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5 Option Strategies if you Think the Market is Headed Lower

Saturday, June 27th, 2015

A subscriber wrote in and asked what he should do if he thought the market would be 6% lower by the end of September.  I thought about his question a little bit, and decided to share my thoughts with you, just in case you have similar feelings at some time along the way.Terry

5 Option Strategies if you Think the Market is Headed Lower

We will use the S&P 500 tracking stock, SPY, as a proxy for the market.  As I write this, SPY is trading just below $210.  If it were to fall by 6% by the end of September (3 months from now), it would be trading about $197 at that time.  The prices for the possible investments listed below are slightly more costly than the mid-point between the bid and ask prices for the options or the option spreads, and include the commission cost (calculated at $1.25 per contract, the price that Terry’s Tips subscribers pay at thinkorswim).

#1.  Buy an at-the-money put.  One of the most common option purchases is the outright buy of a put option if you feel strongly that the market is crashing.  Today, with SPY trading at $210, a September 2015 put option at the 210 strike would cost you $550.  If SPY is trading at $197 (as the subscriber believed it would be at the end of September), your put would be worth $1300.  You would make a profit of $750, or 136% on your investment.

Buying a put involves an extremely high degree of risk, however. The stock must fall by $5 ½ (about 2.6%) before you make a nickel of profit.  If the market remains flat or goes higher by any amount, you would lose 100% of your investment.  Studies have shown that about 80% of all options eventually expire worthless, so by historical measures, there is a very high likelihood that you will lose everything.  That doesn’t sound like much of a good investment idea to me, even if you feel strongly about the market’s direction.  It is so easy to get it wrong (I know from frequent personal experience).

If you were to buy an out-of-the-money put (i.e., the strike price is below the stock price), the outlook is even worse.  A Sept-15 205 put would cost about $400 to buy.  While that is less than the $550 you would have to shell out for the at-the-money 210 put, the market still has to fall by a considerable amount, $9 (4.3%) before you make a nickel.  In my opinion, you shouldn’t even consider it.

#2.  Buy an in-the-money put.  You might consider buying a put which has a higher strike than the stock price.  While it will cost more (increasing your potential loss if the market goes up), the stock does not need to fall nearly as far before you get into a profit zone.  A Sept-15 215 put would cost you $800, and the stock would only have to fall by $3 (1.4%) before you could start counting some gains.  If the market remains flat, your loss would be $300 (38%).

If the stock does manage to fall to $197, your 215 put would be worth $1800 at expiration, and your gain would be $1000, or 125% on your investment.  In my opinion, buying an in-the-money put is not a good investment idea, either, although it is probably better than buying an at-the-money put, and should only be considered if you are strongly convinced that the stock is headed significantly lower.

#3.  Buy a vertical put spread.  The most popular directional option spread choice is probably a vertical spread.  If you believe the market is headed lower, you buy a put and at the same time, sell a lower-strike put as part of a spread.  You only have to come up with the difference between the cost of the put you buy and what you receive from selling a lower-strike put to someone else.  In our SPY example, you might buy a Sept-15 210 put and sell a Sept-15 200 put.  You would have to pay $300 for this spread.  The stock would only have to fall by $3 before you started collecting a profit.  If it closed at any price below $200, your spread would have an intrinsic value of $1000 and you would make a profit of $700 (230% on your investment), less commissions.

With this spread, however, if the stock remains flat or rises by any amount, you would lose your entire $300 investment.  That is a big cost for being wrong.  But if you believe that the market will fall by 6%, maybe a flat or higher price isn’t in your perceived realm of possible outcomes.

Another (more conservative) vertical put spread would be to buy an in-the-money put and sell an at-the-money put. If you bought a Sept-15 220 put and sold a Sept-15 210 put, your cost would be $600.  If the stock closed at any price below $210, your spread would be worth $1000 and your gain ($400) would work out to be about 64% after commissions. The neat thing about this spread is that if the stock remained flat at $210, you would still gain the 64%.  If there is an equal chance that a stock will go up, go down, or stay flat, you would have two out of the three possible outcomes covered.

