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Posts Tagged ‘VIX’

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.

Knowing When to Bite the Bullet

Friday, October 17th, 2014

Sometimes, the market does just the opposite of what you hoped it would, and you are faced with the decision to hang on and hope it will reverse itself, or accept that you guessed wrong, and close out your position and move on to something else.

That will be our subject today.

Terry

Knowing When to Bite the Bullet

Kenny Rogers said it well – “You’ve got to know when to walk away and know when to run.”  We set up demonstration portfolio to trade diagonal spreads on an ETP called SVXY.  We were betting that the stock would go up.  In each of the last two years, SVXY had doubled in value.  Its inverse, VXX, had fallen from a split-adjusted $3000+ to under $30 over the past 5 years, making it just about the biggest dog on the entire stock exchange (selling it short would have made anyone a bundle over that time period).  We felt comfortable being long (i.e., the equivalent of owning stock) in something that would do just the opposite of VXX.

In our demonstration portfolio, we decided to trade puts rather than calls because there was a lot more time premium in the weekly puts that we planned to sell to someone else than there was in the calls.  Each Friday, we would buy back the expiring put and replace it by selling another put with a week of remaining life.  This strategy enabled us to be short put options that had extremely high decay.

The biggest challenge was to decide which strikes to sell new puts at.  We selected a strike that was about $1 in-the-money (i.e., about a dollar higher than the stock price), or if the put we were buying back was well into the money so that the trade could not be made at a credit, we would select the highest strike we could take that could yield us a credit on the spread.  This meant that when the stock tumbled, the best we could do would be to sell a calendar spread at a very small credit.

In a six-week period, the stock managed to fall by over 30%.  Not such good news when we were betting that it would go up.  The biggest problem with a drop of this magnitude was that our short put was so far in the money that we risked an execution.  This would mean that the stock would be put to us (i.e., we would be forced to buy it at the strike price).  With that risk hanging over our head, the time has come to recognize our loss.

Admitting that you were wrong, at least for a certain time period, and closing out your trade, is sometimes the best thing you could do.  Many people hang on to their losing investments and sell the winners (usually for a smaller profit than they could have made by hanging on).  In the long run, this strategy leaves you with a portfolio of losing stocks that you are hoping will go higher (and probably never will).  Better to sell your losers and move on to something more promising.

Today we placed the following trade which closed out our spread:

Buy to Close 1 SVXY Oct4-14 80.5 put (SVXY141024P80.5)
Sell to Close 1 SVXY Jan-15 90 put (SVXY150117P90) for a credit of $9.71  (selling a diagonal)

When the trade was executed at this price, we were left with $1,234 in the account after paying commissions.  Since we started with $1500, we were faced with a loss of $266, or a little less than 18%.  This was over a period in which the stock we were betting on lost over 30%.  This is another example of how options can protect you better than merely buying stock.

We expected to make 150% a year on this portfolio, many times greater than the 18% we lost in the couple of months we operated it.  If the stock had remained flat or moved higher as we expected, we could have expected to gain the 3% a week we were hoping for.

Today, in the special account I set up this portfolio with $1500 (and now is down to $1234), I am trying again, this time at lower strike prices which are more appropriate to the current level of the stock.

This was the trade I executed today when the stock was trading about $57:

Buy To Open 1 SVXY Mar-15 65 put (SVXY150320P65)
Sell To Open 1 SVXY Oct4-14 59 put (SVXY141025P59) for a debit of $12.07 (buying a diagonal)

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.

Handling an Adverse Price Change

Friday, October 10th, 2014

Our SVXY demonstration hit a real snag this week, as the volatility index (VIX) soared to over 20 and SVXY got hammered, falling from the mid-$80’s level when we started the portfolio to about $65 while we were betting that it would move higher.

I hope you find this ongoing demonstration of a simple options strategy designed to earn 3% a week to be a simple way to learn a whole lot about trading options.

