Posts Tagged ‘VXX’

Volatility’s Impact on Option Prices

Monday, May 14th, 2012

Last week, the market (SPY) fell 1%, the second down week in a row.  Our 10K Bear portfolio gained 17.8%, after commissions.  Over the past two weeks SPY has fallen by 3.4% while this bearish portfolio has gained a whopping 42.6%, proving once again that it is an excellent hedge against other investments when the market is weaker.  Do you have this kind of protection in your investment accounts?

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

Volatility’s Impact on Option Prices

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

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

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

A staid old stock like Procter & Gamble would not be expected to vary in price much over the course of a year, and its options would carry a low volatility number.  For P & G, this number currently is 17%.  That is how much the market expects the stock might vary in price, either up or down, over the course of a year.

Here are some volatility numbers for other popular companies:

IBM  – 20%
Apple Computer – 31%
GE – 26%
Johnson and Johnson – 16%
Goldman Sachs – 37%
Amazon – 37%

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

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

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

Dow Jones Industrial (Tracking Stock – DIA) – 19%
S&P 500 (Tracking Stock – SPY) –21%
Nasdaq (Tracking Stock – QQQ) – 20%
Russell 2000 (Small Cap – IWM) – 27%
Oil Services ETF (OIH) – 32%

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

If implied volatility is high, the option prices are high.  If expectations of fluctuation in the company stock are low, implied volatility and option prices are low. 

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

Tags: , , , , , , ,
Posted in Stock Option Trading Idea Of The Week, Stock Options Strategies, Terry's Tips Portfolios | 1 Comment »

Choose an Option Strategy Based on Actual vs. Implied Volatility

Monday, October 31st, 2011

It is important to differentiate between the implied volatility of option prices and the actual volatility of the underlying stock or ETF.  It is not an easy task to recognize when the two measures deviate from one another, but if you can identify a difference, huge gains can be made with the proper option strategy.

Today we will discuss how you can capitalize on any differences that you might be able to find.

Choose an Option Strategy Based on Actual vs. Implied Volatility: 

 
Last week the European debt crisis was apparently averted, at least in the eyes of option investors.  VIX, the so-called “fear index”, the average implied volatility of option prices on the S&P 500 tracking stock (SPY) fell dramatically to just below 25 (still above its mean average of about 20 but well below the 40+ it has sometimes been at during the previous month).

When option prices are high (i.e., implied volatility, VIX) is high, there are huge gains possible by writing call options (not our favorite ploy) or buying calendar spreads (our favorite most of the time).  However, when actual market volatility is greater than the expected volatility (i.e., implied volatility of the option prices), writing calls or buying calendar spreads is generally unprofitable.

Over the last three months, we have had great difficulty making gains with our calendar spreads because actual market volatility was too great.  On the other hand, we have had some luck with buying straddles (or strangles), a strategy of buying both a put and a call on the same underlying and hoping that there is a big fluctuation in either direction.

Last Wednesday, after following VXX (a “stock” that is based on the futures of VIX), we noticed that actual volatility was huge – it had fluctuated $2 or more almost every single day for several weeks.  On Wednesday in one of our portfolios we made a small ($1400) buy of 5 VXX 43 puts and calls which would expire two days later.  We paid $279 per straddle.  When the market for VXX opened up sharply lower on Thursday, we sold the straddle for $596, netting 117% after commissions.

In another portfolio where we owned calendar spreads on VXX, we lost money.  Our results in these two portfolios clearly demonstrated that when high actual volatility occurs, you do best by buying short-term options, either puts or calls depending on which way you believe the market is headed, or both puts and calls if you admit you really don’t know which way it will go (as we usually do).  On the other hand, when actual volatility is low, calendar spreads deliver higher returns.
Now that much of the uncertainty facing the market has subsided a bit, we believe it is time for the calendar spreads to prosper once again as they have for most of the past few years (since late 2008 extending up to August of this year).

Tags: , , , , , , , , , , , , , ,
Posted in SPY, Stock Option Trading Idea Of The Week, Stock Options Strategies, Terry's Tips Portfolios, VXX | 1 Comment »

Using Options to Hedge Market Risk

Monday, September 12th, 2011

Another crazy week in the market.  Investors vacillated from panic to manic and back to panic.  The net change for the week was not so significant, but the fluctuations were huge.  How can you cope with a market like this?

You might consider using options to hedge against market moves in both directions.  Check out how two of our portfolios are doing it.

Using Options to Hedge Market Risk   

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116): 

Using Options to Hedge Market Risk

  

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116):



Remember, this is an actual brokerage account at thinkorswim which any paying Terry’s Tips subscriber can duplicate if he or she wishes.  The graph shows that if the stock stays absolutely flat next week, there could be a gain of over $1000 for the week.  If the stock should fall by $2, an even higher gain should result.  (Once the stock falls by $2, we would likely make some downside adjustments so that further drops in the stock price would generate higher gains.  After all, this is our bearish bet.)

Where else could you expect a 20% gain if the market doesn’t move one bit?  In a single week?  Or even more if the market should fall?

Admittedly, today’s option prices are extremely high (in 92% of the weeks over the last 5 years, option prices have been lower than they are right now, so we are in truly unusual times).  The risk profile graphs for our portfolios usually do not look as promising as they do right now.

