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Archive for the ‘VXX’ Category

Using Puts vs. Calls for Calendar Spreads

Monday, April 7th, 2014

I like to trade calendar spreads.  Right now my favorite underlying to use is SVXY, a volatility-related ETP which is essentially the inverse of VXX, another ETP which moves step-in-step with volatility (VIX).  Many people buy VXX as a hedge against a market crash when they are fearful (volatility, and VXX. skyrockets when a crash occurs), but when the market is stable or moves higher, VXX inevitably moves lower.  In fact, since it was created in 2009, VXX has been just about the biggest dog in the entire stock market world.  On three occasions they have had to make 1 – 4 reverse splits just to keep the stock price high enough to matter.

Since VXX is such a dog, I like SVXY which is its inverse.  I expect it will move higher most of the time (it enjoys substantial tailwinds because of something called contango, but that is a topic for another time).  I concentrate in buying calendar spreads on SVXY (buying Jun-14 options and selling weekly options) at strikes which are higher than the current stock price.  Most of these calendar spreads are in puts, and that seems a little weird because I expect that the stock will usually move higher, and puts are what you buy when you expect the stock will fall.  That is the topic of today’s idea of the week.

Terry

Using Puts vs. Calls for Calendar Spreads

It is important to understand that the risk profile of a calendar spread is identical regardless of whether puts or calls are used.  The strike price (rather than the choice of puts or calls) determines whether a spread is bearish or bullish.  A calendar spread at a strike price below the stock price is a bearish because the maximum gain is made if the stock falls exactly to the strike price, and a calendar spread at a strike price above the stock price is bullish.

When people are generally optimistic about the market, call calendar spreads tend to cost more than put calendar spreads.  For most of 2013-14, in spite of a consistently rising market, option buyers have been particularly pessimistic.  They have traded many more puts than calls, and put calendar prices have been more expensive.

Right now, at-the-money put calendar spreads cost more than at-the-money call calendar spreads for most underlyings, including SVXY.  As long as the underlying pessimism continues, they extra cost of the put spreads might be worth the money because when the about-to-expire short options are bought back and rolled over to the next short-term time period, a larger premium can be collected on that sale.  This assumes, of course, that the current pessimism will continue into the future.

If you have a portfolio of exclusively calendar spreads (you don’t anticipate moving to diagonal spreads), it is best to use puts at strikes below the stock price and calls for spreads at strikes which are higher than the stock price.  If you do the reverse, you will own a bunch of well in-the-money short options, and rolling them over to the next week or month is expensive (in-the-money bid-asked spreads are greater than out-of-the-money bid asked spreads so you can collect more cash when rolling over out-of-the-money short options).

How to Play War Rumors

Monday, March 10th, 2014

Last week, on Monday, there were rumors of a possible war with Russia.  The market opened down by a good margin and presented an excellent opportunity to make a short-term gain.  Today I would like to discuss how we did it at Terry’s Tips and how you can do it next time something like this comes along.

Terry

How to Play War Rumors

When the market opens up at a higher price than the previous day’s highest price or lower than the previous day’s lowest price, it is said to have a gap opening.  Gap openings unusually occur when unusually good (or bad) news has occurred.  Since there are two days over which such events might occur on weekends, most gap openings happen on Mondays.

A popular trading strategy is to bet that a gap opening will quickly reverse itself in the hour or two after the open, and day-trade the gap opening.  While this is usually a profitable play even if it doesn’t involve the possibility of a war, when rumors of a war prompted the lower opening price, it is a particularly good opportunity.

Over time, rumors of a new war (or some other economic calamity) have popped up on several occasions, and just about every time, there is a gap (down) opening. This time, the situation in Ukraine flared, even though any reasonable person would have figured out that we were highly unlikely to start a real war with Russia.

When war rumors hit the news wires, there is a consistent pattern of what happens in the market.  First, it gaps down, just like it did on Monday.  Invariably, it recovers after that big drop, usually within a few days.  Either the war possibilities are dismissed or the market comes to its senses and realizes that just about all wars are good for the economy and the market.  It is a pattern that I have encountered and bet on several times over the years and have never lost my bet.