Terry

Handling an Adverse Price Change

There wasn’t much we could do today.  The short 80.5 SVXY put that we had sold was expiring about $15 in the money, a situation that makes it quite difficult to roll it over to next week as a calendar and still enjoy a credit on the trade.  Instead, we chose to go out two weeks and sell an Oct4-14 80.5.  This is the trade we executed:
Buy to Close 1 SVXY Oct2-14 80.5 put (SVXY141010P80.5)
Sell to Open 1 SVXY Oct4-14 80.5 put (SVXY141024P80.5) for a credit of $.20  (selling a calendar)

Hot tip of the week.  With SVXY trading below $66 and VIX over 20, buying any call on SVXY is probably an excellent speculative purchase (go out a couple of months to give the stock some time to recover, as it surely will).  As usual, only invest money in options that you can truly afford to lose.  I am buying Dec-14 66 calls, paying $8.50 ($850) per contract with an idea to sell shorter-term calls against them at a later time once the stock has recovered some.

Ongoing SVXY Spread Strategy – Week 6

Friday, September 19th, 2014

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

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

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

Terry

Ongoing SVXY Spread Strategy – Week 6

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

Here is the trade we placed today:

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

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

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

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

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

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

In this simple portfolio, we own an SVXY Jan-15 90 put.   We will use this as collateral for selling a put each week in the weekly series that expires a week later than the current short put that we sold a week ago.  Today’s value of our long put is about $14 ($1200) and decay of this put (theta) is $4 (this means that if SVXY remains unchanged, the put will fall in value by $4 each day).  The decay of our short put is $13 (and will increase every day until next Friday).  This means that all other things being equal, we should gain $9 in portfolio value every day at the beginning of the week and about double that amount later in the week.

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

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

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

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

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

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

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

Ongoing SVXY Spread Strategy – Week 4

Friday, September 5th, 2014

 

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

 

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

 

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

 

Terry

 

Ongoing SVXY Spread Strategy – Week 4

 

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

 

Here is the trade we placed today:

 

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

 

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

 

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

 

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

 

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

 

In this simple portfolio, we own an SVXY Jan-15 90 put.   We will use this as collateral for selling a put each week in the weekly series that expires a week later than the current short put that we sold a week ago.  Today’s value of our long put is about $14 ($1400) and decay of this put (theta) is $4 (this means that if SVXY remains unchanged, the put will fall in value by $4 each day).  The decay of our short put is $13 (and will increase every day until next Friday).  This means that all other things being equal, we should gain $9 in portfolio value every day at the beginning of the week and about double that amount later in the week.

 

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

 

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

 

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

 

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

 

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

 

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

 

We paid a commission of $2.50 for this trade, the special rate for Terry’s Tips customers at thinkorswim.  The balance in our account is now $1730 which shows a $230 gain over the three weeks we have held the positions.  This is much more than the $45 average weekly gain we are shooting for to make our goal of 3% a week.  We now have $624 in cash in the portfolio.

 

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

 

Ongoing Spread SVXY Strategy – Week 3

Friday, August 29th, 2014

Two weeks ago we started a $1500 demonstration portfolio using SVXY, an ETP that is destined to move higher over the long run because of the way it is constructed (selling VIX higher-priced futures each day and buying at the spot price of VIX, a condition called contango which exists about 90% of time).

Today, contango is about 6% (that is how much higher the futures are that this ETP is selling each day when it buys at the spot price of VIX).  In rough terms, this means that SVXY should go up by 6% each month that VIX remains unchanged.  This works out to be about $1.25 per week that SVXY should go up, all other things being equal (which, unfortunately, they usually aren’t).

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

Terry

Ongoing Spread SVXY Strategy – Week 3

In this simple portfolio, we own an SVXY Jan-15 90 put.  We will use this as collateral for selling a put each week in the weekly series that expires a week later than the current short put that we sold a week ago.  The decay of our long put (theta) is $4 (this means that if SVXY remains unchanged, the put will fall in value by $4 each day.  The decay of our short put is $13 (and will increase every day until next Friday).  This means that all other things being equal, we should gain $9 in portfolio value every day at the beginning of the week and about double that amount later in the week.

Each Friday we will have to make a decision as to which strike we should sell the following week’s put at.  Our goal is two-fold – sell a put at a strike which is closest to being $1 in the money (i.e., the strike price is about $1 higher than the current price of the stock), and second, it must be sold at a credit so that we add cash to our portfolio each week.