You also might think about compromising between the above two vertical put spreads and buy a Sept-15 215 put and sell a Sept-15 205 put.  It would cost you about $420.  Your maximum gain, if the stock ended up at any price below $205, would be $580, or about 135% on your investment.  If the stock remains flat at $210, your spread would be worth $500 at expiration, and you would make a small gain over your cost of $420.  You would only lose money if the stock were to rise by more than $.80 over the time period.

#4.  Sell a call credit vertical spread.  People with a limited understanding of options (which includes a huge majority of American investors) don’t even think about calls when they believe that the market is headed lower.  However, you can gain all the advantages of the above put vertical spreads, and more, by trading calls instead of puts if you want to gain when the market falls.  When I want to make a directional bet on a lower market, I always use calls rather than puts.

If you would like to replicate the risk-reward numbers of the above compromise vertical put spread, you would buy a Sept-15 215 call and sell a Sept-15 205 call. The higher-strike call that you are buying is much cheaper than the lower-strike call you are selling.  You could collect $600 for the spread.  The broker would place a $1000 maintenance agreement (no interest charge) on your account (this represents the maximum possible loss on the spread if you had not received any credit when placing it, but in our case, you collected $600 so the maximum possible loss is $400 – that is how much you will have to have in your account to sell this spread).  Usually, buying a vertical put spread or selling the same strikes with a credit call vertical spread cost about the same – in this case, the call spread happened to be a better price (an investment of $400 rather than $420).

There are two advantages to selling the call credit spread rather than buying the vertical put spread.  First, if you are successful and the stock ends up below $205 as you expect, both the long and short calls will expire worthless.  There will be no commission to pay on closing out the positions. You don’t have to do anything other than wait a day for the maintenance requirement to disappear and you get to keep the cash you collected when you sold the spread at the outset.

Second, when you try to sell the vertical put spread for $10 (the intrinsic value if the stock is $205 or lower), you will not be able to get the entire $10 because of the bid-ask price situation.  The best you could expect to get is about $9.95 ($995) as a limit order.  You could do nothing and let the broker close it out for you – in that case you would get exactly $1000, but most brokers charge a $35 or higher fee for an automatic closing spread transaction.  It is usually better to accept the $995 and pay the commission (although it is better to use calls and avoid the commissions altogether).

#5.  Buy a calendar spread.  My favorite spreads are calendar spreads so I feel compelled to include them as one of the possibilities. If you think the market is headed lower, all you need to do is buy a calendar spread at a strike price where you think the stock will end up when the short options expire. In our example, the subscriber believed that the stock would fall to $197 when the September options expired.  He could buy an Oct-15 – Sept-15 197 calendar spread (the risk-reward is identical whether you use puts or calls, but I prefer to use calls if you think the market is headed lower because you are closing out an out-of-the-money option which usually has a lower bid-ask range).  The cost of this spread would be about $60.  Here is the risk profile graph which shows the loss or gain from the spread at the various possible stock prices:

Bearish SPY Risk Profile Graph June 2015

Bearish SPY Risk Profile Graph June 2015

You can see that if you are exactly right and the stock ends up at $197, your gain would be about $320, or over 500% on your investment (by the way, I don’t expect the stock will fall this low, but I just went into the market to see if I could get the spread for $60 or better, and my order executed at $57).

What I like about the calendar spread is that the break-even range is a whopping $20.  You can be wrong about your price estimate by almost $10 in either direction and you would make a profit with the spread.  The closer you can guess to where the stock will end up, the greater your potential gain.  Now that I have actually bought a calendar spread at the 197 strike, I will buy another calendar spread at a higher strike so that I have more upside protection (and be more in line with my thinking as to the likely stock price come September).

There are indeed an infinite number of option investments you could make if you have a feeling for which way the market is headed.  We have listed 5 of the more popular strategies if someone believes the market is headed lower.  In future newsletters we will discuss more complicated alternatives such as butterfly spreads and iron condors.

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.

