from the desk of Dr. Terry F Allen

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Posts Tagged ‘implied volatility’

Why Option Prices are Often Different

Monday, June 1st, 2015

This week I would like to discuss why stock option prices are low in some weeks and high in others, and how option spread prices also differ over time.  If you ever decide to become an active option investor, you should understand those kinds of important details.Terry

Why Option Prices are Often Different

The wild card in option prices is implied volatility (IV).  When IV is high, option prices are higher than they are when IV is lower.  IV is determined by the market’s assessment of how volatile the market will be at certain times.  A few generalizations can be made:

1. Volatility (and option prices) are usually lower in short trading weeks.  When there is a holiday and only four trading days, IV tends to be lower.  This means that holiday weeks are not good ones to write calls against your stock.  It is also a poor time to buy calendar spreads.  Better to write the calls or buy the calendar spread in the week before a holiday week.

2. Volatility is higher in the week when employment numbers are published on Friday.  This is almost always the first week of the calendar month.  The market often moves more than usual on the days when those numbers are published, and option prices in general tend to be higher in those weeks.  These would be good weeks to sell calls against your stock or buy calendar spreads.

3. IV rises substantially leading up to a company’s earnings announcement.  This is the best of all times to write calls against stock you own.  Actual volatility might be great as well, so there is some danger in buying the stock during that time.

4. Calendar spreads (our favorite) are less expensive if you buy spreads in further-out months rather than shorter terms.  For example, if you were to buy an at-the-money SPY calendar spread, buying an August-July spread would cost $1.44, but a September–August spread would cost only $.90.  If you were to buy the longer-out month spread and waited a month, you might be able close out the spread for a 50% gain if the price is about the same after 30 days.

Today we created a new portfolio employing further-out calendar spreads at Terry’s Tips.  We used the underlying SVXY which (because of contango) can usually be counted on to move higher (it has averaged about a 45% gain every year historically, just as its inverse, VXX, has fallen by that much).  We added a bullish diagonal call spread to several calendars (buying December and selling September) to create the following risk profile graph:

SVXY Risk Profile Graph June 2015

SVXY Risk Profile Graph June 2015

We will have to wait 109 days for the September short options to expire, and hopefully, we will not have to make any more trades before then. This portfolio was set up with $4000, and we have set aside almost $400 to make an adjusting trade in case the stock makes a huge move in either direction.

The neat thing about this portfolio is that there is a very large break-even range.  The stock can fall about $15 before we lose on the downside, or it can go almost $30 higher before we lose on the upside.  With the extra cash we have, these break-even numbers can be expanded quite easily by another $10 or so in either direction, if necessary.

It would be impossible to set up a risk profile graph with such a large break-even range if we selected shorter-term calendar spreads instead of going way out to the December-September months.  Now we will just have to wait a while before we collect what looks like a 25% gain over quite a large range of possible stock prices.

Try a Vertical Put Credit Spread on a Stock That You Like

Thursday, January 8th, 2015

This week I would like to share my thoughts about the market for 2015, and also one of my favorite option strategies when I find a stock I really like. Whenever I find a stock I particularly like for one reason or another, rather than buy the stock outright, I use options to dramatically increase the returns I enjoy if I am right (and the stock goes up, or at least stays flat).

Today I would like to share a trade that I made today in my personal account.  Maybe you would like to do something similar with a company you particularly like.

And Happy New Year – I hope that 2015 will by your best year ever for investments (even if the market falls a bit).

Terry

Try a Vertical Put Credit Spread on a Stock That You Like

First, a few thoughts about the market for 2015.  The Barron’s Roundtable (made up of 10 mostly large investment bank analysts) predicted an average 10% market gain for 2015.  None of the analysts predicted a market loss for the year.  Others have suggested that the year should be approached with more caution, however. The whopping gain in VIX in the last week of 2014 is a clear indication that investors have become more fearful of what’s ahead. The market has gained about 40% over the past two years.  The bull market has continued for 90 months, a near-record–breaking string.

The forward P/E for the market has expanded to 19, several points higher than the historical average, and 2 points above where it was a year ago.  The trailing market P/E is 22.7x compared to 14x for the 125-year average.  Maybe such high valuations are appropriate for a zero-interest environment, but that is about to change. For the first time since 2007, the Fed will not be propping up the market with their Quantitative Easing purchases. The Fed has essentially promised that they will raise interest rates in 2015.  The only question is when it will happen.

