. My handle is Andrew Horowitz, one word. If you want to follow me, at Andrew Horowitz on Twitter. He asked me, he said, you know, well, do we tip less now? Kind of an interesting question because, you know, there's machines that come to you that we get after our meal that automatically puts 22 % on no matter what you buy.

5:50Or in fact, if you do a takeaway or, you know, a delivery, you should be giving all this money too, even though they get a fee for it. Okay, whatever your choice is, whatever you want to do, whatever your level of generosity is, maybe the new tip should be, I don't know, 13 % is the new 18 % because it's not taxable. Now, what would that would do? And he said to me, well, you know, think about it for a second. If we tip less, and again, that's only a small amount of money, but if we tip less, there's more money in our pocket, we can go and spend it in the economy. If we give it to the food service worker, I'm like, uh-huh.

6:26Well, then they get to spend it, because they have less taxes due, sometime in the future on whatever they're spending it on. How about I make the choice of where I want to put my money to work? I'm like, okay, if that's what you're going to do, if that's how it works, I don't know. The interesting thing about that line of questioning and that line of thinking is that that is what is going to have to be anticipated through economists. That's their job. They got to figure out all these different variables inside of these kind of laws. And the fact is it probably wasn't done ahead of time. We don't know exactly the impact of how this is going to play out.

7:04Is it going to be on higher end items, paying down credit card, putting into savings? Who is going to actually be spending the money or not that is saved from this? Something that's really interesting to think about. I think the question was kind of silly and I told him, but nonetheless, the exercise in that line of questioning is pretty fascinating because we really do not know when you push a little bit over here, what bulges over there. You know the butterfly effect, right? Where a butterfly can flap its wings in Asia and it creates a storm in South Africa. That's the kind of thing that we're dealing with here.

7:47We do not know the impact of how this is going to actually play out long term. Something that we're going to have to watch. Now, earnings season is right around the corner. I think JP Morgan is going to be reporting on the 20th. No, no, on the 15th. The 15th, that's next week. Yeah, JP Morgan is going to be reporting next week. And that's what the official kickoff is to earnings season these days. It used to be Alcoa when that was important, but they're not. Now, according to Facts, I did some digging in to see what was going on. During the second quarter, the outlook that we're going to find coming out right now, analysts reduce earnings per share estimates by a wider margin than usual.

8:28Now, this is a bottoms-up EPS estimate for quarter two, which means that we look at each of the various companies in the S &P 500. We look at their earnings per share, and then we add it up, and then divide it by the appropriate level of the way that the construction of the S &P 500 is, and you come out with a number, right? This aggregation of EPS forecasts for all companies, the median fell by 4.2%, dropping from 65.55 in March to 6 ,283. That was the last number. So we got a 4 % drop. Now, markets don't seem to care. Hitting on all-time highs, even a little tariff didn't bother anybody when the letters went out.

9:13You know, the bottom line here is that when you look at what went on with the recent rally that we saw, it really doesn't have to do with anything more than, at this point, hope for the future. because if you look at where we are with regard to the earnings estimates, well, they're down. Now, it's common, by the way, for analysts to lower EPS estimates during a quarter. And that seems to happen a lot because they want companies to reach that bar, it seems. But this particular quarter's decline stands out. When you look at the past 20 quarters, which is five years, the average quarterly decline in bottoms-up EPS estimates has been only 3 % Over the past years, 3.1%.

9:57Over the past 15 years, 3.2%. Now, when you look at the past 20 years, 80 quarters worth of data, estimates, et cetera, the average was actually 4.2%. So basically, the second quarter reduction in EPS estimates, it exceeded the 5, 10, and 15-year averages. I'm not sure what exactly that means per se. Does that mean that, well, on one hand, What we're looking at is that we're getting more of a reality check here, or are we saying, well, you know, it's more in line with the long-term average. I guess you can look at it a lot of different ways. But right now, we did see a larger-than-usual rate, earnings analysis estimate cut without a commensurate stock market drop into it, which means, by the way, this is important, that earnings season may be setting up to be a disappointment.

