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Posts Tagged ‘implied volatility’

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).

Check Out the Volatility in SVXY

Monday, June 9th, 2014

This week is a further discussion of my favorite ETP (Exchange Traded Product), SVXY.  We have already discussed this unusual equity.  Because of contango, it is destined to move higher every week that there is not a market crash or correction.  It has doubled in value in each of the last two years.  If you have an idea of which way an underlying is headed, there are extremely attractive option strategies that you might use.  I will talk about one such strategy this week.Terry

Check Out the Volatility in SVXY

Every week for the past four weeks in my personal account, I have bought at least 200 out-of-the-money weekly call options on SVXY, paying $.20 ($20) for each option.  In every single instance, I was able to sell those options for at least $1.00 ($100), and sometimes much more.  That works out to 500% a week for 4 weeks in a row.  I could make that same bet every week for the next 16 weeks and lose every time and still be ahead.  (As we will see below, in half the weeks in 2014 so far, my bet would have been a winner, however).

Last week I was delighted to unload t hese calls because I figured that after moving higher for 6 consecutive weeks, it might be in for some weakness.  Not so.  The options I sold for $100 each could have been sold later in the week for $550.  I left a lot of money on the table.

I shared these trades with Terry’s Tips subscribers, by the way.  They were an insurance purchase as part of a larger portfolio of long and short options on SVXY.  Usually insurance costs money. I expected to lose money on it.  Over the past few weeks, it paid off nicely.

An interesting feature of SVXY price changes is the weekly volatility numbers.  This is an extremely volatile stock. The following table shows the biggest up and down changes in 2014 from the previous Friday’s close for SVXY.

This stock is unbelievably volatile.  In 19 of the 22 weeks, it either rose or fell by more than $3 (highlighted weeks). It rose over $3 in exactly half the weeks and if fell by more than $3 in 8 of the weeks.

SPXY Changes Newsletter June 2014

SPXY Changes Newsletter June 2014
With this kind of volatility, maybe buying a straddle each week at the close on Friday would be a good idea. The cheapest straddle last Friday would have been at the 84 strike (SVXY closed at $84.11) and would have cost about $3.35 (in most previous weeks, this straddle could have been bought for about $1 less – this week’s 10% rise in the stock price pushed IV much higher).

The biggest challenge with buying straddles is to figure out when to sell.  If you waited until the stock had moved by $4 to sell, you could have made a gain in 14 if the 22 weeks (64% of the time) but you would be only making about 20% at this week’s straddle cost and possibly losing almost everything in the remaining weeks. Not a good prospect, except maybe if you had bought at earlier-week prices.

A better idea would have been to buy a slightly out-of-the-money weekly call, paying about $.80 for it, and selling it when you have tripled your money.  You could have done that in half the weeks in 2014, insuring a great profit no matter what happened in the other half the weeks.

After SVXY rose $3 or more at some point in 7 of the last 8 weeks, however, call prices have moved higher this week (for the first time, surprisingly).  It would now cost about $1.20 to buy a weekly 85 call with the stock closing at $84.11.  A week ago, that same call would have cost about half as much.
This week I am not making an insurance purchase of out-of-the-money calls on SVXY.  The call option prices have become too rich for my taste. I suspect that a week from now, they might be back to a more reasonable level.

For several months, the call options have been much less expensive that the put options, but they are about the same right now.  In the past, traders were buying puts as a hedge against a market crash (when the market tanks, SVXY falls by a much greater percentage than the market).  This phenonemon will probably return soon, and make buying out-of-the-money calls a good strategy.

I suspect that SVXY might take a breather here for a week or two, so I will be sitting on the sidelines.  When call prices retreat a bit, I plan to start buying cheap out-of-the-money weekly calls once again.

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).

 

A Look at the Downsides of Option Investing

Monday, May 12th, 2014

Most of the time we talk about how wonderful it is to be trading options.  In the interests of fair play, today I will point out the downsides of options as an investment alternative.

Terry

A Look at the Downsides of Option Investing

1. Taxes.  Except in very rare circumstances, all gains are taxed as short-term capital gains.  This is essentially the same as ordinary income.  The rates are as high as your individual personal income tax rates. Because of this tax situation, we encourage subscribers to carry out option strategies in an IRA or other tax-deferred account, but this is not possible for everyone.  (Maybe you have some capital loss carry-forwards that you can use to offset the short-term capital gains made in your option trading).

2. Commissions.  Compared to stock investing, commission rates for options, particularly for the Weekly options that we trade in many of our portfolios, are horrendously high.  It is not uncommon for commissions for a year to exceed 30% of the amount you have invested.  Because of this huge cost, all of our published results include all commissions.  Be wary of any newsletter that does not include commissions in their results – they are misleading you big time.

Speaking of commissions, if you become a Terry’s Tips subscriber, you may be eligible to pay only $1.25 for a single option trade at thinkorswim.  This low rate applies to all your option trading at thinkorswim, not merely those trades made mirroring our portfolios (or Auto-Trading).

3. Wide Fluctuations in Portfolio Value.   Options are leveraged instruments.  Portfolio values typically experience wide swings in value in both directions.

Many people do not have the stomach for such volatility, just as some people are more concerned with the commissions they pay than they are with the bottom line results (both groups of people probably should not be trading options).

4. Uncertainty of Gains. In carrying out our option strategies, we depend on risk profile graphs which show the expected gains or losses at the next options expiration at the various possible prices for the underlying.  We publish these graphs for each portfolio every week for subscribers and consult them hourly during the week.