On Monday, when the market gapped down at the open (SPY fell from $186.29 to $184.85, and later in the day, as low as $183.75), we took action in one of the 10 actual portfolios we carry out for Terry’s Tips paying subscribers (who either watch, mirror, or have trades automatically placed in their accounts for them through Auto-Trade).

One of these portfolios is called Terry’s Trades.  It usually is just sitting on cash.  When a short-term opportunity comes along that I would do in my personal account, I often place it in this portfolio as well.  On Monday, shortly after the open, we bought Mar2-14 weekly 184 calls on SPY (essentially “the market”), paying $1.88 ($1880 plus $12.50 commissions, or $1900.50) for 10 contracts.  When the market came to its senses on Tuesday, we sold those calls for $3.23 ($3230 less $12.50 commission, or $3217.50), for a gain of $1317, or about 70% on our investment.  We left a lot of money on the table when SPY rose even higher later in the week, but 70% seemed like a decent enough gain to take for the day.

War rumors are even more detrimental to volatility-related stocks.  Uncertainty soars, as does VXX (the only time this ETP goes up) while XIV and SVXY get crushed.  In my personal account, I bought SVXY and sold at-the-money weekly calls against it.  When the stock ticked higher on Friday, my stock was exercised away from me but I enjoyed wonderful gains from the call premium I had sold on Monday.

Whether you want to bet on the market reversing or volatility receding, when rumors of a war come along (accompanied by a gap opening), it might be time to act with the purchase of some short-term near-the-money calls.  Happy trading.

How the Dog of Dogs Portfolio Made 124% Last Week

Monday, January 7th, 2013

Two messages  again today – first, a reminder that in celebration of the New Year, I am making the best offer to come on board that I have ever offered.  The offer expires in three days.  Don’t miss out.

 

Second, one of our portfolios gained an astonishing 124% last week.  I want to tell you about this portfolio, reveal the exact positions we hold, and show how it should unfold next week (and thereafter).

How the Dog of Dogs Portfolio Made 124% Last Week

This portfolio is based on the expectation that the volatility ETN VXX will continue its downward slope in the future.  The following is an excerpt from the weekly newsletter I send to my paying subscribers:

Summary of Dog of Dogs Portfolio

This $5000 portfolio is designed to take advantage of the long-term inevitable price pattern of VXX.. Because of contango, the way it is constructed, and the management fee, the stock is destined to fall over the long term.  Twice in the last three years, 1 – 4 reverse splits had to be made so there would be some reasonable price to trade.  We use calendar spreads at strikes below the underlying price.
As a reminder why we call this the Dog of Dogs portfolio, here is the 4-year graph of this ETN since it was formed:

VIX Futures January 2013

The stock never really traded for $2800 as the graph suggests – adjusting for the two reverse splits made it seem that way.  This surely is the worst-performing “stock” in the entire universe over the past four years.

Here are the current positions we hold in this portfolio:

 

     

Dog Of Dogs

 
 

Price:

 

$27.55

Portfolio Gain since 12/04/12 =

+14.5%

   
                   
 

Option

 

Strike

Symbol

Price

Total

Delta

Gamma

Theta

-3

Jan2-13

P

27

VXX130111P27

$0.42

($126)

     

-6

Jan2-13

P

28

VXX130111P28

$0.97

($579)

     

-4

Jan2-13

P

28.5

VXX130111P28.5

$1.32

($528)

     

-3

Jan-13

P

28

VXX130119P28

$1.46

($437)

     

6

Feb-13

P

28

VXX130216P28

$2.59

$1,551

     

6

Feb-13

P

29

VXX130216P29

$3.23

$1,935

     

7

Feb-13

P

30

VXX130216P30

$4.03

$2,818

     

3

Mar-13

P

28

VXX130316P28

$3.45

$1,035

     
         

Cash

$57

-303

-167

$9

  Total Account Value  

$5,726

-5.3%

   

6

        Annualized ROI at today’s net Theta:

57%

 

Results for the week: With VXX down $7.88 (22.2%) for the week, the portfolio gained $3,361 or 142.1%. We were patient while VXX headed higher due to fiscal cliff uncertainties, and this week our patience was rewarded as VXX fell big-time. Next week looks potentially great even if VXX does not continue to fall. A flat or lower price for VXX should result in a double-digit gain for the week.