How to Make 20% in one Month on Your Favorite Stock (Using Options)

Thursday, January 22nd, 2015

 

This week I would like to show you the exact positions of one of the 9 portfolios we are currently carrying out for Insiders at Terry’s Tips.  It involves one of my favorite places to shop, Costco, and its stock, COST.  We expect to make just under 20% on this portfolio in the next four weeks, even if the stock does not go up a single penny.  Welcome to the wonderful world of stock options.Terry

How to Make 20% in one Month on Your Favorite Stock (Using Options)

The basic strategy that we carry out at Terry’s Tips is to buy longer-term options on stocks we like and sell shorter-term options against them.  Since the decay rates of the shorter-term options is much higher than the decay rates of the long-term options we own, we hope to make money every day that the stock remains flat or moves in the direction that we expect it will.  In options terms, we have positions that have a positive theta value.

Most of the time, we buy these option spreads on stocks we like, so by selecting strike prices that are higher than the current stock price, we create a portfolio that gains more than the theta value when the stock moves higher.  In options terms, we have a portfolio which is positive net delta.  It gains in value when the stock moves higher, just as owners of the stock enjoy.

Here is the risk profile graph for our actual Costco portfolio.  We have just under $5000 invested in these positions.  The curve shows how much we will make or lose at each of the possible stock prices when the February options expire on February 20, 2015, four weeks from tomorrow.
COST Risk Profile Graph 2015

COST Risk Profile Graph 2015

This graph is created by the free Analyse Tab software that is available at thinkorswim. You can see that if the stock remains flat at today’s price ($139.63 when I created this graph), the portfolio is slated to gain $960.38 when the February options expire.  That is almost 20% on our portfolio value.  If the stock moves higher (as we expect it will most of the time), the gain is just about the same, even if it moves as much as $10 higher in a single month.  (While we love this stock, it is probably unlikely to go that much higher).

On the downside, the stock can fall almost $2 and we will still make a small gain.  How can anybody disagree that these options positions are vastly better than just buying COST stock?  Most months, the stock will remain about flat or edge higher.  In each case, we should pick up almost 20% while stock-buyers gain little or nothing.

In this actual portfolio, we own the following call options:

1 COST Apr-15 145 call (COST150417C145)
4 COST Jul-15 135 calls (COST150717C135)
3 COST Jul-15 140 calls (COST150717C140)
3 COST Jul-15 150 calls (COST150717C150)

These are the calls that we have sold (are short):

6 COST Feb-15 140 calls (COST150220C140)
1 COST Feb-15 145 call (COST150220C145)
3 COST Feb-15 150 calls (COST150220C150)

When we have bought and sold a call at the same strike price, we own what is called a calendar spread (also called a time spread).  When the long and short call are at different strike prices, we own what is called a diagonal spread.  Most of the time, the short call is at a higher strike price than the long call (so we don’t incur a maintenance requirement).

We have one more long call than we have short calls.  We could make a greater gain at a flat stock price if we sold a February call against our extra long call, but we might end up not gaining nearly as much if the stock should move significantly higher in the next four weeks.

We are satisfied with making 20% in the next month in this portfolio.  Most people would be happy gaining that much for an entire year. If you like, COST, NKE, SBUX, GMCR, or SPY (to name a few we are currently trading), you could join us, and have all the trades made for you through Auto-Trade at thinkorswim by becoming a Terry’s Tips Insider.  Why not do it today?  It might be a great way to start out the New Year.

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.

Further Discussion on an Options Strategy Designed to Make 40% a Month

Thursday, December 4th, 2014

Last week we outlined an options play based on the historical fluctuation pattern for our favorite ETP called SVXY.  This week we will compare those fluctuations to the market in general (using the S&P 500 tracking stock, SPY, as the market definition). We proposed buying a vertical call spread for a one-month-out expiration date with the lower strike about 6% above the starting stock price.

The results were a little unbelievable, possibly gaining an average of 65% a month (assuming the fluctuation pattern continued into the future). If you used an outside indicator to determine which months were more likely to end up with a winning result, you would invest in just under half the months, but when you did invest, your average gain might be in the neighborhood of 152%.  Your average monthly gain would be approximately the same if you only invested half the time or all the time, but some people like to increase the percentage of months when they make gains (the pain of losing always seems to be worse than the pleasure of winning).