10:53That's the point you want to really look at. If the earnings estimates were reduced and companies don't meet those higher levels by a substantial measure because their stocks are already at a peak level, that could be problematic for many companies. I want to talk about one other thing. Let's talk about rate cut probabilities, shall we? You know, after that recent unemployment report that we saw last week, where it dropped to 4.1%. And we saw, generally speaking, a better overall employment report, right? The probability of a 25 basis point cut in July meeting is 4.7 % versus 21 % a week ago. The probability of a 25 basis point cut or a quarter basis point cut in September meeting still about the same 65 versus 68.

11:49October goes to 41 versus 74%. And December goes from 93 % down to 74%. So a huge change in expectations for rate cuts. And that is in line also with the very, I would say, stubborn. The stubborn Jay Powell and crew who say, you know what, it's really not time to do so. We don't know how the impact of tariffs are going to affect inflation, PCE, and other areas of the economy. There was a report last week during Prime Days, the Amazon Prime Days, that said that on average there was about a 4.5 % increase in most prices during this season compared to last. That's still a drop when you look at the Amazon products That I think mandate a 20 % reduction in overall pricing Compared to their average price or their normal price There still was an increase of about, I think, 4 % But the high-end pricing, this is where it really got interesting There was anywhere from, I think, a 5 % to a 15 % increase in overall pricing Over the last year in the higher-end products So we're starting to see that this little bit of volatility and pricing is starting to creep in, probably due to a year later, some inflation that's been already in the system and the impact of tariffs or the perception of the increase of tariffs.

13:26Or better yet, the fact that companies are saying to hell with it, we're just going to raise prices because, well, we got the cover of tariffs that, who's going to get upset with that? So just think about that. Something interesting. One of the things I also was looking at recently was the VIX. I talked about that a little bit. We're going to talk about that with our guest because he's the option strategist. And the VIX is an option that you could utilize, right? It's VIX futures, but you really could play it probably the purest way through options. We're going to get to that. First, let's talk about interactive brokers for a minute because if you want to navigate political uncertainty, well, disciplined investors, they don't panic.

14:06We prepare. At Interactive Brokers, you can help protect your portfolio and hedge market risks with bonds, precious metals, and foreign exchange, all from one powerful platform. With advanced tools, global access, and low cost, IBKR helps you manage volatility and stay ahead, even in uncertain times. The best informed investors choose Interactive Brokers. To learn more, visit ibkr.com slash navigate. Let me give you a quick intro to our guest before we get to him. Larry McMillan. He's a professional trader, perhaps best known as the author of Options as a Strategic Investment, the best-selling work on stock and index strategies, which has sold over more than 300 ,000 copies.

14:58He's an active trader on his own account. He also manages option-oriented accounts for some individuals. In a research capacity, he edits and contributes to his firm's publication, Daily Volume Alerts, The Option Strategist, and The Daily Strategist, derivative product newsletters covering equity, index, and future options. Finally, he speaks on option strategies in many seminars all over the world, United States, Canada, Europe. He gets to travel. And he's been all over TV. He's been all over TV and radio, podcasts. You've seen his writings. You've seen him somewhere. So I'm interested. I have a lineup of questions.

15:32So, Larry, how are you? I'm doing great, Andrew. Things are, you know, summer. That's good, right? Yeah, exactly. A nice time of year. And we have great things happening, which we're going to get into, like the VIX is low and there's some complacency or at least something's going on. And, you know, we have organized chaos. But I want to back up. I want to ask you. So I don't think I've ever asked you. Um, what was, you know, there's different strokes for different folks. People, you know, some people like the buy and hold methodology of, of investing. Some people like trading. Some people love the futures market, the currency markets, you know, a lot of people, newbies always seem to be really enthralled with the currency market.

16:14But what first drew you into the world of options trading? Well, actually it's kind of funny. I was in grad school at the University of Colorado, and the Denver Broncos used to sell a certain number of tickets to the public. You had to stand in line to get them, so I went down to standing in line. I always joked that line was a mile high and a mile long. Anyway, so to pass some time, I jumped into a bookstore, grabbed a book called How to Make a Million. Well, it turned out it was really, despite the frivolous title, it was actually a serious book about convertible arbitrage, or convertible bonds anyways.