The risk profile graph shows that if the stock is at the same level ($27.55) next Friday, the premium we collect from having sold puts at the 27, 28, and 28.5 strikes will decay sufficiently to return a gain of $740 (about 12%) even if the stock does not fall as history suggests it will. The graph also shows that a double-digit gain for the week can be expected at almost any lower price for the stock as well (this is possible because we hold six extra uncovered long puts).

Note: Most Terry’s Tips paying subscribers mirror this portfolio (and/or others of our 8 total portfolio offerings) through the Auto-Trade program at thinkorswim rather than making the trades on their own.  We invite you to join us as a paying subscriber at the lowest price we have ever offered.

 

Black Swan Insurance

Monday, December 3rd, 2012

This week I wrote an article for Seeking Alpha which describes an option portfolio that bets on VIX moving higher as uncertainty grows over the looming fiscal cliff.  The best part of the deal is that the options will make about a 50% gain even if VIX doesn’t go up a bit over the next three weeks until the options expire.
Please read this important article as it could show you a way to provide extremely good protection against you other investments should the market take a big dive this month.

Black Swan Insurance
Here’s the link:

Black Swan Insurance That Might Pay Off Even If There Is No Crash

This is a very simple strategy that involvBlack Swan Insurance That Might Pay Off Even If There Is No Crashes buying in-the-money Dec-12 13 calls and selling a smaller number of Dec-12 16 calls.  You are setting up a vertical spread for some of the calls and holding several calls uncovered long.  The 13 calls have essentially no time premium in them and the 16 calls have a lot of time premium since they are very close to the money.

The only scenario where these positions lose money is if VIX falls much below 15 when the options expire on December 19.  For its entire history, VIX has traded below 15 on only a few rare occasions, and it always moved higher shortly thereafter.

If VIX does get down close to 15 as expiration nears, additional calls might be sold against the uncovered long calls you own, maybe at the 15 strike..  This would expand the downside break-even range about a half a dollar.

There are a few things that you should know about trading VIX options. Weekly options are not available.  You are restricted to the regular monthly option series.  Even more restricting, calendar spreads and diagonal spreads are not allowed in VIX options because the underlying entity is a derivative rather than an actual stock.  You are pretty much restricted to vertical or back spreads unless you want to post a large maintenance requirement.

In spite of these limitations, VIX options are a lot better than VXX if you want to buy portfolio insurance.  VXX suffers from contango dilution most of the time while VIX fluctuates independent of any such headwinds.

 

Contango, Backwardation, and VXX

Monday, November 26th, 2012

This week we will discuss three investment concepts that you probably never heard of. If you understood them, they might just change your investment returns for the rest of your life.  Surely, it will be worth your time to read about them. 

Contango, Backwardation, and VXX

There seems to be a widespread need for a definition of contango.   I figure that about 99% of investors have no idea of what contango or backwardation are.  That’s a shame, because they are important concepts which can be precisely measured and they strongly influence whether certain investment instruments will move higher (or lower).  Understanding contango and backwardation can seriously improve your chances of making profitable investments.

Contango sounds like it might be some sort of exotic dance that you do against (con) someone, and maybe the definition of backwardation is what your partner does, just the opposite (indeed, it is, but we’re getting a little ahead of ourselves because we haven’t defined contango as yet). 

If you have an idea (in advance) which way a stock or other investment instrument is headed, you have a real edge in deciding what to do.  Contango can give you that edge.

So here’s the definition of contango – it is simply that the prices of futures are upward sloping over time, (second month more expensive than front month, third month more expensive than second, etc.), Usually, the further out in the future you look, the less certain you are about what will happen, and the more uncertainty there is, the higher the futures prices are.  For this reason, contango is the case about 75 – 90% of the time.

Sometimes, when a market crash has occurred or Greece seems to be on the brink of imploding, the short-term outlook is more uncertain than the longer-term outlook (people expect that things will settle down eventually).  When this happens, backwardation is the case – a downward-sloping curve over time. 