This week we will offer a second way to bet that the stock will rise by 12.5% in about 38% of the months (as it has in the past).  It involves buying a calendar spread rather than a vertical call spread (and sort of legging into a long call position as an alternative to the simple purchase of a call).

Terry

Further Discussion on an Options Strategy Designed to Make 40% a Month

First. Let’s compare the monthly price fluctuations of SPY and SVXY.  You will see that they are totally different.

Here is a graph showing how much SPY has fluctuated each month over the past 38 months:

Over the 38 months of the time period, SPY rose in 28 months and fell in 10 months.  By far, the most popular monthly change was in the zero to +2.5% range.  Note that in less than 8% of the months (3 out of 38) SPY fluctuated by more than 5%, while in over 92% of the months, the fluctuation was less than 5%.

Compare the monthly fluctuations of SPY with those for SVXY over the same time period:

SVXY rose in 28 of the 38 months, exactly the same number as SPY. However, the absolute percentage price changes are far higher for SVXY.  In nearly half the months, SVXY fluctuated by more than 10% either way (18 of 38 months).  In 24 of the 38 months (63%), SVXY changed by more than 5% in either direction compared to less than 8% of the months for SPY.  In 21 of the 38 months (55%)  SVXY gained over 5%.

Bottom line, monthly fluctuations for SVXY are considerably greater than they are for SPY.  In most months, the price change for SPY is relatively insignificant and for SVXY, the price is rarely anywhere near where it started out each expiration month.

Buying Vertical Spreads:

If you were to buy a one-month vertical spread on SPY, buying the at-the-money strike price and selling at a strike $5 higher, the spread would cost about $1.65 ($165) and you could sell it for $5.00 ($500) if the stock rose about 2 1/2% or more.  However, if the historical pattern persisted, you would make the maximum gain in only 13 of 38 months, or 34% of the time.

The same 5-point spread in SVXY would cost far more ($2.50) but you could look forward to making the maximum gain in 21 of 38 months (55% of the time).  While buying this spread would give you a statistical edge, it probably is not the best spread to purchase.  A more profitable spread would be at higher strike prices – betting that the stock would increase by 12.5% or more (which it has 38% of the time).  Since this higher-strike price would cost far less, your statistical edge would be much greater as would your gains in those months when a big increase took place.

A second alternative would be to simply buy a call which was about 6% above the purchase price.  Last week, in a demonstration portfolio at Terry’s Tips, with SVXY trading at $75, we bought a one-month-out 80 call.  It cost $1.40.  If the stock rose by 12.5% from $75, it would be trading around $84 ½ and you could sell the call for about 3 times what you paid for it.

We also bought some SVXY Dec4-14 – Dec2-14 80 calendar call spreads for $1.14.  This is a way of buying a 5-week call at the 80 strike, paying less than a 4-week call which cost $1.40.  When the Dec2-14 short calls expire in two weeks, we would not replace them, and stick with uncovered long calls that expires a week later than the Dec-14 call.  The only extra risk we are taking here is that the stock skyrockets 12.5% in the very first two weeks so that the Dec2-14 80 call finishes in the money (something that seems unlikely to happen his month since VIX is so low so that most of the increase in SVXY should come from the contango component).  This spread seems to be a better alternative than just buying the Dec-14 80 call, but we will see how it works out. Of course, I’ll report back to you.

So far, the stock has edged up to close today about 5% higher than it started out last week (after recovering from a big drop on Monday).  Contango is above 10%, unusually high, but not so unusual for the month of December because of the “holiday effect” (December is often characterized by low volume and higher stock prices, and VIX futures for this month are typically lower than any other month).  The contango number is a rough approximation of how much SVXY should increase in one month from the daily adjustment which is made (selling the one-month-out futures and buying at the spot price of VIX).  Of course, if VIX fluctuates, SVXY will move in the opposite direction.  If VIX moves higher, SVXY might move lower even if it is helped by the contango tailwinds.

