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Tip 4 - All About Contango

There seems to be a widespread need for a definition of contango.   Surely, 99% of investors have no idea of what contango or backwardation are.  That’s a shame, because they are important concepts which can be precisely measured and they strongly influence whether certain investment instruments will move higher (or lower).  Understanding contango and backwardation can seriously improve your chances of making profitable investments.

Contango sounds like it might be some sort of exotic dance that you do against (con) someone, and maybe the definition of backwardation is what your partner does, just the opposite (indeed, it is, but we’re getting a little ahead of ourselves because we haven’t defined contango is yet).  

If you have an idea (in advance) which way a stock or other investment instrument is headed, you have a real edge in deciding what to do.  Contango can give you that edge.

So here’s the definition of contango – it is simply that the prices of futures are upward sloping over time, (second month more expensive than front month, third month more expensive than second, etc.), Usually, the further out in the future you look, the less certain you are about what will happen, and the more uncertainty there is, the higher the futures prices are.  For this reason, contango is the case about 75 – 90% of the time.

Sometimes, when a market crash has occurred or Greece seems to be on the brink of imploding, the short-term outlook is more uncertain than the longer-term outlook (people expect that things will settle down eventually).  When this happens, backwardation is the case – a downward-sloping curve over time. 

So what’s the big deal about the shape of the price curve?  In itself, it doesn’t mean much, but when it gets involved in the construction of some investment instruments, it does become a big deal.

All about VXX

One of the most frequent times that contango appears in the financial press is when VXX is discussed. VXX is an ETN (Exchange Traded Note) created by Barclay’s which trades very much like any stock.  You can buy (or sell) shares in it, just like you can IBM.  You can also buy or sell options using VXX as the underlying (that’s why it important at Terry’s Tips). 

People purchase VXX as protection against a market crash.  It is based on the short-term futures of VIX, the so-called “fear index” which is a measure of the implied volatility of options on SPY, the tracking stock for the S&P 500.  When the market crashes, VIX usually soars, the futures for VIX move higher as well, pushing up the price of VXX.

In August of 2011 when the market (SPY) fell by 10%, VXX rose from $21 to $42, a 100% gain.  It performed exactly as it was intended to.  Pundits have argued that a $10,000 investment in VXX protects a $100,000 portfolio of stocks against loss in case of a market crash.  No wonder it is so popular.  Investors buy about $3 billion worth of VXX every month as crash protection against their other investments in stocks or mutual funds.

There is only one small problem with VXX.  Over the long term, it is just about the worst stock you could ever buy.  Check out its graph since it was first created in January of 2009.:

Have you ever seen such a dog?  (OK, maybe you have bought one or two on occasion, but surely, the graph wasn’t ever this bad.)  On two occasions (November 9, 2010 and October 5, 2012) Barclay’s had to make 1 – 4 reverse splits to make the stock have a reasonable value.  It never really traded at $2000 as the graph suggests, but two reverse splits will make it seem that way.

VXX is designed to mimic a 30-day futures contract on the VIX spot index (the VIX "spot" index is not directly tradable, so short term futures are the nearest proxy). Every day, Barclays VXX "sells" 1/30th of its assets in front month VIX futures contracts and buys second month contracts which are almost always more costly. This is where contango comes into play.  It causes VXX to fall about 5% - 8% every month as Barclay’s rolls from one futures series to the next.

 It’s the old story of “buy high” and “sell low” that so many of us have  done with their stock investments, but Barclays does it every day (don’t feel sorry for them – they are selling VXX, not buying it, and they are making a fortune every month).

There are two other reasons besides contango that VXX is destined to move lower over time. First, when the value of an instrument is based on changes in the value of another measure, a mathematical glitch always occurs.  When VIX is at 20 and increases by 10%, it goes up by 2, and the tracking instrument (VXX) is likely to move by about that much in the same direction.  If the next day, VIX falls by 10%, it goes down by 2.20.  VXX ends up $.20 lower than where it started.