So what’s the big deal about the shape of the price curve?  In itself, it doesn’t mean much, but when it gets involved in the construction of some investment instruments, it does become a big deal.

All about VXX

One of the most frequent times that contango appears in the financial press is when VXX is discussed. VXX is an ETN (Exchange Traded Note) which trades very much like any stock.  You can buy (or sell) shares in it, just like you can IBM.  You can also buy or sell options using VXX as the underlying (that’s why it important at Terry’s Tips). 
VXX was created by Barclay’s on January 29, 2009 and it will be closed out with a cash settlement on January 30, 2019 (so we have a few years remaining to play with it).

VXX is an equity that people purchase as protection against a market crash.  It is based on the short-term futures of VIX, the so-called “fear index” which is a measure of the implied volatility of options on SPY, the tracking stock for the S&P 500.  When the market crashes, VIX usually soars, the futures for VIX move higher as well, pushing up the price of VXX.

In August of 2011 when the market (SPY) fell by 10%, VXX rose from $21 to $42, a 100% gain.  Backwardation set in and VXX remained above $40 for several months.  VXX had performed exactly as it was intended to.  Pundits have argued that a $10,000 investment in VXX protects a $100,000 portfolio of stocks against loss in case of a market crash.  No wonder it is so popular.  Investors buy about $3 billion worth of VXX every month as crash protection against their other investments in stocks or mutual funds.

There is only one small bad thing about VXX.  Over the long term, it is just about the worst stock you could ever buy.  Check out its graph since it was first created in January of 2009.

 

Have you ever seen such a dog?  (Maybe you bought stock in one or two of these, but I suspect no matter how bad they were, they couldn’t match VXX’s performance). On two occasions (November 9, 2010 and October 5, 2012) they had to make 1 – 4 reverse splits to make the stock have a reasonable value.  It never really traded at $2000 as the graph suggests, but two reverse splits will make it seem that way.
VXX is designed to mimic a 30 day futures contract on the VIX spot index (note: the VIX “spot” index is not directly tradable, so short term futures are the nearest proxy). Every day, Barclays VXX “sells” 1/30th of its assets in front month VIX futures contracts and buys second month contracts which are almost always more costly. This is where contango becomes important.
 It’s the old story of “buy high” and “sell low” that so many of us have  done with their stock investments, but Barclays does it every day (don’t feel sorry for them – they are selling VXX, not buying it, and they are making a fortune every month).
There are two other reasons besides contango that VXX is destined to move lower over time. First, when the value of an instrument is based on changes in the value of another measure, a mathematical glitch always occurs.  When VIX is at 20 and increases by 10%, it goes up by 2, and the tracking instrument (VXX) is likely to move by about that percentage in the same direction. If the next day, VIX falls by 10%, it goes down by 2.20 (10% of 22).  At the end of the two-day period, VXX will end up $.20 lower than where it started.

This is the same thing that happens if you lose 50% of the value of a stock investment.  The stock has to go up by 100% for you to get your money back.  In the day-by-day adjusting of the value of VXX based on changes in VIX, the value of VXX gets pushed lower by a tiny amount every day because of the mathematical adjustment mechanism.

A third reason that VXX gets lower in the long run is that Barclay’s charges a 0.89% fee each year to maintain the ETN. 

In summary, because of the predominant condition of contango as well as the way VXX is constructed, it is destined to go down consistently every month.  Coming soon, we will discuss option strategies that can prosper from this phenomenon.

A Timely Test of the Ultimate Hedge Against a Market Crash

Monday, November 12th, 2012

A week ago I gave you details on how to use stock options to create the perfect hedge against a market crash.  Last Monday, a mini-crash took place.  It was the worst day for the market all year. While the market (SPY) fell 2.3%, VXX rose 7.6%.  The Crash Control portfolio I set up as a hedge against a crash gained 18%, and is poised to gain at an accelerated rate if the market continues to fall. 

The market totally vindicated my analysis.

First, the high inverse correlation between VXX and the market came true, and the options strategy we set up using VXX as the underlying had a high correlation with the price of VXX.  So when the market tanked, the Crash Control portfolio prospered.