16:59And so that was my first experience with derivatives, and kind of really struck me something I liked. And then the CBOE opened the next year, so I was pretty much on board right from the beginning. And I don't know, I really understood option strategies just sort of inherently. So I just stuck with that. So how were the Broncos that year? They were okay. You know, nothing great. Going way back, I think Frank Chupuka was their quarterback. Going back. Going back. You know, it's interesting you mentioned this. It jogs my memory. I remember one time I was somewhere and I was like, oh, maybe I'll talk about, think about investing as something, right?

17:50I'll do it. And I got a book. And the reason I got the book was because I didn't exactly understand what the title meant at all. But it looked kind of thin. I was like, all right, I'll start with that. It was something called the TED spread. And it was something, I don't know if you know that, it's something about currency spread. I don't remember even what it was. As a matter of fact, when I read it, I probably, but it was very, I thought it was very interesting to a point that I'm like, all right, well, I don't really get this, but it's kind of interesting how you could do this. It was another arbitrage book, right?

18:21How do you do this currency thing and all that? Well, maybe I'll look at that. I think it had to do with the 10-year and the dollar and some other currencies. Well, I regularly remember it myself, but I couldn't tell you what it was. Yeah, exactly. So that was kind of interesting. So that then took you into the world of directly into options trading or what? You started working at the CBOE? No, no, no. I was working at, well, I was in grad school at that time. Then when the CBOE opened, I was working at Bell Labs. I was a programmer. So I started my own newsletter. I used to have some interesting subscribers, one of whom was Ivan Boski.

19:01Really? Yeah. So I just advertised it in Barron's and it got, you know, some subscribers. And then about four years later, I had a position opened up at my brokerage firm, which was Thompson McKinnon, for an option strategist. So then I left Bell Labs and went to Wall Street then. Back then, you had to, I'm guessing here, and I know I'm right, but you had to calculate this stuff by hand, all the different variations of the strategies. Well, yeah. I mean, I was a programmer. I did have access to the Bell Labs computers. So I was doing a lot of Black-Scholes modeling and all that stuff back then, even.

19:42It was, you know, the Black-Scholes model came out right about the same time the CBOE opened. So I was able to, you know, do theoretical values, compute implied volatilities, all that sort of stuff, which was in those days considered really advanced. Yeah. And not only that, you didn't have the, I don't think, you didn't have the liquidity like you have today. to really hone in on the valuation models, right? Right, right, yeah. And I didn't have a pricing service either, so I had to type the pricing in by hand. I love that. I love that. How did you get pricing? Originally, there weren't that many.

20:19But how did you get pricing? And then, just take it out of the Wall Street Journal, there were only, in the beginning, 16 stocks with options, and then it went to 32. Two, you know, then it started to increase after that. But it still wasn't all that many. You could, especially if you were just, you know, if you were ignoring the deep out of the monies, you could type in all the at the money stuff pretty quickly. I'd say less than a half an hour or so. That's kind of interesting. So your name is synonymous with option strategy. But you're telling me that before that, you basically, well, there was no really before that, was there?

21:03You were kind of, you cut your teeth on the career that you're doing now. I mean, have you ever thought of maybe, oh, the hell with these options. I want to trade, I don't know, I want to trade some currencies. Yeah, no, that never really attracted me. I never was a floor trader. I was always an upstairs trader. And there's just, you know, there's a lot of option opportunities in general. So I never really felt like I was missing out on anything. Do you remember your first options trade ever? Worst or first? Well, we'll start with first, which was my question, but maybe we'll work our way into that one.

21:46Yeah, but early on, I remember, I think I was just buying some calls on Kodak or something. But then I started to do some put ratio spreads or call ratios. We wouldn't have puts back then, just calls. I did some call ratio spreads, which I got a little too cute. And I had naked calls, and then the market shot up after the October 74 bottom. So I got burned a little bit on that. That was actually probably one of my worst trades. That's a good lesson though, right? I bet. Yeah. Yeah. Absolutely. Always is. I mean, I remember, I can remember a bunch of bad trades. I mean, I remember a trade on a company.