There is an old adage that says “don’t fight the Fed.”  Not only have they stopped pumping billions into the economy every month, they plan to raise interest rates this year.  Like it or not, stock market investments made in 2015 are tantamount to picking a fight with the Fed.

While the U.S. economy is strong (and apparently growing), a great number of U.S. companies depend on foreign sales for a significant share of their business, and the foreign prospects aren’t so great for a number of countries. This situation could cause domestic company earnings to disappoint, and stock prices could fall.  At the very best, 2015 seems like a good time to take a cautious approach to investing.

Even if the market is not great for 2015, surely some shares will move higher. Barron’s chose General Motors (GM) as one of its best 10 picks for 2015 and made a compelling argument for the company’s prospects.  The 3.27% dividend should insulate the company from a big down-draft if the market as a whole has a correction in 2015.

I was convinced by their analysis that GM was highly likely to move higher in 2015.  Today, with GM trading at $35.70, I placed the following trade:

Buy To Open 10 GM Jun-15 32 puts (GM150619P32)

Sell To Open 10 GM Jun-15 37 puts (GM150619P37) for a credit of $2.20  (selling a vertical)

I like to go out about six months with spreads like this to give the stock a little time to move higher.  The above trade put $2200 in my account.  There will be a $5000 maintenance requirement which is reduced to $2800 when you subtract out the amount of cash I received.  This means that my maximum loss would be $2800, and this would come about if the stock closes below $32 on June 19, 2015.

If the stock closes at any price above $37, both the long and short puts will expire worthless and I will not have to make any more trades.  If this happens, I will make a profit of $2200 (less $25 commission, or $2175) on an investment of $2800.  This works out to a gain of 77%.

In order for me to make 77% on this investment, GM only needs to go up by $1.50 (4.2%).  If it stays exactly the same on June 19th ($35.70), I will have to buy back the 37 put for a cost of $1.30 ($1300 for 10 contracts).  That would leave me with a gain of $862.50, or 30.8%.

If I had purchased shares of GM with the $2800 I had at risk, I could have bought 78 shares.  I I might have collected a dividend of $91 over the 6 months.  With my options investment, I would have gained nearly 10 times that much if the stock did not move up at all.

Bottom line, even though I am taking a greater risk with options, the upside potential is so much greater than merely buying the stock that it seems to be a better move when you find a company that looks like it will be a winner.

An Interesting Way to Invest in China Using Options

Monday, November 17th, 2014

A week ago, I reported on a spread I placed in advance of Keurig’s (GMCR) announcement which comes after the market close on Wednesday.  I bought Dec-14 140 puts and sold Nov-14 150 puts for a credit of $1.80 when the stock was trading just under $153.  The spread should make a gain if it ends up Friday at any price higher than $145.  You can still place this trade, but you would only receive about $1.15 at today’s prices.  It still might be a good bet if you are at all bullish on GMCR.Today I would like to discuss a way to invest in China using options.  One of our basic premises at Terry’s Tips is that if you find a company you like, you can make several times as much trading options on that company than you can just buying the stock (and we have proved this premise a number of times with a large number of companies over the years).  If you would like to add an international equity to your investment portfolio, you might enjoy today’s discussion.

Terry

An Interesting Way to Invest in China Using Options:

My favorite print publication these days is Bloomberg BusinessWeek which also includes a monthly edition called Bloomberg Markets.  There are times when I find myself at least skimming nearly every article in both publications.  I used to read the Wall Street Journal every day, but it got to be just too much.  Now I only read the Saturday edition along with Barron’s.  This week’s cover story in Bloomberg Markets is entitled “Jack Ma Wants it All.”  It discusses the fascinating story of Ali Baba (BABA) and Ma’s business philosophy which treats customers first, employees second, and stockholders third.  This is precisely Costco’s philosophy, and it has worked wonders for COST, even for stockholders.

Last week was 11/11, a sort of anti-Valentines Day in China called Singles Day (BABA owns the name as well) when unattached people buy something for themselves.  BABA reported online sales of $9 billion on that day.  For comparison, online spending on Black Friday, the hectic U.S. shopping day after Thanksgiving, totaled $1.2 billion in 2013. On Cyber Monday, the top online spending day, sales totaled $1.84 billion, according to research firm comScore.

The only part about Ma’s strategy I didn’t like was his international investments in apparently unrelated businesses.  I generally prefer companies which “stick to their own knitting.”  But BABA might be an interesting way to invest in China, and the option prices are attractive (high IV, relatively small bid-asked ranges, lots of volume, and weekly options are traded).