The great thing about this market-hedge options portfolio is that it is designed to make a small profit even if the market doesn’t crash.  It’s like buying insurance and getting a settlement even though the bad event that you bought insurance for didn’t actually happen.

A Timely Test of the Ultimate Hedge Against a Market Crash

The link to the follow-up on the options market hedge strategy is:

A Timely Test of the Ultimate Hedge Against a Market Crash

I suspect you will find this market-crash options strategy is so complex that you would be happier just subscribing to Terry’s Tips, sign up for Auto-Trade, and have thinkorswim execute the trades for you in your account.

How To Bet On Volatility Rising

Monday, August 20th, 2012

VIX, the so-called “fear index” hit a 5-year low last week.  What does that mean for investors, and how can they capitalize on this new development?

How To Bet On Volatility Rising

The most popular measure of options prices is the average implied volatility of puts and calls of the S&P 500 tracking stock (SPY).  (Only monthly options are included in this measure, and the increasingly-popular Weekly options are excluded, a serious mistake in my opinion.)

The mean average of VIX is 20.54.  When VIX is below 15, options prices are considered to be extremely low and when VIX is above 35, option prices are considered to be unusually high.  In the crash of 2008, VIX rose to 80 briefly and then fell all the way back to the mean average in about a year.  More recently, about a year ago, VIX rose to 40 when the possibility of a European economic meltdown was making headlines.

When fear is high, option prices as measured by VIX are high, and vice versa. Last week, VIX fell to 13.30, a low number not seen for five years.   Investors seem to have little fear.  By historical standards, they are complacent. After all, the market has moved higher for six consecutive weeks.

But the market is driven by sentiment.  And sentiment changes.  One interesting thing about VIX is that it ultimately moves toward its mean average.  Reversion to the mean is just about the most powerful thing that we know about VIX.

At this point in time, a single news story that Greece or Spain or Italy might encounter difficulties refinancing their debt, or China is slowing down, or Israel bombs Iranian nuclear plants, and VIX will soar through the roof.

So how do you make money when VIX rises (as it inevitably will)?  You could buy calls on VIX, but they are expensive (since everyone knows that VIX is bound to rise sometime), and you lose money if VIX stays flat (or only moves slightly higher, not enough to cover the cost of your call).

One serious problem with options on VIX is that you cannot place spreads (such as calendars or diagonals) with long and short options in different months without posting extremely high cash margin requirements (and you can’t do it at all in an IRA).

There is a better alternative out there, and it is a proxy for VIX.  It is an ETN (Exchange Traded Note) called VXX.  It is based on the futures of VIX and is highly correlated to VIX.  Last Friday, VIX closed at 13.45 and VXX closed at $11.20.  Last fall, both numbers were about at the 40 level, and in 2008, they both got as high as 80.

Of course, you might just buy VXX and hope that VIX rises, but there is a problem with owning VXX for the long run, and that is a thing called contango.  We can’t discuss contango at this time, but essentially, it pushes down the price of VXX about 8% a month at today’s futures prices, all other things being equal (i.e., VIX and VIX futures remain flat).

Our preference for betting that VIX (and VXX) will rise when VIX is at unprecedented low levels is to buy calls on VXX (right now, one of our 8 portfolios owns VXX calls expiring on September 21, 2012).  We sell at-the-money Weekly calls against these long positions, but we only sell enough calls to cover the premium decay on our long call positions.  We have 50% more long calls than we have short calls.

If VIX stays flat, our portfolio should break even (compare this to buying calls on VXX which would lose 100% of their value if VIX remains flat, or falls).  If VIX moves slightly lower (unlikely, in our opinion), we should lose a little.  If VIX moves slightly higher, we should make a small gain.  If VIX moves significantly higher, we should make a windfall gain, maybe five or ten times our total investment.

We believe that our portfolio (we call it the Honey Badger portfolio) provides exceptional protection against a 1987-like market meltdown.  Last week, one writer, Todd Feldman, saw similarities between today’s market and the market in 1987, just before the crash – see it here if you are interested.  

