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Archive for the ‘VXX’ Category

Ongoing Spread SVXY Strategy – Week 3

Friday, August 29th, 2014

Two weeks ago we started a $1500 demonstration portfolio using SVXY, an ETP that is destined to move higher over the long run because of the way it is constructed (selling VIX higher-priced futures each day and buying at the spot price of VIX, a condition called contango which exists about 90% of time).

Today, contango is about 6% (that is how much higher the futures are that this ETP is selling each day when it buys at the spot price of VIX).  In rough terms, this means that SVXY should go up by 6% each month that VIX remains unchanged.  This works out to be about $1.25 per week that SVXY should go up, all other things being equal (which, unfortunately, they usually aren’t).

I hope you find this ongoing demonstration to be a simple way to learn a whole lot about trading options.

Terry

Ongoing Spread SVXY Strategy – Week 3

In this simple portfolio, we own an SVXY Jan-15 90 put.  We will use this as collateral for selling a put each week in the weekly series that expires a week later than the current short put that we sold a week ago.  The decay of our long put (theta) is $4 (this means that if SVXY remains unchanged, the put will fall in value by $4 each day.  The decay of our short put is $13 (and will increase every day until next Friday).  This means that all other things being equal, we should gain $9 in portfolio value every day at the beginning of the week and about double that amount later in the week.

Each Friday we will have to make a decision as to which strike we should sell the following week’s put at.  Our goal is two-fold – sell a put at a strike which is closest to being $1 in the money (i.e., the strike price is about $1 higher than the current price of the stock), and second, it must be sold at a credit so that we add cash to our portfolio each week.

This week, we were a little lucky because the stock is trading today at very near the strike of the 87 put we sold a week ago.  We will buy this put back today and sell a put for next week at the 88 strike and collect cash in doing so.  Here is the trade that we will place today.  If it doesn’t execute after half an hour, we will reduce the credit amount by $.10 (and continue doing this each half hour until we get an execution).

Here is the trade we placed today:

Buy to Close 1 SVXY Aug5-14 86 put (SVXY140829P86)
Sell to Open 1 SVXY Sep1-14 86.5 put (SVXY140905P86.5) for a credit limit of $1.50  (selling a diagonal)

When we entered this order, the natural price (buying at the ask price and selling at the bid price) was $1.25 and the mid-point price was $1.55.  We placed a limit order at $1.50, a number which was $.05 below the mid-point price.  (It executed at $1.50).

Our goal is to generate some cash in our portfolio each week.  This should be possible as long as the stock remains below $90 and we have to move that strike price higher.  We will discuss what we need to do later when it becomes an issue.

We paid a commission of $2.50 for this trade, the special rate for Terry’s Tips customers at thinkorswim.  The balance in our account is now $1670 which shows a $170 gain over the two weeks we have held the positions.  This is much more than the $45 average weekly gain we are shooting for to make our goal of 3% a week.

Next Friday we will make another similar trade and I will keep you posted on what we do.

Ongoing Spread SVXY Strategy – Week 2

Friday, August 22nd, 2014

Last week we started a $1500 demonstration portfolio using SVXY, and ETP that is destined to move higher over the long run because of the way it is constructed (selling VIX higher-priced futures each day and buying at the spot price of VIX, a condition called contango which exists in about 90% of days).Today we bought back an in-the-money expiring put that we had sold last week and rolled it over to next week.

I hope you find this ongoing demonstration to be a simple way to learn a whole lot about trading options.

Terry

Ongoing Spread SVXY Strategy – Week 2

Last week, we used the following trade to set up this portfolio:

Buy To Open 1 SVXY Jan-15 90 put (SVXY150117P90)
Sell To Open 1 SVXY Aug4-14 87 put (SVXY140822P87) for a debit limit of $12.20  (buying a diagonal)

This executed at this price (90 put bought for $15.02, 87 put sold for $2.82 at a time when SVXY was trading at $85.70.

Our goal is to generate some cash in our portfolio each week.  This should be possible as long as the stock remains below $90 and we have to move that strike price higher.  We will discuss what we need to do later when it becomes an issue. Right now, we are facing a market where the stock is trading lower than it was last week when we bought it.  Now it is about $85, and our goal is to sell a weekly put each week that is about $1 in the money, and do it at a credit.

This is the order we placed (and was executed today):

Buy to close 1 SVXY Aug4-14 87 put (SVXY140822P87)
Sell To Open 1 SVXY Aug5-14 86 put (SVXY140829P86) for a credit limit of $  (selling a diagonal)

When we entered this order, the natural price (buying at the ask price and selling at the bid price) was $.65 and the mid-point price was $.90.  We placed a limit order at $.85, a number which was $.05 below the mid-point price.  It was executed at that limit price.