This week, we were a little lucky because the stock is trading today at very near the strike of the 87 put we sold a week ago.  We will buy this put back today and sell a put for next week at the 88 strike and collect cash in doing so.  Here is the trade that we will place today.  If it doesn’t execute after half an hour, we will reduce the credit amount by $.10 (and continue doing this each half hour until we get an execution).

Here is the trade we placed today:

Buy to Close 1 SVXY Aug5-14 86 put (SVXY140829P86)
Sell to Open 1 SVXY Sep1-14 86.5 put (SVXY140905P86.5) for a credit limit of $1.50  (selling a diagonal)

When we entered this order, the natural price (buying at the ask price and selling at the bid price) was $1.25 and the mid-point price was $1.55.  We placed a limit order at $1.50, a number which was $.05 below the mid-point price.  (It executed at $1.50).

Our goal is to generate some cash in our portfolio each week.  This should be possible as long as the stock remains below $90 and we have to move that strike price higher.  We will discuss what we need to do later when it becomes an issue.

We paid a commission of $2.50 for this trade, the special rate for Terry’s Tips customers at thinkorswim.  The balance in our account is now $1670 which shows a $170 gain over the two weeks we have held the positions.  This is much more than the $45 average weekly gain we are shooting for to make our goal of 3% a week.

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

Ongoing Spread SVXY Strategy – Week 2

Friday, August 22nd, 2014

Last week we started a $1500 demonstration portfolio using SVXY, and ETP that is destined to move higher over the long run because of the way it is constructed (selling VIX higher-priced futures each day and buying at the spot price of VIX, a condition called contango which exists in about 90% of days).Today we bought back an in-the-money expiring put that we had sold last week and rolled it over to next week.

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

Terry

Ongoing Spread SVXY Strategy – Week 2

Last week, we used the following trade to set up this portfolio:

Buy To Open 1 SVXY Jan-15 90 put (SVXY150117P90)
Sell To Open 1 SVXY Aug4-14 87 put (SVXY140822P87) for a debit limit of $12.20  (buying a diagonal)

This executed at this price (90 put bought for $15.02, 87 put sold for $2.82 at a time when SVXY was trading at $85.70.

Our goal is to generate some cash in our portfolio each week.  This should be possible as long as the stock remains below $90 and we have to move that strike price higher.  We will discuss what we need to do later when it becomes an issue. Right now, we are facing a market where the stock is trading lower than it was last week when we bought it.  Now it is about $85, and our goal is to sell a weekly put each week that is about $1 in the money, and do it at a credit.

This is the order we placed (and was executed today):

Buy to close 1 SVXY Aug4-14 87 put (SVXY140822P87)
Sell To Open 1 SVXY Aug5-14 86 put (SVXY140829P86) for a credit limit of $  (selling a diagonal)

When we entered this order, the natural price (buying at the ask price and selling at the bid price) was $.65 and the mid-point price was $.90.  We placed a limit order at $.85, a number which was $.05 below the mid-point price.  It was executed at that limit price.

We paid a commission of $2.50 for this trade, the special rate for Terry’s Tips customers at thinkorswim.  The balance in our account is now $1555 which shows a $55 gain (more than the $45 average weekly gain we are shooting for to make our goal of 3% a week).

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

The stock has moved up a bit since we made this trade so you might be able to get a better price if you do this on your own.

This is what the risk profile graph looks like for our positions at next Friday’s expiration:

SVXY Risk Profile Graph August 2014

SVXY Risk Profile Graph August 2014

Ongoing Spread SVXY Strategy For You to Follow if You Wish

Monday, August 18th, 2014

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

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

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

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

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

Terry

Ongoing Spread SVXY Strategy For You to Follow if You Wish

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

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

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

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

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

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

This is the strategy we will employ:

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

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

Buy To Open 1 SVXY Jan-15 90 put (SVXY150117P90)
Sell To Open 1 SVXY Aug4-14 87 put (SVXY140822P87) for a debit limit of $12.20  (buying a diagonal)

This executed at this price (90 put bought for $15.02, 87 put sold for $2.82 at a time when SVXY was trading at $85.70.
2. Each week, we will sell a short-term weekly put (using the Jan-15 90 put for collateral).  We will collect as much time premium as we can while selling a slightly in-the-money put.  That means selling a weekly put at the strike which is slightly higher than the stock price.  We hope to collect about $2 ($200) in time premium by selling this put. Theta will start out at about $20 for the first day and increase each day throughout the week.  If the stock stays flat, we would get to keep the entire $200 and make a net gain of $172 for the week because our long put would fall in value by $28.  This is the best-case scenario.  It only has to happen 6 times out of 22 weeks to recover our initial $1200 investment.