 

An Options Strategy Designed to Make 40% a Month

Friday, November 28th, 2014

I hope you had a wonderful Thanksgiving with your family and/or loved ones, and are ready for some exciting new information.  Admittedly, the title of this week’s Idea of the Week is a little bizarre.  Surely, such a preposterous claim can’t possibly have a chance of succeeding.  Yet, that is about what your average monthly gain would have been if you had used this strategy for the past 37 months that the underlying ETP (SVXY) has been in existence.  In other words, if the pattern of monthly price changes continues going forward, a 40% average monthly gain should result (actually, it would be quite a bit more than this, but I prefer to underpromise and over-deliver).  Please read on.

We will discuss some exact trades which might result in 40%+ monthly gains over the next four weeks.  I hope you will study every article carefully.  Your beliefs about options trading may be changed forever.

Terry

An Options Strategy Designed to Make 40% a Month

First of all, we need to say a few words about our favorite underlying, SVXY.  It is not a stock.  There are no quarterly earnings reports to push it higher or lower, depending on how well or poorly it performs.  Instead, it is an Exchange Traded Product (ETP) which is a derivative of several other derivatives, essentially impossible to predict which way it will move in the next week or month.  The only reliable predictor might be to look how it has performed in the past, and see if there is a way to make extraordinary gains if the historical pattern of price changes manages to extend into the future.  This price change pattern is the basis of the 40% monthly gain potential that we have discovered.

SVXY is the inverse of VXX, a popular hedge against a market crash.  VXX is positively correlated with VIX (implied volatility of SPY options), the so-called fear index.  When the market crashes or corrects, options volatility, VIX, and VXX all soar.  That is why VXX is such a good hedge against a market crash.  Some analysts have written that a $10,000 investment in VXX will protect against any loss on a $100,000 stock portfolio (I have calculated that you would really need to invest about $20,000 in VXX to protect against any loss in a $100,000 stock portfolio, but that is not a relevant discussion here.)

While VXX is a good hedge against a market crash, it is a horrible long-term holding.  In its 7 years of existence, it has fallen an average of 67% a year.  On three occasions, they have had to engineer 1-for-4 reverse splits to keep the stock price high enough to bother trading.  In seven years, it has fallen from a split-adjusted $2000+ price to today’s under-$30.

Over the long run, VXX is just about the worst-performing “stock” that you could possibly find.  That is why we are so enamored by its inverse, SVXY.

Deciding to buy a stock is a simple decision.  Compare that to SVXY, an infinitely more complicated choice.  First, you start with SPY, an ETP which derives its value from the weighted average stock price of 500 companies in the S&P 500 index.  Options trade on SPY, and VIX is derived from the implied volatility (IV) of those options.  Then there are futures which are derived from the future expectations of what VIX will be in future months. SVXY is derived from the value of short-term futures on VIX.  Each day, SVXY sells these short-term futures and buys at the spot price (today’s value) of VIX.  Since about 90% of the time, short-term futures are higher than the spot price of VIX (a condition called contango), SVXY is destined to move higher over the long run – an average of about 67% a year, the inverse of what VXX has done.  Simple, right?

While SVXY is anything but a simple entity to understand or predict, its price-change pattern is indeed quite simple.  In most months, it moves higher.  Every once in a while, however, market fears erupt and SVXY plummets.  In October, for example, SVXY fell from over $90 to $50, losing almost half its value in a single month.  While owning SVXY might be a good idea for the long run, in the short run, it can be an awful thing to own.

Note on terminology: While SVXY is an ETP and not literally a stock, when we are using it as an underlying entity for options trading, it behaves exactly like a stock, and we refer to it as a stock rather than an ETP.

We have performed an exhaustive study of monthly price fluctuations (using expiration month numbers rather than calendar month figures).  Our major finding was that in half the months, SVXY ended up more than 12% higher or lower than where it started out.  It was extremely unusual for it to be trading at the end of an expiration month anyway near where it started out.  This would suggest that buying a straddle (both a put and a call) at the beginning of the month might be a good idea.  However, such a straddle would cost about 10% of the value of the stock, a cost that does not leave much room for gains since the stock would have to move by 10% before your profits would start, and that occurs only about half the time.