I tried to get a link to the Bloomberg Markets article, but there doesn’t appear to be one.  It is fascinating, however, and worth a trip to the library or newsstand to read the December issue.

Proposed New Terry’s Tips Portfolio: One of the most successful strategies we have carried out over the years has been using calendar and diagonal spreads on individual companies we like.  If the stock price moves higher (as we expect), we have often gained several times the percentage increase in the stock.  For example, in the 15 months since we started the Vista Valley portfolio which trades NKE call options, the stock has increased by 51% and our portfolio has gained 141%.

BABA would be an interesting company to start a new portfolio to trade.  An at-the-money July-Dec2 calendar spread would cost about $12.  There would be 7 opportunities to sell a one-month-out at-the-money call, and the going price is about $5. If we could do that 3 times we would have all our money back with 4 more chances to take some pure profits.

If we set up a $5000 portfolio using this strategy (owning Jul-15 calls to start, and selling one weekly at each of 4 weeks, from at-the-money to just out-of-the-money, this is what the risk profile graph would look like for the first full month of waiting:

BABA Risk Profile Graph November 2014

BABA Risk Profile Graph November 2014

The break-even range would extend about $5 on the downside and $15 on the upside, a fairly wide range for a $115 stock for one month.  An at-the-money result would cause a better-than-15% return for the month.  It looks like an attractive way to add a little international coverage to our portfolio choices, and to enjoy gains if the stock falls as much as $5 in a month or does any better than that.  If you just bought the stock, it would have to move higher before you made any gains.  With options, you make the highest gain if it just manages to stay flat for the month.  At all times, you enjoy a wider break-even range than you ever could by merely buying a stock that you like.

Update on the ongoing SVXY put demonstration portfolio.  This sample demonstration portfolio holds a SVXY Mar-15 75, and each week, (almost always on Friday), we buy back an expiring weekly put and sell a one-week put in its place, trying to sell at a strike which is $1 – $2 in the money (i.e., at a strike which is $1 or $2 above the stock price)  Our goal in this portfolio is to make 3% a week.

Last week, SVXY edged up $.70 and we bought back the expiring Nov1-14 73 put  and sold a Nov-14 73 put (selling a calendar), collecting a credit of $1.45 ($143.50 after commissions).

The account value is now $1500, up $55 for the week, and $266 from the starting value of $1234 on October 17th, 4 weeks ago.  This works out to $66 a week, well more than the $37 weekly gain we need to achieve our 3% weekly goal.

I will continue trading this account and let you know from time to time how close I am achieving my goal of 3% a week.  I will follow the guidelines already sent to you for rolling over as outlined above and earlier, so you should be able to do it on your own if you wish.

 

Stock Option Strategy for an Earnings Announcement

Tuesday, November 11th, 2014

One of the best times to use an options strategy is just before a company makes its quarterly earnings announcement.  That is the time when puts and calls get very expensive.  When the earnings come out, investors are usually disappointed or elated, and the stock price often makes a big move.  That is why those puts and calls are so expensive just prior to the announcement.

Since our favorite stock options strategy is to sell options just before expiration, the pre-announcement time is often the perfect time to take action.  Today I would like to share a recommendation I made to paying subscribers over the past weekend.

Terry

Stock Option Strategy for an Earnings Announcement

Keurig Green Mountain (GMCR) has had quite a year, more than doubling in value.  Coke came along at the beginning of 2014 and bought a billion dollars’ worth of GMCR stock (and so far, they have picked up a billion dollar profit – not bad).

On Wednesday, November 19, GMCR announces earnings, two days before the November expiration for stock options.  Option prices are sky high – implied volatility (IV) for the November series is 67 compared to 44 for the January series.  While all the option prices will fall after the announcement, the risk profile graph shows unusually high possible gains at almost any higher price with the spread suggested below, and the stock can also fall by a large margin and gains should result as well.

An interesting way to play this earnings announcement would be to buy a December 140 put and sell a November 150 put.  You could do it at credit of about $1.80 (and with a $1000 maintenance requirement, your net investment (and maximum theoretical loss) would be $820 per spread).  Check out the risk profile graph assuming that IV for the December put would fall by 10 after the announcement (it probably won’t fall that far).