We paid a commission of $2.50 for this trade, the special rate for Terry’s Tips customers at thinkorswim.  The balance in our account is now $1555 which shows a $55 gain (more than the $45 average weekly gain we are shooting for to make our goal of 3% a week).

Next Friday we will make another similar trade and I will keep you posted on what we do.

The stock has moved up a bit since we made this trade so you might be able to get a better price if you do this on your own.

This is what the risk profile graph looks like for our positions at next Friday’s expiration:

SVXY Risk Profile Graph August 2014

SVXY Risk Profile Graph August 2014

A Possible Great Option Trading Idea

Monday, July 14th, 2014

Just before the close on Friday, we made a strongly bullish trade on our favorite underlying stock in a portfolio at Terry’s Tips.  In my personal account, I bought weekly calls on this same underlying.  As I write this in the pre-market on Monday, it looks like that bet could triple in value this week.

I would like to share with you the thinking behind these trades so next time this opportunity comes up (and it surely will in the near future), you might decide to take advantage of it yourself.

Terry

A Possible Great Option Trading Idea: As we have discussed recently, option prices are almost ridiculously low.  The most popular measure of option prices is VIX, the so-called “fear index” which measures option prices on SPY (essentially what most people consider “the” market) is hanging out around 12.  The historical mean is over 20, so this is an unprecedented low value.

When we sell calendar or diagonal spreads at Terry’s Tips, we are essentially selling options to take advantage of the short-term faster-decaying options.  Rather than using stock as collateral for selling short-term options we use longer-term options because they tie up less cash.

With option prices currently so low, maybe it is a time to reverse this strategy and buy options rather than selling them.  One way of doing this would be to buy a straddle (both a put and a call at the same strike price, usually at the market, hoping that the stock will make a decent move in either direction.  In options lingo, you are hoping that actual volatility (IV) is greater than historical volatility.

The biggest problem with buying straddles is that you will lose on one of your purchases while you gain on the other.  It takes a fairly big move in the underlying to cover the loss on your losing position before you can make a profit on the straddle.

A potentially better trade might be to guess which way the market will move in the short term, and then buy just a put or call that will make you money if you are right. The big challenge would be to find a price pattern that could help you choose which direction to bet on?

One historically consistent pattern for most market changes (the law of cycles) is that the direction of the change from one period to the next is about twice as likely to be in the same direction as it was in the previous same time period.  In other words, if the stock went up last week (or month), it is more likely to go up again next week (or month).

We tested this pattern on SPY for several years, and sadly, found that it did not hold up.  The chances were almost 50-50 that it would move in the opposite direction in the second period.

Maybe the pattern would work for our most popular underling, an ETP called SVXY.  You might recall that we love this “stock” because it is extremely volatile and option prices are wonderfully high (great for selling).  In the first 22 weeks of 2014, SVXY fluctuated by at least $3 in one direction or the other in 19 of those weeks.  Maybe we could use the pattern and buy weekly either puts or calls, depending on which way the market had moved in the previous week.

Once again, the historical results did not support the law of cycles pattern.  The stock was almost just as likely to move in the opposite direction as it had in the previous week.  Another good idea dashed by reality.

In making this study, we discovered something interesting, however.  In the first half of 2014, SVXY fell more than $3 in a single week on 5 different occasions.  In 4 of the subsequent weeks, it made a significant move ($3 or more) to the upside.  Buying a slightly out-of-the-money weekly call for about a dollar and a half ($150 per contract) could result in a 100% gain (or more) in the next week in 4 out of 5 weeks.

If this pattern could be counted on to continue, it would be a fantastic trading opportunity.  Yes, you might lose your entire investment in the losing weeks, but if you doubled it in the winning weeks, and there were many more of them than losing weeks, you would do extremely well.

For  those reasons, I bought calls on SVXY on Friday.  The Jul-14 90.5 call that expires this Friday (July 18th) could have been bought for $1.30.  The stock closed at $88.86.  I plan to place an order to sell these calls, half at $2.60, and half at $3.90.  The pre-market prices indicate that one of these orders might exercise sometime today and I will have all my money back and still own half my calls.  It might be a fun week for me.  We’ll see.

On another subject, have you got your free report entitled 12 Important Things Everyone with a 401(K) or IRA Should Know (and Probably Doesn’t).  This report includes some of my recent learnings about popular retirement plans and how you can do better.  Order it here.  You just might learn something (and save thousands of dollars as well).