A second significant finding of our backtest study of SVXY price fluctuations was that in 38% of the months, the stock ended up at least 12.5% higher than it started the expiration month.  If this pattern persisted into the future, the purchase of an at-the-money call (costing about 5% of the stock price) might be a profitable bet.  There are other strategies which we believe are better, however.

One possible strategy would be to buy a one-month out vertical call spread with the lower strike about 6% above the current price of the stock.  Last week, with SVXY trading about $75, we bought a Dec-14 80 call and sold a Dec-14 85 call.  The spread cost us $1.11 ($111 per spread, plus $2.50 in commissions at the special thinkorswim rate for paying Terry’s Tips subscribers).  This means that if the stock ends up at any price above $85 (which it has historically done 38% of the time), we could sell the spread for $497.50 after commissions, making a profit of $384 on an investment of $113.50.  That works out to a 338% gain on the original investment.
If you bought a vertical call spread like this for $113.50 each month and earned a $384 gain in the 14 months (out of 37 historical total) when SVXY ended up the expiration month having gained at least 12.5%, you would end up with $5376 in gains in those months.  If you lost your entire $113.50 investment in the other 23 months, you would have losses of $2610, and this works out to a net gain of $2766 for the total 37 months, or an average of $74 per month on a monthly investment of $113.50, or an average of 65% a month.  Actually, it would be better than this because wouldn’t lose the entire investment in many months when the maximum gain did not come your way.

But as good as 65% a month seems (surely better than the 40% a month I talked about at the beginning), it could get better.  Again using the historical pattern, we identified another variable which could tell us whether or not we should buy the vertical spread at the beginning of the month. If you followed this measure, you would only buy the spread in 17 of the 37 months.  However, you would make the maximum gain in 10 of those months. Your win rate would be 58% rather than 38%, and your average monthly gain would be 152%.  This variable is only available for paying subscribers to Terry’s Tips, although maybe if you’re really smart and can afford to spend a few dozen hours of searching, you can figure it out for yourself.

Starting in a couple of weeks, we are offering a portfolio that will execute spreads like this every month, and this portfolio will be available for Auto-Trading at thinkorswim (so you don’t have to place any of the orders yourself).  Each month, we will start out with $1000 in the portfolio and buy as many spreads as we can at that time.  We expect it will be a very popular portfolio for our subscribers.  With potential numbers like this, I’m sure you can agree with our prognosis.

Of course, this entire strategy is based on the expectation that future monthly price fluctuations of SVXY will be similar to the historical pattern of price changes.  This may or may not be true in the real world, but we think our chances are pretty good.  For example, for the November expiration that ended just one week ago, the stock had risen a whopping 34%.  In the preceding October expiration month, it had fallen by almost that same amount, but at the beginning of the month, our outside variable measure would have told us not to buy the spread for that month, so we would have made the 338% in November and avoided any loss at all in October.

There are other possible spreads that could be placed to take advantage of the unusual price behavior of SVXY, and we will discuss some of them in future reports.  I invite you to check them out carefully, and to look forward for a year-end special price designed to entice you to come on board for the lowest price we have ever offered. It could be the best investment decision you make in 2014.

Update on the ongoing SVXY put demonstration portfolio.  This sample demonstration portfolio holds a SVXY Mar-15 75 put, and each week, (almost always on Friday), we buy back an expiring weekly put and sell a one-week-out 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 to just less than $75 and we bought back the expiring Nov-14 73 put  and sold a Dec1-14 75 put (selling a calendar), collecting a credit of $1.75 ($172.50 after commissions).

The account value was then $1570, up $70 for the week, and $336 from the starting value of $1234 on October 17th, 5 weeks ago.  This works out to $67 a week, well more than the $37 weekly gain we need to achieve our 3% weekly goal.  In fact, we have gained 5.4% a week for the 5 weeks we have carried out this portfolio.