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

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

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

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

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

A Possible Great Option Trading Idea

Monday, July 14th, 2014

Just before the close on Friday, we made a strongly bullish trade on our favorite underlying stock in a portfolio at Terry’s Tips.  In my personal account, I bought weekly calls on this same underlying.  As I write this in the pre-market on Monday, it looks like that bet could triple in value this week.

I would like to share with you the thinking behind these trades so next time this opportunity comes up (and it surely will in the near future), you might decide to take advantage of it yourself.

Terry

A Possible Great Option Trading Idea: As we have discussed recently, option prices are almost ridiculously low.  The most popular measure of option prices is VIX, the so-called “fear index” which measures option prices on SPY (essentially what most people consider “the” market) is hanging out around 12.  The historical mean is over 20, so this is an unprecedented low value.

When we sell calendar or diagonal spreads at Terry’s Tips, we are essentially selling options to take advantage of the short-term faster-decaying options.  Rather than using stock as collateral for selling short-term options we use longer-term options because they tie up less cash.

With option prices currently so low, maybe it is a time to reverse this strategy and buy options rather than selling them.  One way of doing this would be to buy a straddle (both a put and a call at the same strike price, usually at the market, hoping that the stock will make a decent move in either direction.  In options lingo, you are hoping that actual volatility (IV) is greater than historical volatility.

The biggest problem with buying straddles is that you will lose on one of your purchases while you gain on the other.  It takes a fairly big move in the underlying to cover the loss on your losing position before you can make a profit on the straddle.

A potentially better trade might be to guess which way the market will move in the short term, and then buy just a put or call that will make you money if you are right. The big challenge would be to find a price pattern that could help you choose which direction to bet on?

One historically consistent pattern for most market changes (the law of cycles) is that the direction of the change from one period to the next is about twice as likely to be in the same direction as it was in the previous same time period.  In other words, if the stock went up last week (or month), it is more likely to go up again next week (or month).

We tested this pattern on SPY for several years, and sadly, found that it did not hold up.  The chances were almost 50-50 that it would move in the opposite direction in the second period.

Maybe the pattern would work for our most popular underling, an ETP called SVXY.  You might recall that we love this “stock” because it is extremely volatile and option prices are wonderfully high (great for selling).  In the first 22 weeks of 2014, SVXY fluctuated by at least $3 in one direction or the other in 19 of those weeks.  Maybe we could use the pattern and buy weekly either puts or calls, depending on which way the market had moved in the previous week.

Once again, the historical results did not support the law of cycles pattern.  The stock was almost just as likely to move in the opposite direction as it had in the previous week.  Another good idea dashed by reality.

In making this study, we discovered something interesting, however.  In the first half of 2014, SVXY fell more than $3 in a single week on 5 different occasions.  In 4 of the subsequent weeks, it made a significant move ($3 or more) to the upside.  Buying a slightly out-of-the-money weekly call for about a dollar and a half ($150 per contract) could result in a 100% gain (or more) in the next week in 4 out of 5 weeks.

If this pattern could be counted on to continue, it would be a fantastic trading opportunity.  Yes, you might lose your entire investment in the losing weeks, but if you doubled it in the winning weeks, and there were many more of them than losing weeks, you would do extremely well.

For  those reasons, I bought calls on SVXY on Friday.  The Jul-14 90.5 call that expires this Friday (July 18th) could have been bought for $1.30.  The stock closed at $88.86.  I plan to place an order to sell these calls, half at $2.60, and half at $3.90.  The pre-market prices indicate that one of these orders might exercise sometime today and I will have all my money back and still own half my calls.  It might be a fun week for me.  We’ll see.

On another subject, have you got your free report entitled 12 Important Things Everyone with a 401(K) or IRA Should Know (and Probably Doesn’t).  This report includes some of my recent learnings about popular retirement plans and how you can do better.  Order it here.  You just might learn something (and save thousands of dollars as well).

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.

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

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