Contango, Backwardation, and SVXY
This week I would like to introduce you to a thing called contango. This is relevant today because contango just got higher than I have seen it in many years – over 10% while most of the time, it hangs out in the 3% – 4% range. This measure becomes important when you are trading in my favorite ETP (Exchange Traded Product), SVXY. If your eyes haven’t glazed over yet, read on.
Contango, Backwardation, and SVXY
There seems to be a widespread need for a definition of contango. I figure that about 99% of investors have no idea of what contango or backwardation are. That’s a shame, because they are important concepts which can be precisely measured and they strongly influence whether certain investment instruments will move higher (or lower). Understanding contango and backwardation can seriously improve your chances of making profitable investments.
Contango sounds like it might be some sort of exotic dance that you do against (con) someone, and maybe the definition of backwardation is what your partner does, just the opposite (indeed, it is, but we’re getting a little ahead of ourselves because we haven’t defined contango is yet).
If you have an idea (in advance) which way a stock or other investment instrument is headed, you have a real edge in deciding what to do. Contango can give you that edge.
So here’s the definition of contango – it is simply that the prices of futures are upward sloping over time, (second month more expensive than front month, third month more expensive than second, etc.), Usually, the further out in the future you look, the less certain you are about what will happen, and the more uncertainty there is, the higher the futures prices are. For this reason, contango is the case about 75 – 90% of the time.
Sometimes, when a market crash has occurred or Greece seems to be on the brink of imploding, the short-term outlook is more uncertain than the longer-term outlook (people expect that things will settle down eventually). When this happens, backwardation is the case – a downward-sloping curve over time.
So what’s the big deal about the shape of the price curve? In itself, it doesn’t mean much, but when it gets involved in the construction of some investment instruments, it does become a big deal.
A Little About VXX (and its Inverse, SVXY)
One of the most frequent times that contango appears in the financial press is when VXX is discussed. VXX is an ETP which trades very much like any stock. You can buy (or sell) shares in it, just like you can IBM. You can also buy or sell options using VXX as the underlying. VXX was created by Barclay’s on January 29, 2009 and it will be closed out with a cash settlement on January 30, 2019 (so we have a few years remaining to play with it).
VXX is an equity that people purchase as protection against a market crash. It is based on the short-term futures of VIX, the so-called “fear index” which is a measure of the implied volatility of options on SPY, the tracking stock for the S&P 500. When the market crashes, VIX usually soars, the futures for VIX move higher as well, pushing up the price of VXX.
In August of 2011 when the market (SPY) fell by 10%, VXX rose from $21 to $42, a 100% gain. Backwardation set in and VXX remained above $40 for several months. VXX had performed exactly as it was intended to. Pundits have argued that a $10,000 investment in VXX protects a $100,000 portfolio of stocks against loss in case of a market crash. No wonder it is so popular. Investors buy about $3 billion worth of VXX every month as crash protection against their other investments in stocks or mutual funds.
There is only one small bad thing about VXX. Over the long term, it is just about the worst stock you could ever buy. Over the last three years, they have had to have 3 reverse 1 – 4 stock splits just to keep the price of VXX high enough to bother with trading. Every time it gets down to about $12, they engineer a reverse split and the stock is suddenly trading at $48. Over time, it goes back to $12 and they do it again (at least that is how it has worked ever since it was created).
VXX is adjusted every day by buying VIX futures and selling VIX at its spot price. (This is not exactly what happens, but conceptually it is accurate.) As long as contango is in effect, they are essentially buying high (because future prices are higher than the spot price) and selling low (the current spot price). The actual contango number represents an approximation of how much VXX will fall in one month if a market correction or crash doesn’t take place.
So it’s a sort of big deal when contango gets over 10% as it is today. VXX is bound to tumble, all other things being equal. On the other hand, SVXY is likely to go up by that much in a month since it is the inverse of VXX. SVXY has had a nice run lately, moving up an average of 4.5% in each of the last three weeks, in fact. You can see why it is my favorite ETP (I trade puts and calls on it in large quantities every week, usually betting that it will move higher).
That’s enough about contango for today, but if you are one of the few people who have read down this far, I would like to offer you a free report entitled 12 Important Things Everyone with a 401(K) or IRA Should Know (and Probably Doesn’t). I want to share some of my recent learnings about popular retirement plans but I don’t want to be overwhelmed by too much traffic while I get a new website set up. Order it here. You just might learn something (and save thousands of dollars as well).
A Look at the Downsides of Option Investing
Most of the time we talk about how wonderful it is to be trading options. In the interests of fair play, today I will point out the downsides of options as an investment alternative.
A Look at the Downsides of Option Investing
1. Taxes. Except in very rare circumstances, all gains are taxed as short-term capital gains. This is essentially the same as ordinary income. The rates are as high as your individual personal income tax rates. Because of this tax situation, we encourage subscribers to carry out option strategies in an IRA or other tax-deferred account, but this is not possible for everyone. (Maybe you have some capital loss carry-forwards that you can use to offset the short-term capital gains made in your option trading).
2. Commissions. Compared to stock investing, commission rates for options, particularly for the Weekly options that we trade in many of our portfolios, are horrendously high. It is not uncommon for commissions for a year to exceed 30% of the amount you have invested. Because of this huge cost, all of our published results include all commissions. Be wary of any newsletter that does not include commissions in their results – they are misleading you big time.
Speaking of commissions, if you become a Terry’s Tips subscriber, you may be eligible to pay only $1.25 for a single option trade at thinkorswim. This low rate applies to all your option trading at thinkorswim, not merely those trades made mirroring our portfolios (or Auto-Trading).
3. Wide Fluctuations in Portfolio Value. Options are leveraged instruments. Portfolio values typically experience wide swings in value in both directions.
Many people do not have the stomach for such volatility, just as some people are more concerned with the commissions they pay than they are with the bottom line results (both groups of people probably should not be trading options).
4. Uncertainty of Gains. In carrying out our option strategies, we depend on risk profile graphs which show the expected gains or losses at the next options expiration at the various possible prices for the underlying. We publish these graphs for each portfolio every week for subscribers and consult them hourly during the week.
Oftentimes, when the options expire, the expected gains do not materialize. The reason is usually because option prices (implied volatilities) fall. (The risk profile graph software assumes that implied volatilities will remain unchanged.). Of course, there are many weeks when VIX rises and we do better than the risk profile graph had projected. But the bottom line is that there are times when the stock does exactly as you had hoped (usually, we like it best when it doesn’t do much of anything) and you still don’t make the gains you originally expected.
With all these negatives, is option investing worth the bother? We think it is. Where else is the chance of 50% or 100% annual gains a realistic possibility? We believe that at least a small portion of many people’s investment portfolio should be in something that at least has the possibility of making extraordinary returns.
With CD’s and bonds yielding ridiculously low returns (and the stock market not really showing any gains for quite a while – adjusted for inflation, the market is 10% lower than it was in March, 2000,), the options alternative has become more attractive for many investors, in spite of all the problems we have outlined above.