22:32Well, today it's called MicroStrategy still, but this was back in 2000. I remember this and I was like, oh, that was bad. It was just cut in half overnight. And I realized I was in too heavy and this, and kind of set the stage for some deeper analysis and making sure that you have proper money management disciplines going into this, you know? So you've authored one of the most well-respected books in the field. It's called Options as a Strategic Investment. And did you expect it to become such a staple? I mean, what inspired you to write it first? And did you really, I mean, I don't know. I've written two books.

23:09I never thought it was going to be like, oh, my God, these crazy runaway fictional. Somebody's going to write a movie based on my book, right? Well, as I said, I went to Wall Street to be the option of strategist for Thompson McKinnon. And part of that job was writing a weekly letter. So I was just explaining strategies for the brokers, you know, put ratio, call ratio spreads, call buying, cover writing, you know, various things like that. and each issue came out like once a week. Anyways, the New York Institute of Finance was looking for a book on option strategies and they happened to ask the president of the CBOE, who was Jim Dalton at the time, and he said, well, I don't know this guy, but he's writing about strategies he seems to know he's talking about over at Thompson McKinnon.

24:01So they approached me and I submitted a very long outline for the book and they said, all right, let's do this. And so that was 78. Wow. And the book came out at the end of 79. I mean, they put a 1980 copyright date on it. Just to freshen it up. What's that? Just to freshen it up and make it look modern. Yeah, yeah, yeah. So that was the first edition. You know, it's probably 250 pages or so. But then they really sold it. I mean, they spent a lot of time marketing it. And then New York Institute of Finance was eventually bought by Prentice Hall, and they continued to market it. And now it's on, I think, by Pearson.

24:47But they still continue to market it. You know, some publishers really just publish books, and some people, some of them sell books. That's a big difference. So, Ken, I just want to continue on because I think it's fascinating. What was, was there a turning point in your career that it was like this, something that changed the trajectory or your mindset and what you were doing that really catapulted you?

25:15Well, I don't know. I guess when the options first came out, it was trading some, you know, I had some success. But although, like you said, theoretical values weren't doing you much good. I don't think they still really do you all that much good. Now it's all relative stuff.

25:34But, you know, I really felt that it was potentially a much more lucrative career than being a programmer. I don't know if that's really true or not. But there wasn't anything around it at that time like Apple or Microsoft to be a programmer for. So, you know, so I concentrated on that. And then, you know, once I got to Wall Street, I eventually ended up trading the house account, the proprietary account, which was very lucrative for pretty much all of us. And when you say you were programming, what language was back there? Was it Cobalt? Was it, what was it? No, Bell Labs had invented C by that time.

26:17It just was new. So we were programming in C and the Unix operating system, which never did really take off. I programmed in C Sharp. It's all about where you put the semicolon, isn't it? You know, just put it in the right spot. You're halfway there. Right. All right. In Wall Street, they didn't have Unix or C, but we still managed to get some programs done in Fortran. So you mentor, you train, you've taught, you trade, you write. There's a lot of things that you do, right? But give me what it looks like in the world of options trading. I'm talking about trading now. And what does a typical day look like?

27:04Where does it begin? Where does it end? And what happens a bit in between? You can leave out the lunch break. Yeah. Well, so I have a set of criteria that I look at pretty much every day in terms of some theoretical values. Like, for example, I like straddle buying. There hasn't been a lot of opportunity for that recently, but I'll check that. On our website, we crunch all kinds of numbers every night. In a lot of cases, we just put the outputs of all of our data analysis up on the website. So, you know, that straddle buys are there. then I look, I'm pretty much a large seller of naked options, especially puts.

27:53So I'll look for those, you know, where there just seem to be really skewed and out of line. You know, again, sort of a theoretical value thing. The option straddle buying is also theoretical value. and then uh i was as far as speculation i'll look at put call ratios that's a contrary indicator that has a pretty good track record um especially for individual stocks so again on a given day you may not even find any of these you know it's not like i'm trading a million things a day but we did it just have a buy signal and apple based on the put call ratio people have gotten pretty pessimistic on Apple and were buying a lot of puts over the last few weeks.