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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).

Vertical Put Credit Spreads Part 2

Monday, July 7th, 2014

Last week I reviewed the performance of the Terry’s Tips options portfolio for the first half of the year.  I should have waited a week because this week was a great one – our composite average gained another 6%, making the year-to-date record 22%, or about 3 times as great as the market (SPY) gain of about 7%.

Last week I also discussed a GOOG vertical put credit spread which is designed to gain 100% in the year if GOOG finished up 2014 at any price higher than where it started, something that it has done in 9 of its 10 years in business.  I want to congratulate those subscribers who read my numbers closely enough to recognize that I had made a mistake.  I reported that we had sold a (pre-split) 1120 – 1100 vertical put credit spread and collected $5.03 which was slightly more than the $500 per spread that I would have at risk. Actually, if the difference between the short and long sides was $20, and the maximum loss would be almost $15 (and the potential return on investment would be 33% rather than 100%).  We actually sold the spread for $10.06, not $5.03, and I mistakenly reported the post-split price.  We are now short 560 puts and long 550 puts, so the difference between the two strikes is $10 and we collected $5.03, or just about half that amount.  Bottom line, if GOOG finishes the year above $560, we will make 100% on our investment.  It closed at $585 Friday, so it can fall by $25 from here and we will still double our money.

Today we will discuss two other spreads we placed at the beginning of 2014 in one of the 10 portfolios we conduct for all to see at Terry’s Tips.

Terry

Vertical Put Credit Spreads Part 2:

We have a portfolio we call Better Odds Than Vegas.  In January, we picked three companies which we felt confident would be higher at the end of the year than they were at the beginning of the year.  If we were right, we would make 100% on our money.  We believed our odds were better than plunking the money down on red or black at the roulette table.

Late in 2013, the Wall Street Journal interviewed 13 prominent analysts and asked them what they expected the market would do in 2014.  The average projection was that it would gain slightly more than 5%.  The lowest guess was that it would fall by 2%.  We decided to make a trade that would make a nice gain if any one of the 13 analysts were correct.  In other words, if SPY did anything better than falling by 2%, our spread would make money.

In January, when SPY was trading about $184, we sold a vertical credit put spread for December, buying 177 puts and selling 182 puts.  We collected $2.00 at that time.  If the stock manages to close at any price higher than $182 on the third Friday in December, we will get to keep our entire $200 (per spread – we sold 8 spreads, collecting $1600).  The maintenance requirement would be $500 per spread less the $200 we collected, or $300 per spread ($2400, our maximum loss which would come if SPY closed below $177 in December).  Our potential profit would be about 66% on the investment, and this would come if the market was absolutely flat (or even fell a little bit) over the course of the year.  The stock closed Friday at $198.20, so it could fall by $16.20 between now and December and we would still make 66%.

The third company we bet on in this portfolio in January was Green Mountain Coffee Roasters (GMCR), now called Keurig Coffee Roasters.  This was a company with high option premiums that we have followed closely over the years (being in my home state of Vermont).  We have made some extraordinary gains with options on several occasions with GMCR.  Two directors (who were not billionaires) had bought a million dollars each of company stock, and we believed that something big might be coming their way.

With the stock trading about $75, we made an aggressive bet, both in our selection of strike prices and expiration month. Rather than giving the stock a whole year to move higher, we picked June, and gave it only 6 months to do something good.  We sold Jun-14 80 puts and bought Jun-14 70 puts, and collected $5.40.  If the stock stayed at $75, we would make only a small profit on the third Friday in June, but if it rose above $80 by that time, we would make $5.40 on an investment of $4.60, or 117%.

The good news that we anticipated came true – Coke came along and bought 10% of the company for $1 billion and signed a 10-year licensing agreement with GMCR.  The stock shot up to $120 overnight (giving Coke a $500 million windfall gain, by the way).  At that point, we picked up a little extra from the original spread.  We sold a vertical call credit spread for the June expiration month, buying the 160 calls and selling 150 calls, collecting an extra $1.45 per spread.  This did not increase our maintenance requirement because we had, in effect, legged into a short iron condor spread. It would be impossible for us to lose money on both our spreads, so the broker only charged the maintenance requirement on one of them.

Selling the call spread meant that our total gain for the six months would amount to almost 150% if GMCR ended up at any price between $80 and $150.  It ended up at about $122 and we enjoyed this entire gain.

We have since sold another GMCR vertical credit put spread for Jan-15, buying 90 puts and selling 100 puts for a credit of $3.45.  Our maximum loss is $6.55, and this would come if the stock closed below $90 on the third Friday in January.  The potential maximum gain would amount to 52% for the six months.  This amount was far less than the first spread because we selected strikes which were well below the then-current price of the stock (GMCR is now $125, well above our $100 target).  This makes our potential gain for this stock for the year a very nice 200%.

