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Posts Tagged ‘Contango’

Update on Oil Play Designed to Make 25% in One Month

Friday, April 3rd, 2015

About a month ago I sent out a strategy we were using to capitalize on the price of oil falling further (as many analysts, including those at Goldman, Citi, and Barclays, were predicting).  We set up a small demonstration portfolio which had $2910 to start, and bought calendar spreads at the 18, 17, and 16 strikes when USO was trading at $18.45.When the price of oil did retreat further, USO fell to about $17, and we sold our calendar spreads at the 17 and 18 strikes and replaced them with calendar spreads at the 15 and 14 strikes.  Since the strike prices of calendar spreads is what determines whether you are bullish or bearish on the stock, when we had all our calendar spreads at strikes below the stock price, we were extremely bearish.

Then the stock turned around and headed higher, taking away the gains we had made, and we were right back to where we started.  Today we made a new start, and I would like to share our thinking at this time.

Terry

Update on Oil Play Designed to Make 25% in One Month

USO is an Exchange Traded Product (ETP) which is highly correlated to the price of oil (West Texas Intermediate). But there is another component that is not as easy to contend with, and that is the speculative element.  Oil prices are less than half of what they were a year ago, and in spite of most of the big investment banks warning that even lower prices are coming, there seems to be some people out there who are betting that oil prices will eventually recover, and this may be a good time to get on board.  For example, Robert Shiller, Nobel laureate and Yale University economist  made a strong pitch to “buy oil” this week.  Consequently, over the past few days, USO has inched up a bit in spite of these recent developments:

• The supply of oil is at an 80-year high, and grew at more than 4 million barrels last week in spite of expectations far less than that.
• The rate of oil rigs closing down has fallen drastically (and it appears that the rigs that have been closed down so far were the lowest-producing ones so the supply of oil gets higher each week)
• There appears to be an accord with Iran which could flood the market with new oil from Iran if sanctions are removed.

We are siding with the investment banks’ predictions instead of Mr. Shiller’s (who is likely to be thinking longer-term). While we believe the short-term price of USO is headed lower (for the above reasons and the headwinds caused by contango), we hedged our bet a little, and established new positions in our demonstration portfolio.  We own puts expiring in Jan-16 and we have sold Apr-4 15 puts which expire in 3 weeks (on April 24th).  We have 8 calendar spreads at the 15 strike, 8 at the 16 strike, and 5 at the 17 strike at a time when the stock is trading at $17.45.  Our portfolio is worth $2910 today.

This is the risk profile graph for these calendar spread positions for April 24th:

USO Risk Profile Graph April 2015

USO Risk Profile Graph April 2015

The graph shows that if USO doesn’t change one cent in value for the next three weeks, we will make about 20% with our positions.  If it falls by about a dollar (or more) as we expect, we could make double that amount.  If we are wrong, and it goes higher by a dollar in three weeks, we will break even.

We like our chances with these positions, and they demonstrate how you can make extraordinary gains with options, even if you are not quite right in guessing which way a stock price is headed.  I always like the feeling that if the stock doesn’t change at all (which is so often the case), I will still make a nice gain when the short options expire.

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).

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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