GMCR Risk Profile Graph November 2014

GMCR Risk Profile Graph November 2014

No matter how high the stock goes, there will be a gain because the 150 put would expire worthless, and the stock could fall $12 before a loss would result on the downside.  I like those odds.

Maybe you are a little more bearish on the stock (the whisper numbers for earnings are about 10% higher than analysts’ projections which means that expectations may be too high, and a lower stock price may come about because of those expectations).  In that case, you might consider buying a December 135 put and selling a November 145 put.  You could collect about $1.10 for the spread and risk $890, and the risk profile graph would look like this (again assuming IV for the December put will fall by 10):

GMCR Risk Profile Graph 2 November 2014

GMCR Risk Profile Graph 2 November 2014

The downside break-even point is about $140, or almost $13 lower than the current price, and a gain of some sort will accrue at any price above $145 because of the intitial credit and the fact that the put will expire worthless (and there will be some residual value with the December 135 put).  This looks like a pretty secure way to make 10% (or maybe a whole lot more) in the next two weeks. A profit should result if the stock does anything other than fall by more than 8% after the announcement.  The maximum gain would be about 30%, and would come if the stock fell by about $8 after the announcement (and some sort of gain would come no matter how high the stock might go).

Note: GMCR has gone up about $2 in early trading today, and the above spreads we discussed in our Saturday Report would net slightly less if you placed them today today (i.e., your investment would be slightly higher than the above numbers).

Update on the ongoing SVXY put demonstration portfolio.  This sample demonstration portfolio holds a SVXY Mar-15 70, and each week, (almost always on Friday), we buy back an expiring weekly put and sell a one-week put in its place, trying to sell at a strike which is $1 – $2 in the money (i.e., at a strike which is $1 or $2 above the stock price)  Our goal in this portfolio is to make 3% a week.

Last week, SVXY rose about $3, and we bought back the expiring Nov1-14 70 put (then out of the money) and sold a Nov2-14 73 put, collecting a credit of $2.53 ($250.50 after commissions).  That made our long Mar-15 70 put $3 below the strike of the put we had sold, and the broker would assess a $300 maintenance call.  We could have handled that because we had over $600 in cash in the account, but we decided to roll the Mar-15 70 put up to the 75 strike, (buying a vertical spread).  We paid $2.55 ($252.50 after commissions).  We can now sell weekly puts at strikes as high as 75 without incurring a maintenance requirement.

The account value is now $1445, up $211 from the starting value of $1234 on October 17th ,3 weeks ago.  This works out to $70 a week, nearly double the $37 weekly gain we need to achieve our 3% weekly goal.

I will continue trading this account and let you know from time to time how close I am achieving my goal of 3% a week, although I will not report every trade immediately as I make it.  I will follow the guidelines for rolling over as outlined above and earlier, so you should be able to do it on your own if you wish.

How to Make 60% to 100% in 2014 if a Single Analyst (Out of 13) is Right – an Update

Friday, October 31st, 2014

Last week we discussed vertical spreads.  This week, I would like to continue that discussion by repeating some of what we reported in late December of last year.  It involves making a relatively long-term (one year) bet on the direction of the entire market.

And again, a brief plug for my step-daughter’s new fitness invention called the Da Vinci BodyBoard – it gives you a full body workout in only 20 minutes a day right in your home.  She has launched a KickStarter campaign to get financing and offer it to the world – check it out: https://www.kickstarter.com/projects/412276080/da-vinci-bodyboard

Terry

How to Make 60% to 100% in 2014 if a Single Analyst (Out of 13) is Right – an Update

This is part of we wrote last December – “Now is the time for analysts everywhere to make their predictions of what will happen to the market in 2014.  Last week, the Wall Street Journal published an article entitled Wall Street bulls eye more stock gains in 2014.  Their forecasts – ”The average year-end price target of 13 stock strategists polled by Bloomberg is 1890, a 5.7% gain … (for the S&P 500).  The most bullish call comes from John Stoltzfus, chief investment strategist at Oppenheimer (a prediction of +13%).”

The Journal continues to say “The bad news: Two stock strategists are predicting that the S&P 500 will finish next year below its current level. Barry Bannister, chief equity strategist at Stifel Nicolaus, for example, predicts the index will fall to 1750, which represents a drop of 2% from Tuesday’s close.”

I would like to suggest a strategy that will make 60% to 100% or more (depending on which strike prices you choose to use) if any one of those analysts is right. In other words, if the market goes up by any amount or falls by 2%, you would make those returns with a single options trade that will expire at the end of 2014.