This is the same thing that happens if you lose 50% of the value of a stock investment.  The stock has to go up by 100% for you to get your money back.  In the day-by-day adjusting of the value of VXX based on changes in VIX, the value of VXX gets pushed lower by a tiny amount every day because of the mathematical adjustment mechanism.

A third reason that VXX gets lower in the long run is that Barclay’s charges a 0.89% fee each year to maintain the ETN. 

In short, buying VXX is like eating sausage – you don’t want to do it once you understand what goes into it.

Bottom line, VXX can suddenly shoot higher in the short run, but it will inevitably fall in the long run. Our challenge is to create a strategy that will take advantage of this reliable phenomenon.

Market Crash Protection Insurance Choices


What do you do if you believe that the market is headed for a crash?  One way would be to sell shares short (of SPY, or any equity you believe is likely to fall). The problem with this is that most of the time, the market moves higher.  If you are wrong, you will lose money.

Another popular way to protect against a market crash is to buy puts on SPY (when most people talk about “the market” they are referring the the S&P 500 which is a lot more representative of the market in general than other measures such as the Dow Jones Industrial Average which includes only 30 companies).  The problem with buying puts is that they are a depreciating asset.  You lose money if you are wrong (i.e., the market goes up), and you also lose money if the market stays flat.  You may even lose money if you are right – the market goes down, but not enough to cover the cost of the puts you bought.

A third way is buy protection against a market crash is to make a bet on VIX, as this measure moves higher when the market falls.  But you can’t buy VIX itself – it is merely a measure of option volatility.  You can buy calls on VIX, but once again, you have bought a depreciating asset that loses money most of the time.  Options on VIX are European options (which means they settle in cash).  Since there is no actual underlying stock or other equity, cash settlement is the only choice.  If you were right and your calls finished in the money, you end up with cash and will have to buy new calls to maintain your downside bet (and once again end up with an asset that goes down in value every day the market doesn’t drop).

Instead of buying VIX, thousands of investors buy VXX as the closest proxy to buying VIX, but we have just discussed the danger of doing this.

It is not easy to find a good insurance plan to protect your other investments against a market crash.  Like any insurance plan, it inevitably costs you money.

Further Thoughts on VXX


If VXX is destined to fall in the long run, why not sell it short?  Over the long run, it would seem to be a great bet.  However, in the short term, it can kill you.  In the summer of 2011 when the European debt crisis fears erupted, VXX doubled in value in less than a month (from about $20 to over $40) and stayed up there for about six agonizing months after backwardation set in (yes, I was short VXX it at the time) until it fell to below $9 in October 2012 when the latest 1 - 4 reverse split took place.  I was reminded that if you do short VXX, make sure not to do it on margin.
 
My preference is to own XIV instead, which is the reverse of VXX, and contango works in its favor.  I first recommended it to Terry’s Tips subscribers in October 2011.  XIV was trading under $7 at the time, and had nearly tripled in value by the end of 2012. I continue to hold XIV, the only “stock” I own, by the way (all my other investments are in options).  Again, it is important not to buy it on margin because it is likely to tank in the short run and force you to unload shares at the worst possible time.

Bottom line, VXX can suddenly shoot higher in the short run, but it will surely fall in the long run. At Terry’s Tips, our challenge is to create a strategy that will take advantage of this reliable pattern.  We carry out one options portfolio using puts called the Dog of Dogs which is based on the inevitability of VXX moving lower in the long run.  We encourage subscribers to follow this portfolio when contango is the dominant condition.

We have a second portfolio called Crash Control which trades call options on VXX in a way that is designed to break even or make a small gain in most time periods but if VXX skyrockets because of a market crash or something like the 9/11 disaster, this portfolio should double in value.  We like to think that is like having insurance with no insurance premiums.  This portfolio does best when investors are unusually fearful or backwardation is the current condition of the futures slope.

 

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Terry's Tips Stock Options Trading Blog

January 22, 2015

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

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 . . .

January 8, 2015

Try a Vertical Put Credit Spread on a Stock That You Like

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.

December 4, 2014

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

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. . . .

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