We advocate making these kinds of long-term options bet when you feel confident that a company will somehow be the same or higher than it is at the beginning. If you are right, extraordinary gains are possible. In our case, our portfolio has gained 41% for the year so far, and the three stocks can all fall by a fair amount and we will still make 100% on our starting investment when these options expire (hopefully worthless so we can keep all the cash we collected at the outset) on January 17, 2015.

Six-Month Review of Our Options Strategies – Part 1

Monday, June 30th, 2014

We have just finished the first half of 2014.  It has been a good year for the market.  It’s up about 6.7%.  Everyone should be fairly happy.  The composite portfolios conducted at Terry’s Tips have gained 16% over these months, almost 2 ½ times as much as the market rose.  Our subscribers are even happier than most investors.

Our results would have been even better except for our one big losing portfolio which has lost nearly 80% because we tried something which was exactly the opposite to the basic strategy used in all the other portfolios (we essentially bought options rather than selling short-term options as our basic strategy does).  In one month, we bought a 5-week straddle on Oracle because in was so cheap, and the stock did not fluctuate more than a dollar for the entire period. We lost about 80% of our investment.  If we had bought a calendar spread instead (like we usually do), it would have been a big winner.

Today I would like to discuss the six-month results of a special strategy that we set up in January which was designed to make 100% in one year with very little (actually none) trades after the first ones were placed.

Terry

Six-Month Review of Our Options Strategies:

We have a portfolio we call Better Odds Than Vegas.  In January, we picked three companies which we felt confident would be higher at the end of the year than they were at the beginning of the year.  If we were right, we would make 100% on our money.  We believed our odds were better than plunking the money down on red or black at the roulette table.

Today we will discuss the first company we chose – Google (GOOG).  This company had gone public 10 years earlier, and in 9 of those 10 years, it was higher at the end of the calendar year than it was at the outset.  Only in the market melt-down of 2007 did it fail to grow at least a little bit over the year.  Clearly, 9 out of 10 were much better odds than the 5 out of 10 at the roulette table (actually the odds are a little worse than this because of the two white or yellow possibilities on the wheel).

In January 2014 when we placed these trades, GOOG was trading just about $1120.  We put on what is called a vertical credit spread using puts.  We bought 5 January 2015 1100 puts and with the same trade sold 5 Jan-15 1120 puts for a credit spread of $5.03.  That put a little more than $2500 in our account after commissions.  The broker would charge us a maintenance requirement of $5000 on these spreads.  A maintenance requirement is not a loan, and no interest is charged on it – you just can’t spend that money buying other stocks or options.

If you subtract the $2500 we received in cash from the $5000 maintenance requirement you would end up with an investment of $2500 which represented the maximum loss you could get (and in this case, it was the maximum gain as well).  If GOOG ended up the year (actually on the third Friday in January 2015) at any price higher than where it started ($1120), both put options would expire worthless, the maintenance requirement would disappear, and we would get to keep the $2500 we got at the beginning.

Then GOOG declared a 2 – 1 stock split (first time ever) and we ended up with 10 put contracts at the 560 and 550 strike prices.  Usually, when a company announces that a split is coming, people buy the stock and the price moves higher.  Once the split has taken place, many people sell half their shares and the stock usually goes down a bit.  That is exactly what happened to GOOG.  Before the split, it rose to over $1228.  We were happy because it could then fall by over $100 and we would still double our money with our original put spreads.  But then, after the split, following the pattern that so many companies do, it fell back to a split-adjusted $1020, a level at which we would lose our entire investment.

Fortunately, today GOOG is trading at about $576, a number which is above our break-even post-split price of $560.  All it has to do now for the rest of the year is to go up by any amount or fall by less than $16 and we will double our money.  We still like our chances. If we were not so confident, we could buy the spread back today and pay only $4.25 for it and that would give us a profit of about 15% for the six months we have held it.

Next week we will discuss the two other vertical put spreads we sold in January.  After you read about all 3 of our plays, you will have a better idea on how to use these kinds of spreads on companies you like, and return a far greater percentage gain than the stock goes up (in fact, it doesn’t have to go up a penny to earn the maximum amount).

Maybe it’s Time to Buy Options Rather Than Sell Them

Monday, June 23rd, 2014

Last week I recommended buying a calendar spread on SVXY to take advantage of the extremely high option prices for the weekly options (at-the-money option prices had more than doubled over the past two weeks).  The stock managed to skyrocket over 7% for the week and caused the calendar spread to incur a loss.  When you sell a calendar spread, you want the stock to be trading very close to the strike price when the short options expire.  When the underlying stock makes a big move in either direction, you generally lose money on these spreads, just as we did last week.