The S&P tracking stock (SPY) is trading around $180.  If it were to fall by 2% in 2014, it would be trading about $176.40.  Let’s use $176 as our downside target to give the pessimistic analyst a little wiggle room.  If we were to sell a Dec-14 176 put and buy a Dec-14 171 put, we could collect $1.87 ($187) per contract.  A maintenance requirement of $500 would be made.  Subtracting the $187 you received, you will have tied up $313 which represents the greatest loss that could come your way (if SPY were to close below $171, a drop of 5% from its present level).  We placed this exact spread in one of the 10 actual portfolios we carry out at Terry’s Tips.

Once you place these trades (called selling a vertical put spread), you sit back and do nothing for an entire year (until these options expire on December 20, 2014). If SPY closes at any price above $176, both puts would expire worthless and you would get to keep $187 per contract, or 60% on your maximum risk.

If you wanted to get a little more aggressive, you could make the assumption that the average estimate of the 13 analysts was on the money, (i.e., the market rises 5.7% in 2014).  That would mean SPY would be at $190 at the end of the year. You could sell a SPY Dec-14 190 put and buy a Dec-14 185 put and collect $2.85 ($285), risking $2.15 ($215) per contract.  If the analysts are right and SPY ends up above $190, you would earn 132% on your investment for the year.

By the way, you can do any of the above spreads in an IRA if you choose the right broker.

Note: I prefer using puts rather than calls for these spreads because if you are right, nothing needs to be done at expiration, both options expire worthless, and no commissions are incurred to exit the positions.  Buying a vertical call spread is mathematically identical to selling a vertical put spread at these same strike prices, but it will involve selling the spread at expiration and paying commissions.”

We are now entering November, and SPY is trading around $201.  It could fall by $25 and the 60%-gainer spread listed above would make the maximum gain, or it could fall by $12 and you could make 132% on your money for the year.  Where else can you make these kinds of returns these days?

On a historical basis, for the 40 years of the S&P 500’s existence, the index has fallen by more than 2% in 7 years.  That means if historical patterns continue for 2014, there is a 17.5% chance that you will lose your entire bet and an 83.5% chance that you will make 60% (using the first SPY spread outlined above).  If you had made that same bet every year for the past 40 years, you would have made 60% in 33 years and lost 100% in 7 years.  For the entire time span, you would have enjoyed an average gain of 32% per year.  Not a bad average gain.

Update on the ongoing SVXY put demonstration portfolio.  (We owned one Mar-15 65 put, and each week, we roll over a short put to the next weekly which is about $1 in the money (i.e., at a strike which is $1 higher than the stock price).  SVXY soared higher this week, and we had to make an adjustment.  We wanted to sell a weekly put at the 70 strike since the stock was trading around $68, but that strike is $3 higher than our long put, and we would create a maintenance requirement of $300 to sell that strike put.

Instead, today I sold the Mar-15 65 put and bought a Mar-15 70 put (buying a vertical spread) for $2.43 ($243).  Then I bought back the Oct4-14 65 put for a few pennies and sold a Nov1-14 70 put, collecting $2.94 $294) for the spread.   The account value is at $1324, or $90 higher than $1234 where we started out.  This averages out to $45 per week, slightly above the 3% ($37) average weekly gain we are shooting for.  (Once again, we would have done much better this week if the stock had moved up by only $2 instead of $5).

I will continue trading this account and let you know from time to time how close I am achieving my goal of 3% a week, although I will not report every trade I make each week.  I will follow the guidelines for rolling over as outlined above, so you should be able to do it on your own if you wished.

 

Ongoing SVXY Spread Strategy – Week 6

Friday, September 19th, 2014

Today we will continue our discussion of both SVXY and the actual portfolio we are carrying out with only two positions.  Every Friday, we will make a trade in this portfolio and tell you about it here.

Our goal is to earn an average gain of 3% a week in this portfolio after commissions.  So far, we are well ahead of this goal.

I hope you find this ongoing demonstration to be a simple way to learn a whole lot about trading options.  We will also discuss another Greek measure today – gamma.

Terry

Ongoing SVXY Spread Strategy – Week 6

Near the open today, SVXY was trading about $89.00.  We want to sell a put that is about $1 in the money (i.e., at a strike one dollar higher than the current stock price).  Our maximum gain each week will come if we are right, and the stock ends the week very close to the strike of our short put.