If the market crashes for any reason whatsoever, or if VIX moves significantly higher for any reason (or for no reason other than reverting to its mean), our Honey Badger portfolio should yield huge returns.

You can mirror our Honey Badger portfolio, or any of our other seven portfolios, and not have to make a single trade on your own, through the Auto-Trade service offered by TD Ameritrade/thinkorswim.

To celebrate the re-establishment of Auto-Trade at TD Ameritrade/thinkorswim, we are offering our Premium service at the lowest price in the history of our company.  We have never before offered such a large discount.  If you ever considered becoming a Terry’s Tips Insider, this would be the absolute best time to do it.

And now for the Special Offer – If you make this investment in yourself by midnight, September 4, 2012, this is what happens:

1)    For a one-time fee of only $75.95, you receive the White Paper  (which normally costs $79.95 by itself), which explains my favorite option strategies in detail, 20 “Lazy Way” companies with a minimum 100% gain in 2 years, mathematically guaranteed, if the stock stays flat or goes up, plus the following services:
 
2)    Two free months of the Terry’s Tips Stock Options Tutorial Program, (a $49.90 value).  This consists of 14 individual electronic tutorials delivered one each day for two weeks, and weekly Saturday Reports which provide timely Market Reports, discussion of option strategies, updates and commentaries on 8 different actual option portfolios, and much more.  

3)    Emailed Trade Alerts.  I will email you with any trades I make before I make them so you can mirror them yourself or have them executed for you by TD Ameritrade/thinkorswim through their Auto-Trade program. These Trade Alerts cover all 8 portfolios we conduct.

4)    Access to the Insider’s Section of Terry’s Tips, where you will find many valuable articles about option trading, and several months of recent Saturday Reports and Trade Alerts.

5)    A FREE special report  “How We Made 100% on Apple in 2010-11 While AAPL Rose Only 25%”.

6)    A free copy of my e-book, Making 36%: Duffer’s Guide to Breaking Par in the Market Every Year, In Good Years and Bad (2012 Updated Version).

With this one-time offer, you will receive all of these Premium Service benefits for only $75.95, (normal price $119.95). I have never made an offer anything like this in the eleven years I have published Terry’s Tips.  But you must order by midnight on September 4, 2012. Click here, and enter Special Code Auto12 in the box on the right side of the screen.

I feel confident that this offer could be the best investment you ever make in yourself.  Celebrate the resumption of Auto-Trade at TD Ameritrade/thinkorswim with us.  But do it before the day after Labor Day, as this offer will not be available after that day.

I look forward to prospering with you. 

Terry

P.S.  If you would have any questions about this offer or Terry’s Tips, please call Seth Allen, our Senior Vice President at 800-803-4595.  Or make this investment in yourself at the lowest price ever offered in our 11 years of publication – only $75.95 for our entire package using Special Code Auto12.

How to Cash in on the Crash of VIX:

Monday, July 23rd, 2012

Last week, VIX fell to as low as we have seen in four years.  I believe this has created a short-term buying opportunity.  Option prices (volatility) should be headed higher (in my opinion). 

How to Cash in on the Crash of VIX:  

As most of you know, VIX is the volatility measure based on option prices of the S&P 500 tracking stock, SPY. Last week, it had fallen all the way to 15.45, about the lowest level we have seen in several years. 

VIX is the so-called “fear index,” and historically has moved higher when there was uncertainty (or lower stock prices) in the market.  Back in 2007, a VIX this low was probably appropriate.  The stock market had been on a slightly-upward flattish direction for many months, and there was little unrest in our domestic economy or around the world.  In 2008 when markets imploded, VIX rose as high as 80.

Today, there seems to be uncertainty all over the place.  Some people are talking about the possibility of a double dip recession, while others focus on escalating oil prices, high unemployment, and most of all, a melt-down in several European countries that might have a domino effect on our economy.

So where has all the market fear gone?  There are a huge number of uncertainties in the current economic world, both at home and abroad, and the market seems to be ignoring them. 

Over the years, VIX has shown a strong inclination to revert to the mean, and the mean is 20.54.  I think it is inevitable that VIX will climb back up toward, or above, 20 in the near future.  If this is the case, how can you benefit from it?