An Interesting Trade to Make on Monday

Monday, June 16th, 2014

The recent developments in Iraq have nudged options volatility higher, but for one underlying, SVXY, it has apparently pushed IV through the roof.  This development has brought about some potentially profitable option spread possibilities.Terry

An Interesting Trade to Make on Monday

In case you don’t know what SVXY is, you might check out the chart of its volatility-related inverse, VXX.  This is the ETP many investors use as a protection against a market crash.  If a crash comes along, options volatility skyrockets, taking VXX right along with it.  The only problem with VXX is that over time, it is just about the worst investment you could imagine making.  Three times in the last five years they have had to engineer 1 – for – 4  reverse splits to keep the price higher enough to bother with buying.  Over the past 7 years, VXX has fallen from a split-adjusted price over $2000 to its current $32.

Wouldn’t you like to buy the inverse of VXX?  You can.  It’s called SVXY  (XIV is also its inverse, but you can’t trade options on XIV).

Last week I talked about buying short-term (weekly) call options on SVXY because in exactly half the weeks so far in 2014, the stock had moved $4 higher at least once during the week.  I also advised waiting until option prices were lower before taking this action.  Now that option prices have escalated, the best thing seems to be selling option premium rather than buying it.

Two weeks ago, a slightly out-of-the-money weekly SVXY option had a bid price of $1.05.  Friday, that same option had a bid price of $2.30, more than double that amount.

All other things being equal, SVXY should move higher each month at the current level of Contango (6.49%).  That works out to about $1.20 each week.  I would like to place a bet that SVXY moves higher by about that amount and sell a calendar spread at a strike price about that much above Friday’s close ($79.91).

Below I have displayed the risk profile graph  for a July-June 81 calendar put spread (I used puts rather than calls because if the stock does move higher, the June puts will expire worthless and I will save a commission by not buying them back.

This would be the risk profile graph if we were to buy 5 Jul-14 – Jun-14 put calendar spreads at the 81 strike price at a cost of $3.00 (or less).  You would have $1500 at risk and could make over 50% on your investment if the stock goes up by amount that contango would suggest.  Actually, as I write this Monday morning, it looks like SVXY will open up about a dollar lower, and the spread might better be placed at the 80 strike instead of the 81.

SVXY Risk Profile Graph June 2014
SVXY Risk Profile Graph June 2014

A break-even range of $3 to the downside and about $5 on the upside looks quite comfortable.  If you had a little more money to invest, you might try buying September puts rather than July – this would allow more time for SVXY to recover if it does fall this week on scary developments in Iraq (or somewhere else in the world).

I have personally placed a large number of Sep-Jun calendar spreads on SVXY at strike prices both above and below the current stock price in an effort to take advantage of the unusually higher weekly option prices that exist  right now.

That’s enough about SVXY for today, but I would like to offer you a free report entitled 12 Important Things Everyone with a 401(K) or IRA Should Know (and Probably Doesn’t).  This report includes some of my recent learnings about popular retirement plans and how you can do better.  Order it here.  You just might learn something (and save thousands of dollars as well).

Contango, Backwardation, and SVXY

Monday, May 19th, 2014

This week I would like to introduce you to a thing called contango.  This is relevant today because contango just got higher than I have seen it in many years – over 10% while most of the time, it hangs out in the 3% – 4% range.  This measure becomes important when you are trading in my favorite ETP (Exchange Traded Product), SVXY.  If your eyes haven’t glazed over yet, read on.
Terry

Contango, Backwardation, and SVXY

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 is 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.

A Little About VXX (and its Inverse, SVXY)

One of the most frequent times that contango appears in the financial press is when VXX is discussed. VXX is an ETP 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. 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. Over the last three years, they have had to have 3 reverse 1 – 4 stock splits just to keep the price of VXX high enough to bother with trading.  Every time it gets down to about $12, they engineer a reverse split and the stock is suddenly trading at $48.  Over time, it goes back to $12 and they do it again (at least that is how it has worked ever since it was created).

VXX is adjusted every day by buying VIX futures and selling VIX at its spot price.  (This is not exactly what happens, but conceptually it is accurate.)  As long as contango is in effect, they are essentially buying high (because future prices are higher than the spot price) and selling low (the current spot price).  The actual contango number represents an approximation of how much VXX will fall in one month if a market correction or crash doesn’t take place.

So it’s a sort of big deal when contango gets over 10% as it is today.  VXX is bound to tumble, all other things being equal.  On the other hand, SVXY is likely to go up by that much in a month since it is the inverse of VXX.  SVXY has had a nice run lately, moving up an average of 4.5% in each of the last three weeks, in fact.  You can see why it is my favorite ETP (I trade puts and calls on it in large quantities every week, usually betting that it will move higher).

That’s enough about contango for today, but if you are one of the few people who have read down this far, I would like to offer you a free report entitled 12 Important Things Everyone with a 401(K) or IRA Should Know (and Probably Doesn’t).  I want to share some of my recent learnings about popular retirement plans but I don’t want to be overwhelmed by too much traffic while I get a new website set up.  Order it here.  You just might learn something (and save thousands of dollars as well).

 

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.

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