Here is the trade we placed today:

Buy to Close 1 SVXY Sep-14 86.5 put (SVXY140920P86.5)
Sell to Open 1 SVXY) Sep4-14 90 put (SVXY140926P90 for a credit limit of $2.70  (selling a diagonal)

Each week, we try to sell a weekly put which is at a strike about $1 in the money (i.e., the strike price is about a dollar higher than the stock price) as long as selling a diagonal (or calendar) spread can be done for a credit.

When we entered this order, the natural price (buying at the ask price and selling at the bid price) was $2.50 and the mid-point price was $2.75.  We placed a limit order at $2.70, a number which was $.05 below the mid-point price.  (It executed at $2.70).

If it hadn’t executed after half an hour, we would have reduced the credit amount by $.10 (and continue doing this each half hour until we got an execution).

Each week, we will make a trade that puts cash in our account (in other words, each trade will be for a credit).  Our goal is to accumulate enough cash in the portfolio between now and January 17, 2015 when our long put expires so that we have much more than the $1500 we started with.  Our Jan-15 may still have some remaining value as well.

This is the 6th week of carrying out our little options portfolio using SVXY as the underlying.  SVXY is constructed to move up or down in the opposite directions as changes in volatility of stock option prices (using VIX, the measure of option volatility for the S&P 500 tracking stock, SPY). SVXY is a derivative of a derivative of a derivative, so it is really, really complex.  Right now, option prices are trading at historic lows, and lots of people believe that they will move higher.  If they are right, SVXY will fall in value, but if option prices (i.e., volatility) don’t rise, SVXY will increase in value.  In our demonstration portfolio, we are assuming that option prices will not rise dramatically and that SVXY will move higher, on average, about a dollar a week.

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.  Today’s value of our long put is about $14 ($1200) and decay of this 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.

Last week we spoke a little about delta.  As you may recall, delta is the equivalent number of shares your option represents.  If an option has a delta of 70, it should gain $70 in value if the stock goes up by one dollar.  Today we will briefly introduce another options “Greek” called gamma.  Gamma is simply the amount that delta will change if the underlying stock goes up by one dollar.

If your option has a delta of 70 and a gamma of 5, if the underlying stock goes up by a dollar, your option would then have a delta of 75.  Gamma becomes more important for out-of-the-money options because delta tends to increase or decrease at faster rates when the stock moves in the direction of an out-of-the-money option.

To repeat what we covered last week, since we are dealing in puts rather than calls, the delta calculation is a little complicated.  I hope you won’t give up.  Delta for our Jan-15 90 put is minus 50.  This means that if the stock goes up a dollar, our long put option will lose about $.50 ($50) in value.  The weekly option that we have sold to someone else has a delta value of about 75 (since we sold it, it is a positive number).  If the stock goes up by a dollar, this option will go down by about $.75 ($75) which will be a gain for us because we sold that to someone else.

Our net delta value in the portfolio is +25.  If the stock goes up by a dollar, the portfolio should go up about $25 in value because of delta.  (Unfortunately, this gets more confusing when you understand that delta values will be quite different once the stock has moved in either direction, but we will discuss that issue later).

If the stock behaves as we hope, and it goes up by about a dollar in a week, we will gain about $25 from the positive delta value, and about $100 from net theta (the difference between the slower-decaying option we own and the faster-decaying weekly option that we have sold to someone else.

Our goal is to generate some cash in our portfolio each week.  This should be possible as long as the stock remains below $90. We will discuss what we need to do later if the stock moves higher than $90.

To update our progress to date, the balance in our account is now $1870 which shows a $370 gain over the 5 weeks we have held the positions.  This is well more than the $45 average weekly gain we are shooting for to make our goal of 3% a week.  We now have $1009 in cash in the portfolio.

Ongoing SVXY Spread Strategy – Week 4

Friday, September 5th, 2014

 

Today we will continue our discussion of both SVXY and the actual portfolio we are carrying out with only two positions.  Every Friday, we will make a trade in this portfolio and tell you about it here.

 

Our goal is to earn an average gain of 3% a week in this portfolio after commissions.

 

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

 

Terry

 

Ongoing SVXY Spread Strategy – Week 4

 

Near the open today, SVXY was trading about $86.  We want to sell a put that is about $1 in the money (i.e., at a strike one dollar higher than the current stock price).  Our maximum gain each week will come if we are right, and the stock ends the week very close to the strike of our short put.