At this point, we closed out this portfolio so that we could replace the positions with new options plays designed to take advantage of the SVXY price fluctuation pattern we spoke about today.  It seems like very few people were following our strategy of selling weekly puts against a long Mar-15 put, but we clearly showed how 3% a week was not only possible, but fairly easy to ring up.  Where else but with stock options can you achieve these kinds of investment returns?

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.

 

A Little About Vertical Spreads

Friday, October 24th, 2014

Today we will discuss vertical spreads, and how you can use them when you have a strong feeling about which way a stock is headed.

But first, 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

A Little About Vertical Spreads

Vertical spreads are known as directional spreads.  When you place such a spread, you are betting that the stock will move in a particular direction, either up or down.  If you are right, you can make a nice gain.  Even better, you can usually create a vertical spread that also makes money if the stock doesn’t move in the direction you hoped, but stays absolutely flat instead.

If you have a strong feeling that a particular stock will move higher in the near future, you might be inclined to either buy the stock or buy a call on it.  Both of these choices have disadvantages.  Buying the stock ties up a great deal of money, and even if you are right and the stock moves higher, your return on investment is likely to be quite small.

Buying calls gives you great leverage and a much higher return on investment if you are indeed right and the stock moves higher.  But much of the cost of a call is premium (the extra amount you pay out so that you don’t have to put up so much cash compared to buying the stock).  The stock needs to go up a certain amount just to cover the premium, and you don’t start making money until that premium is covered.  If the stock doesn’t go up (and no matter how great you are at picking winners, you will probably be disappointed many times), you could lose some or all of your investment.  Bottom line, buying calls is a losing proposition much of the time – you have to be really lucky to come out a winner.

Buying a vertical spread is a safer alternative than either buying stock or calls.  You give up some of the extraordinary gains for a great likelihood of making a more moderate gain, and if you play your cards right, you can also make a gain if the stock stays flat.

Let’s look at an example.  Last week, my favorite underlying, SVXY, had been beaten down because VIX had shot up over 25.  I felt very strongly that the market fears would eventually subside, VIX would fall back to the 15 level, and SVXY (which moves in the opposite direction of VIX) would move higher.

Late last week, when SVXY was trading right at $60, I bought November 55 calls and sold November 60 calls as a vertical spread.  It cost me $3 ($300 per contract).  When these calls expire in about a month, if the stock is any higher than $60, my spread will be worth exactly $5, and I will make about 60% on my investment.  The interesting thing is that it doesn’t have to move any higher than was at the time for me to make that kind of a gain.

In reality, while I did make this vertical spread, I didn’t use calls.  Instead, I sold a vertical spread using puts, buying November 60 puts and selling November 55 puts. I collected $2, an amount which is the exact same risk that I would have taken if I had bought the vertical spread with calls.  The broker will charge a maintenance fee of $5 ($500) on each spread, but since I collected $200 at the outset, my risk, and the amount I had to put up, is only $300.

The risks and rewards are identical if you buy a vertical with calls or sell a vertical with puts (assuming the strike prices are the same), but there is a neat thing about using puts if you believe the stock is headed higher.  In this case, if the stock ends up at the November expiration at any price higher than $60, both the long and short puts will expire worthless (and I get to keep the $200 I got at the beginning).  There is no exit trade to make, and best of all, no commissions to pay.  For this reason, I almost always use puts when I buy a vertical spread betting on a higher stock price rather than calls (the only exceptions come when the spread can be bought for a lower price using calls, something which occurs on occasion).

Update on the ongoing SVXY put demonstration portfolio.  (We own 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).

This week, SVXY moved sharply higher, from about $57 to about $62.  Today I bought back the out-of-the-money Oct4-14 59 put for a few cents and sold an Oct5-14 64 put (about $2 in the money) for a credit of $3.65 ($365) on the diagonal spread.  The account value is at $1290, just a little higher than $1234 where we started out (we would have done much better 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.  This week I sold the next weekly put at a strike which was $2 in the money because I think the stock is headed higher because VIX is still at an elevated level compared to where it has been for the past year or so.

Making 36%

Making 36% — A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

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Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

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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.

~ John Collins