A Time to Buy VXX? This stock (actually an exchange-traded note, ETN) is highly correlated to VIX.  It is based on the futures of VIX which are generally closely related to VIX.  It closed yesterday at $13.20, the lowest price in quite a long time.  About six months ago (when VIX was in the 30’s), VXX traded in the low $40’s).

On one hand, I believe that it is highly unlikely to go much lower, and on the other, I expect that some unforeseen event will surely come along at some point to spook the market and send VIX and VXX sharply higher.

There is one serious shortcoming of owning VXX, however.  Due to the way it is constructed, something called contango reduces its value every month that the futures for VIX remain unchanged.  For this reason, the only time that it is a good idea to buy VXX is when VIX is unusually low (and there are reasons to believe that it is headed higher).

An ETN that benefits every month from contango is the inverse of VXX.  It is called XIV (the inverse of VIX).  Last October, when XIV was trading about $6.70 (and VIX was in the 30’s), I made a major investment in VIX (and made an impassioned plea to my subscribers to do the same).  Now that VIX is less than half what it was then, last week I sold most of my holdings for more than $13, almost doubling my money over that period.  With VIX so low, I believe that there is a better chance that XIV will suffer from a rising VIX than there is that it will benefit from the contango tailwinds that it usually enjoys.  (When VIX moves over 20, I will probably buy XIV once again).

On last Friday when the market fell by almost 1%, VIX rose from 15.45 to 16.27 (5.3%) and VXX rose from $12.55 to $13.20 (5.2%) to give an idea of the potential gain for VXX if option volatility moves back to its mean average of 20.54.

Another way to play VXX is to buy the stock and write a call against it, or at least against some of it.  With VXX trading at $13.20, an August 14 call could be sold for $.74 which would give you a 5.6% gain for one month if the stock doesn’t change, or an 11.6% gain if it closes above $14, the call you sold is exercised, and you lose the stock.  Either scenario does not seem so bad for a single month. 

The key assumption here is that VXX is quite unlikely to trade any lower than it is right now.  I believe that this is a reasonable assumption to make.  While it might trade lower temporarily, history says that it won’t stay down there for long.

VXX has been recognized as one of the best hedges against a falling market.  Some analysts have stated that a $10,000 investment in VXX will protect a $100,000 market portfolio of stock (although my estimate is that it would take about a $25,000 investment to accomplish that).  Once again, however, because of the contango issue, when VIX is at or above the mean of 20.54, it is generally not a good idea to buy VXX unless you strongly believe that uncertainty, and option prices, are headed higher.

In any event, I think VXX is a good short-term buy right now as a bet that option volatility will rise as things in Europe start spooking the market once again (in spite of the contango issue that will depress its value somewhat).

Choose an Option Strategy Based on Actual vs. Implied Volatility

Monday, October 31st, 2011

It is important to differentiate between the implied volatility of option prices and the actual volatility of the underlying stock or ETF.  It is not an easy task to recognize when the two measures deviate from one another, but if you can identify a difference, huge gains can be made with the proper option strategy.

Today we will discuss how you can capitalize on any differences that you might be able to find.

Choose an Option Strategy Based on Actual vs. Implied Volatility: 

 
Last week the European debt crisis was apparently averted, at least in the eyes of option investors.  VIX, the so-called “fear index”, the average implied volatility of option prices on the S&P 500 tracking stock (SPY) fell dramatically to just below 25 (still above its mean average of about 20 but well below the 40+ it has sometimes been at during the previous month).

When option prices are high (i.e., implied volatility, VIX) is high, there are huge gains possible by writing call options (not our favorite ploy) or buying calendar spreads (our favorite most of the time).  However, when actual market volatility is greater than the expected volatility (i.e., implied volatility of the option prices), writing calls or buying calendar spreads is generally unprofitable.

Over the last three months, we have had great difficulty making gains with our calendar spreads because actual market volatility was too great.  On the other hand, we have had some luck with buying straddles (or strangles), a strategy of buying both a put and a call on the same underlying and hoping that there is a big fluctuation in either direction.