 

Here is the trade we placed today:

 

Buy to Close 1 SVXY Sep1-14 86.5 put (SVXY140905P86.5)
Sell to Open 1 SVXY Sep2-14 86.5 put (SVXY140912P86.5) for a credit limit of $1.15  (selling a calendar)

 

When we entered this order, the natural price (buying at the ask price and selling at the bid price) was $.85 and the mid-point price was $1.25.  We placed a limit order at $1.15, a number which was $.05 below the mid-point price.  (It executed at $1.16).

 

If it hadn’t executed after half an hour, we would have reduced the credit amount by $.10 (and continue doing this each half hour until we got an execution).

 

Each week, we will make a trade that puts cash in our account (in other words, each trade will be for a credit).  Our goal is to accumulate enough cash in the portfolio between now and January 17, 2015 when our long put expires so that we have much more than the $1500 we started with.  Our Jan-15 may still have some remaining value as well.

 

This is the 4th week of carrying out our little options portfolio using SVXY as the underlying.  SVXY is constructed to move up or down in the opposite directions as changes in volatility of stock option prices (using VIX, the measure of option volatility for the S&P 500 tracking stock, SPY). SVXY is a derivative of a derivative of a derivative, so it is really, really complex.  Right now, option prices are trading at historic lows, and lots of people believe that they will move higher.  If they are right, SVXY will fall in value, but if option prices (i.e., volatility) don’t rise, SVXY will increase in value.  In our demonstration portfolio, we are assuming that option prices will not rise dramatically and that SVXY will move higher, on average, about a dollar a week.

 

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.  Today’s value of our long put is about $14 ($1400) and decay of this 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.

 

Let’s bring a couple of other option terms into this conversation.  First, we are bullish on the stock (we are betting that contango will continue to exist and provide more tailwinds for the stock than increasing volatility will hurt the stock).  When you are bullish on a stock, you want to own a portfolio that is delta-positive.  Delta is the measure of how much the option will increase in value if the underlying stock moves $1 higher.

 

Most options traders like to maintain a delta-neutral portfolio condition.  This means they don’t care if the stock goes up or down, at least for small changes.  We want to be a little bullish in our portfolio, so we are aiming for a net-delta-positive condition.

 

Since we are dealing in puts rather than calls, this is extremely complicated.  I hope you won’t give up.  Delta for our Jan-15 90 put is minus 50.  This means that if the stock goes up a dollar, our long put option will lose about $.50 ($50) in value.  The weekly option that we have sold to someone else has a delta value of about 75 (since we sold it, it is a positive number).  If the stock goes up by a dollar, this option will go down by about $.75 ($75) which will be a gain for us because we sold that to someone else.

 

Our net delta value in the portfolio is +25.  If the stock goes up by a dollar, the portfolio should go up about $25 in value because of delta.  (Unfortunately, this gets more confusing when you understand that delta values will be quite different once the stock has moved in either direction, but we will discuss that issue later).

 

If the stock behaves as we hope, and it goes up by about a dollar in a week, we will gain about $25 from the positive delta value, and about $100 from net theta (the difference between the slower-decaying option we own and the faster-decaying weekly option that we have sold to someone else.

 

Our goal is to generate some cash in our portfolio each week.  This should be possible as long as the stock remains below $90. We will discuss what we need to do later if the stock moves higher than $90.

 

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 $1730 which shows a $230 gain over the three 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.  We now have $624 in cash in the portfolio.

 

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

 

Ongoing Spread SVXY Strategy For You to Follow if You Wish

Monday, August 18th, 2014

A couple of weeks ago, I put $1500 into a separate brokerage account to trade put options on an Exchange Traded Product (ETP) called SVXY.  I placed positions that were betting that SVXY would not fall by more than $6 in a week (it had not fallen by that amount in all of 2014 until that date).  My timing was perfectly awful.  In the next 10 days, the stock fell from $87 to $72, an unprecedented drop of $15.

Bottom line, my account balance fell from $1500 to $1233, I lost $267 in two short weeks when just about the worst possible thing happened to my stock.  Now I want to put $267 back in and start over again with $1500, and make it possible for you to follow if you wish.

This will be an actual portfolio designed to demonstrate one way how you can trade options and hopefully outperform anything you could expect to do in the stock market.  Our goal in this portfolio is to make an average gain of 3% every week between now and when the Jan-15 options expire on January 15, 2015 (22 weeks from now).

That works out to 150% a year annualized.  I think we can do it.  We will start with one trade which we will make today.