One of the bullish portfolios that we recommend to be matched against the 10K Bear portfolio is called the Ultra Vixen.  This portfolio is based on the underlying “stock” (actually an ETN, an exchange traded note) called VXX.  This index is based on the short-term futures of VIX (the measure of SPY option prices, the so-called “fear index”).  When the market drops, VIX generally rises (as do the VIX futures prices), and VXX usually moves higher.  Over the last month while the market dropped over 10%, VXX has more than doubled in price.  For that reason, many people consider VXX to be an excellent hedge against market crashes.

We don’t like VXX as an investment possibility, however.  Over time, due to a mechanism called contango (futures prices become more expensive in further-out months), VXX is destined to fall over time.  It may be a good hedge as a short-term investment but is awful as a long-term holding.  It fell for 12 consecutive months last year, for example, even though VIX fluctuated in both directions.

Our Ultra Vixen portfolio is set up to benefit when VXX goes down (which it does when the market is flat or goes up).  We generally maintain a net short position on VXX with some call positions for protection in case the stock does go up.  However, our portfolio does best if the market stays flat or moves higher, so it is a good hedge against the 10K Bear portfolio.

Here is the risk profile graph for Ultra Vixen for next Friday’s expiration (September 16th).  It is a $10,000 portfolio and the underlying stock (VXX) is trading about $45.83:





The graph shows that a 10% gain for the week is possible if the stock falls as much as $3 or goes up by as much as $2.  (Historically, in about half the weeks, VXX fluctuates by less than a dollar in either direction.)  Where else besides options do you find opportunities like this?  In a single week?

Both the 10K Bear and Ultra Vixen portfolios should make excellent gains every week when the market is flat, and one or the other should make gains when the market moves more than moderately in either direction.  Theoretically, if the two portfolios together break even in the high-fluctuation weeks and they both make gains when the market doesn’t do much of anything, the long-run combined results should be extraordinary.

Tags: , , , , , , , , , , , , , , , , , , , ,
Posted in 10K Strategies, Monthly Options, SPY, Stock Option Trading Idea Of The Week, Stock Options Strategies, Terry's Tips Portfolios, VXX | No Comments »

Unusual Option Opportunity Using VXX

Thursday, July 7th, 2011

As you probably know, VIX is a volatility index, a measure of the implied volatility of the option prices on the S&P 500 tracking stock, SPY. VIX is often called the “Fear Index” since it tends to rise when the market falls or investors are concerned about the future.  When VIX is high, option prices in general are high, and vice versa.

Unfortunately, you can’t trade VIX.  It is just a measure of how high option prices are.  However, another instrument was created that is designed to mirror VIX, and you can trade this one.  It is an ETN called VXX.  Its value is derived from the futures prices of VIX and is supposed to be highly correlated with the volatility measure VIX.

Since VIX typically rises when the market (SPY) falls, VXX has been promoted as a good hedge against a stock portfolio.  Several months ago when VIX was about 16 and VXX was trading about $28, I recommended VXX as a good buy because I did not believe that VIX would trade much lower than 16, and if the two were highly correlated, that meant that VXX was unlikely to fall by very much.

At last Friday’s close, VXX was at $25.24 while VIX was at 21.85.  Over the past several months since I made my recommendation, VXX had fallen 10% while VIX had risen 35%.  That certainly is not a positive correlation.  I was bamboozled by the reports that said they were highly correlated.

I thought it would be interesting to compare the two instruments over time. Check out the graphs of the two equities for the past year:

VIX for Last 12 Months

 

 

VXX for Last 12 Months

Can you find any correlation between these two equities?  VIX has fluctuated in both directions throughout the year while VXX has done nothing but consistently move lower. In fact, last year VXX had to do a reverse 4-1 split of its shares so it would still have enough value to continue trading. While it looks from the chart that VXX traded about $120 a year ago, it was actually at only $30 (when the reverse 4-1 split took place on October 26, 2010).  The chartists had to multiply those old numbers by 4 to get them on the same scale as the current numbers.

The bottom line:  VXX is clearly a real dog, and seems destined to fall no matter what VIX does.

True, when VIX shoots higher, VXX follows right along, but VXX consistently fails to hang onto those higher numbers, even if VIX remains at the higher level.

The VXX chart suggests that selling the stock short might be a good investment idea.  I have personally done some of that, in fact. One problem may be that it might be difficult to short VXX.  Schwab (and other brokers) have VXX on their “Hard to Locate” list for borrowing to cover the short sale.  So far, I have not had problems shorting it at thinkorswim (although once I had to telephone in the order because the electronic order was rejected).

An even greater opportunity exists, however, at least in my opinion, using options.  We have created a portfolio at Terry’s Tips to carry out an option strategy for paying subscribers to mirror (or have trades executed automatically for them through the Auto-Trade service that thinkorswim offers).

Here is the risk profile graph for that portfolio for the July 16, 2011 expiration, less than four weeks from now:

This graph shows the theoretical loss or gain from a $10,000 portfolio based on VXX (currently trading at $25.24).  If the stock is at this exact same price on July 16th, the portfolio should gain about 8%.  If it falls into the $23 – $25 range, the gain should be about 10%.  On the upside, a profit should result at any stock price that is less than $28.

Since most months, VXX has steadily declined in price, it seems to us that this portfolio has a very good chance of making 100% a year if that price behavior continues into the future.

I invite you to join our service and participate in this investment opportunity along with us.  This is not just a theoretical exercise.  I have my own money riding in it, as I believe in it totally.

Tags: , , , , , , ,
Posted in SPY, Stock Option Trading Idea Of The Week, Stock Options Strategies, VXX | No Comments »

Making 36%

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

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

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.

Order Now

Success Stories

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