Last Wednesday, after following VXX (a “stock” that is based on the futures of VIX), we noticed that actual volatility was huge – it had fluctuated $2 or more almost every single day for several weeks.  On Wednesday in one of our portfolios we made a small ($1400) buy of 5 VXX 43 puts and calls which would expire two days later.  We paid $279 per straddle.  When the market for VXX opened up sharply lower on Thursday, we sold the straddle for $596, netting 117% after commissions.

In another portfolio where we owned calendar spreads on VXX, we lost money.  Our results in these two portfolios clearly demonstrated that when high actual volatility occurs, you do best by buying short-term options, either puts or calls depending on which way you believe the market is headed, or both puts and calls if you admit you really don’t know which way it will go (as we usually do).  On the other hand, when actual volatility is low, calendar spreads deliver higher returns.
Now that much of the uncertainty facing the market has subsided a bit, we believe it is time for the calendar spreads to prosper once again as they have for most of the past few years (since late 2008 extending up to August of this year).

Using Options to Hedge Market Risk

Monday, September 12th, 2011

Another crazy week in the market.  Investors vacillated from panic to manic and back to panic.  The net change for the week was not so significant, but the fluctuations were huge.  How can you cope with a market like this?

You might consider using options to hedge against market moves in both directions.  Check out how two of our portfolios are doing it.

Using Options to Hedge Market Risk   

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116): 

Using Options to Hedge Market Risk

  

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116):



Remember, this is an actual brokerage account at thinkorswim which any paying Terry’s Tips subscriber can duplicate if he or she wishes.  The graph shows that if the stock stays absolutely flat next week, there could be a gain of over $1000 for the week.  If the stock should fall by $2, an even higher gain should result.  (Once the stock falls by $2, we would likely make some downside adjustments so that further drops in the stock price would generate higher gains.  After all, this is our bearish bet.)

Where else could you expect a 20% gain if the market doesn’t move one bit?  In a single week?  Or even more if the market should fall?

Admittedly, today’s option prices are extremely high (in 92% of the weeks over the last 5 years, option prices have been lower than they are right now, so we are in truly unusual times).  The risk profile graphs for our portfolios usually do not look as promising as they do right now.

One of the bullish portfolios that we recommend to be matched against the 10K Bear portfolio is called the Ultra Vixen.  This portfolio is based on the underlying “stock” (actually an ETN, an exchange traded note) called VXX.  This index is based on the short-term futures of VIX (the measure of SPY option prices, the so-called “fear index”).  When the market drops, VIX generally rises (as do the VIX futures prices), and VXX usually moves higher.  Over the last month while the market dropped over 10%, VXX has more than doubled in price.  For that reason, many people consider VXX to be an excellent hedge against market crashes.

We don’t like VXX as an investment possibility, however.  Over time, due to a mechanism called contango (futures prices become more expensive in further-out months), VXX is destined to fall over time.  It may be a good hedge as a short-term investment but is awful as a long-term holding.  It fell for 12 consecutive months last year, for example, even though VIX fluctuated in both directions.

Our Ultra Vixen portfolio is set up to benefit when VXX goes down (which it does when the market is flat or goes up).  We generally maintain a net short position on VXX with some call positions for protection in case the stock does go up.  However, our portfolio does best if the market stays flat or moves higher, so it is a good hedge against the 10K Bear portfolio.

Here is the risk profile graph for Ultra Vixen for next Friday’s expiration (September 16th).  It is a $10,000 portfolio and the underlying stock (VXX) is trading about $45.83:





The graph shows that a 10% gain for the week is possible if the stock falls as much as $3 or goes up by as much as $2.  (Historically, in about half the weeks, VXX fluctuates by less than a dollar in either direction.)  Where else besides options do you find opportunities like this?  In a single week?

Both the 10K Bear and Ultra Vixen portfolios should make excellent gains every week when the market is flat, and one or the other should make gains when the market moves more than moderately in either direction.  Theoretically, if the two portfolios together break even in the high-fluctuation weeks and they both make gains when the market doesn’t do much of anything, the long-run combined results should be extraordinary.

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