Ironically, this spread was the only losing portfolio out of the 10 portfolios we carry out at Terry’s Tips (ok, one other portfolio lost a couple of dollars, but 8 others gained an average of almost 5% for the week).  The only losing spread was the one I told the free newsletter subscribers about.  Sorry.  I’ll try to do better next time.

Terry

Maybe it’s Time to Buy Options Rather Than Sell Them:

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).  Last week VIX fell almost 11% to end up below 11.  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.  On Friday, in the portfolio that that lost money on the SVXY calendar spread, we bought at-the-money calls on SPY  for $1.36.  It seems highly likely that  the stock will move higher by $1.50 or more at some point in the next 3 weeks and make this a winning trade (SPY rose $1.81 last week, for example).

With option prices generally low across the board and the stock market chugging consistently higher in spite of the turmoil in Iraq, maybe this would be a good time to buy a call option on your favorite stock.  Just a thought.

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.

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.

An Interesting Calendar Spread Trade Idea

Monday, April 14th, 2014

Today I would like to share with you an investment I made in my personal account just today.  It involves buying three calendar spreads and waiting about a month to see if you hit the jackpot.  See if you agree with me that it is a potentially great trade.Terry

An Interesting Calendar Spread Trade Idea 

The underlying company is Keurig Green Mountain Coffee (GMCR).  I have traded options on this company almost every week for the last few years.  I like it because the options carry an exceptionally high implied volatility (IV) because the stock has been so volatile.

A few months ago, when Coke signed an exclusive license with them and agreed to buy 10% of the company, the stock shot up by about 50%.  It has since retreated from those lofty levels, recently pushed lower because several competitors have brought a suit against them because their new Keurig machine won’t accept other companies’ single cup offerings.  That sounds like a good business idea to me, not something that they could be sued over.  But our legal system never ceases to surprise me.

In any event, the stock has settled down a bit, and since the lawsuits won’t get anywhere for several months, I only care what happens in the next month.  The stock closed at $98 Friday.  I think it won’t go much lower than that, and maybe will edge higher over the next month.

I am buying June options and selling May options as a calendar spread.  I bought June 105 calls and sold May 105 calls, June 100 calls and sold May 100 calls, June 95 puts and sold May 95 puts, all as calendar spreads.  The natural price for the call spreads was $2.00 and for the puts, $1.70 (you should be able to pay a little less than the natural prices).

In one month, when the May options expire (on the 16th), if any of those three strike prices are at the money (i.e., the stock price is very near one of the strike prices), the May option will expire nearly worthless and the June option should be worth $6.35 (based on the current value of an at-the-money option with four weeks of remaining life).  That means if I could get back more than I paid for all three spreads today by selling a single spread a month from now.  Whatever I got from selling the other two spreads would be pure profit.

If the stock ends up on May 16th being $5 away from one of my 3 strike prices, based on today’s values, the spread could be sold for $4.45, or more than double what I paid for any of the spreads I bought.  If the stock is $10 away from a strike price, it could be sold for $3.05 based on today’s prices.  That is 50% more than I paid for any of the spreads.

However, the company announces earnings on May 7th.  Because of the uncertainty surrounding that event, option prices are much higher now than they will be after the announcement.  IV for the June options is 55 right now, and it is only 44 for weekly options that expire before the announcement.  If we assume that IV for the June options will fall by 11 after the announcement, this is what the risk profile graph looks like:

GMCR Risk Profile Graph April 2014

GMCR Risk Profile Graph April 2014

This graph has numbers for 5 calendar spreads at each of the 3 strikes, with a total investment of about $4800.  If the stock ends up flat or up to $7 higher than it is right now, there would be about a 60% gain from the spreads.  If it falls by $10 (an unlikely event, in my opinion), a loss of about $400 would result.  Although the graph does not show it, the upside break-even is $15 higher than the current price.  It shows that above $113, losses would result.

Many stocks move higher in the few days before an announcement in anticipation of good results, a good reason I like to have a little more coverage on the upside (if you are more bullish, you would buy more spreads at higher strike prices, and if your were bearish on the company or the market, you would buy more spreads at lower strike prices).

One nice thing about calendar spreads is that the options you buy have a longer life span than those you are selling, so their value will always be higher, no matter how far from the stock price they might be.  You can never lose all of your money with a calendar spread, unlike who might happen in a vertical spread or short iron condor, two popular option spreads.

If the stock moves dramatically either way between now and announcement day, I would add another calendar in the direction the stock has moved (at the 115 strike if it moves higher, or the 90 strike if it moves lower).  That move would give me a wider break-even range than presently exists.

I will report back to you on how these spreads turn out in four weeks.

 

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