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 For You to Follow if You Wish

Our underlying “stock” is an ETP called SVXY.  It is a complex volatility-related instrument that has some interesting characteristics:

1. It is highly likely to move steadily higher over time.  This is true because it is adjusted each day by buying futures on VIX and selling the spot (current) price of VIX.  Since over 90% of the time, the futures are higher than the spot price (a condition called contango), this adjustment almost always results in a gain.  SVXY gained about 100% in both 2012 and 2013 and is up about 30% this year.

2. SVXY is extremely volatile.  Last Friday, for example, it rose $2 in the morning, fell $6 mid-day, and then reversed direction once again and ended up absolutely flat (+$.02) for the day.  This volatility causes an extremely high implied volatility (IV) number for the options (and very high option prices). IV for SVXY is about 65 compared to the market (SPY) which is about 13.

3. While it is destined to move higher over the long run, SVXY will fall sharply when there is a market correction or crash which results in VIX (market volatility) to increase.  Two weeks ago, we started this demonstration portfolio when SVXY was trading at $87, and it fell to $72 before recovering to its current $83.

4. Put option prices are generally higher than call option prices.  For this reason, we deal entirely in puts.

5. There is a large spread between the bid and ask option prices.  This means that every order we place must be at a limit.  We will never place a market order.  We will choose a price which is $.05 worse for us than the mid-point between the bid and ask prices, and adjust this number (if necessary) if it doesn’t execute in a few minutes.

This is the strategy we will employ:

1. We will own a Jan-15 90 put.  It cost us $15.02 ($1502) to buy (plus $2.50 commission for the spread).  Theta is $4 for this option.  That means that if the stock is flat, the option will fall in value by $4 each day ($28 per week).

This is the trade we made today to get this demonstration portfolio established:

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.
2. Each week, we will sell a short-term weekly put (using the Jan-15 90 put for collateral).  We will collect as much time premium as we can while selling a slightly in-the-money put.  That means selling a weekly put at the strike which is slightly higher than the stock price.  We hope to collect about $2 ($200) in time premium by selling this put. Theta will start out at about $20 for the first day and increase each day throughout the week.  If the stock stays flat, we would get to keep the entire $200 and make a net gain of $172 for the week because our long put would fall in value by $28.  This is the best-case scenario.  It only has to happen 6 times out of 22 weeks to recover our initial $1200 investment.

3. Each Friday we will need to make a decision, and often a trade. If the put we have sold is in the money (i.e., the stock is trading at a lower price than the strike price), we will have to buy it back to avoid it being exercised.  At the same time, we will sell a new put for the next weekly series.  We will choose the strike price which is closest to $1 in the money.  Our goal is to take some money off the table each and every week. If it is not possible to buy back an expiring weekly put and replace it with the next-week put at the $1 in-the-money strike at a credit we will select the highest-strike option we can sell as long as the spread is made at a credit.  We eventually have to cover the $1220 original spread cost, and collecting about $200 as we will some weeks would recover that amount quite quickly  – we have 22 weeks to collect a credit, so we only need an average of about $45 each week (after commissions).

4. On Friday, if the stock is higher than the strike price, we will not do anything, and let the short put expire worthless.  On the following Monday, we will sell the next-week put at the at-the-money strike price, hopefully collecting another $200.

5. We are starting off by selling a weekly put which has a lower strike price than the long Jan-15 put we own.  In the event that down the line (when the stock price rises as we expect it will), we may want to sell a weekly put at a higher strike price than the 90 put we own.  In that event, we will incur a maintenance requirement of $100 for each dollar of difference between the two numbers.  There is no interest charged on this amount, but we just can’t use it for buying other stocks. For now, we don’t have to worry about a maintenance requirement because our short put is at a lower strike than our long put.  If that changes down the line, we will discuss that in more detail.

This strategy should make a gain every week that the stock moves less than $3 on the downside or $4 on the upside.  Since we are selling a put at a strike which is slightly higher than the stock price, our upside break-even price range is greater. This is appropriate because based solely on contango, the stock should gain about $1.00 each week that VIX remains flat.

I think you will learn a lot by following this portfolio as it unfolds over time.  You might find it to be terribly confusing at first.  Over time, it will end up seeming simple.  Doing it yourself in an actual account will make it more interesting for you, and will insure that you pay close attention.  The learning experience should be valuable, and we just might make some money along the way as well.

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).

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