Oftentimes, when the options expire, the expected gains do not materialize.  The reason is usually because option prices (implied volatilities) fall.   (The risk profile graph software assumes that implied volatilities will remain unchanged.).   Of course, there are many weeks when VIX rises and we do better than the risk profile graph had projected.   But the bottom line is that there are times when the stock does exactly as you had hoped (usually, we like it best when it doesn’t do much of anything) and you still don’t make the gains you originally expected.

With all these negatives, is option investing worth the bother?  We think it is.  Where else is the chance of 50% or 100% annual gains a realistic possibility?  We believe that at least a small portion of many people’s investment portfolio should be in something that at least has the possibility of making extraordinary returns.

With CD’s and bonds yielding ridiculously low returns (and the stock market not really showing any gains for quite a while – adjusted for inflation, the market is 10% lower than it was in March,  2000,), the options alternative has become more attractive for many investors, in spite of all the problems we have outlined above.

Volatility’s Impact on Option Prices

Monday, April 28th, 2014

Today I would like to talk a little about an important measure in the options world – volatility, and how it affects how much you pay for an option (either put or call).

Terry

Volatility’s Impact on Option Prices

Volatility is the sole variable that can only be measured after the option prices are known.  All the other variables have precise mathematical measurements, but volatility has an essentially emotional component that defies easy understanding.  If option trading were a poker game, volatility would be the wild card.

Volatility is the most exciting measure of stock options.  Quite simply, option volatility means how much you expect the stock to vary in price. The term “volatility” is a little confusing because it may refer to historical volatility (how much the company stock actually fluctuated in the past) or implied volatility (how much the market expects the stock will fluctuate in the future).

When an options trader says “IBM’s at 20” he is referring to the implied volatility of the front-month at-the-money puts and calls.  Some people use the term “projected volatility” rather than “implied volatility.”  They mean the same thing.

A staid old stock like Procter & Gamble would not be expected to vary in price much over the course of a year, and its options would carry a low volatility number.  For P & G, this number currently is 12%.  That is how much the market expects the stock might vary in price, either up or down, over the course of a year.

Here are some volatility numbers for other popular companies:

IBM  – 16%
Apple Computer – 23%
GE – 14%
Johnson and Johnson – 14%
Goldman Sachs – 21%
Amazon – 47%
eBay – 51%
SVXY – 41% (our current favorite underlying)

You can see that the degree of stability of the company is reflected in its volatility number.  IBM has been around forever and is a large company that is not expected to fluctuate in price very much, while Apple Computer has exciting new products that might be great successes (or flops) which cause might wide swings in the stock price as news reports or rumors are circulated.

Volatility numbers are typically much lower for Exchange Traded Funds (ETFs) than for individual stocks.  Since ETFs are made up of many companies, good (or bad) news about a single company will usually not significantly affect the entire batch of companies in the index.  An ETF such as OIH which is influenced by changes in the price of oil would logically carry a higher volatility number.

Here are some volatility numbers for the options of some popular ETFs:

Dow Jones Industrial (Tracking Stock – DIA) – 13%
S&P 500 (Tracking Stock – SPY) –14%
Nasdaq (Tracking Stock – QQQ) – 21%
Russell 2000 (Small Cap – IWM) – 26%

Since all the input variables that determine an option price in the Black-Scholes model (strike price, stock price, time to expiration, interest and dividend rates) can be measured precisely, only volatility is the wild card.   It is the most important variable of all.

If implied volatility is high, the option prices are high.  If expectations of fluctuation in the company stock are low, implied volatility and option prices are low.  For example, a one-month at-the-money option on Johnson & Johnson would cost about $1.30 (stock price $100) vs. $2.00 for eBay (stock price $53).  On a per-dollar basis, the eBay option trades for about three times as much as the JNJ option.

Of course, since only historical volatility can be measured with certainty, and no one knows for sure what the stock will do in the future, implied volatility is where all the fun starts and ends in the option trading game.

How Option Prices are Determined

Monday, April 21st, 2014

Last week was one of the best for the market in about two years.  Our option portfolios at Terry’s Tips made great gains across the board as well.  One portfolio gained 55% for the week, in fact.  It is fun to have a little money tied up in an investment that can deliver those kinds of returns every once in a while.

This week I would like to discuss a little about what goes into an option price – what makes them what they are?

Terry

How Option Prices are Determined

Of course, the market ultimately determines the price of any option as buyers bid and sellers ask at various prices.  Usually, they meet somewhere in the middle and a price is determined.  This buying and selling action is generally not based on some pie-in-the-sky notion of value, but is soundly grounded on some mathematical considerations.

There are 5 components that determine the value of an option:

1. The price of the underlying stock

2. The strike price of the option

3. The time until the option expires

4. The cost of money (interest rates less dividends, if any)

5. The volatility of the underlying stock

The first four components are easy to figure out.  Each can precisely be measured.  If they were the only components necessary, option pricing would be a no-brainer.  Anyone who could add and subtract could figure it out to the penny.

The fifth component – volatility – is the wild card.  It is where all the fun starts.  Options on two different companies could have absolutely identical numbers for all of the first four components and the option for one company could cost double what the same option would cost for the other company.  Volatility is absolutely the most important (and elusive) ingredient of option prices.

Volatility is simply a measure of how much the stock fluctuates.  So shouldn’t it be easy to figure out?   It actually is easy to calculate, if you are content with looking backwards.  The amount of fluctuation in the past is called historical volatility.  It can be precisely measured, but of course it might be a little different each year.

So historical volatility gives market professionals an idea of what the volatility number should be.  However, what the market believes will happen next year or next month is far more important than what happened in the past, so the volatility figure (and the option price) fluctuates all over the place based on the current emotional state of the market.

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I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

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