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.

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

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

October 31, 2023

Dear [[firstname]],

Happy Halloween!

I haven’t written in a couple of weeks since credits weren’t close enough to my target entry prices when I initially sent the trades to my subscribers. However, the credit for last week’s trade on Charles Schwab (SCHW) has come back and now exceeds my initial target.

So, I figured why not send it now since I still like the setup. I’m not changing the initial write-up that I sent to my Saturday Report subscribers on October 21, so it may sound a bit outdated. But the trade is still a good play.

Moreover, this week’s trade credit is a little above my entry level, so it’s good to go as well. So, you’re getting a first this week – two trades. Both bearish call credit spreads on stocks after they reported earnings.

Before I get to the trades, I want to let you know that our Terry’s Tips portfolios have caught fire in the past couple of weeks. We’re up 7% for the past two weeks while the S&P 500 fell nearly 5%. Our recent surge has pushed our overall return to more than triple that of the S&P this year.

I’m also happy to highlight our Microsoft (MSFT) portfolio, which gained 14% just last week alone and 40% over the past four weeks. It’s now up 65% for the year and is challenging our QQQ portfolio, which is up more than 70%!

How long can you afford to miss out on these profits? For our loyal newsletter subscribers (that’s you), I’m of course keeping the sale going that saves you more than 50% on a monthly subscription to Terry’s Tips.

You’ll get …

A month of all trade alerts in our four portfolios, giving detailed instructions for entering and exiting positions. Trade one portfolio or all four. It’s up to you.
Four to five (depending on the month) weekly issues of our Saturday Report, which shows all the trades and positions for our four portfolios, a discussion of the week’s trading activity and early access to our Option Trade of the Week.
Instructions on how to execute the 10K Strategy on your own.
A 14-day options tutorial on the opportunities and risks of trading options.
Our updated 10K Strategy white paper, a thorough discussion of the strategy basics and tactics.
Full-member access to all our premium special reports that can make you a wiser and more profitable options trader.

To become a Terry’s Tips Insider Member, just Click Here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off. You can cancel after a month but, of course, keep all the valuable reports.

I look forward to having you join in the fun and profits! Now on to the trades, starting with the previous week’s trade …

Avast Ye Schwabs

Two call spreads in Estee Lauder (EL) and the SPDR Healthcare ETF (XLV) expired worthless yesterday for gains of 25% apiece. To be fair, our bullish spread on Lululemon Athletica (LULU) expired in the money a week earlier for a larger loss. But the LULU misstep interrupted a string of seven straight winners. A large part of this success has been due to taking a more bearish stance toward the market. In fact, today’s trade marks the fifth straight bearish call spread and eighth of the past 11. And with good reason, as our only losses of the past two months have been bullish positions. We’re on a solid roll. I hope you’re banking some winners.

With earnings season hitting full stride this week, there’s no end to the trade possibilities. Of course, there were the spotlight names, such as Tesla (TSLA) and Netflix (NFLX), whose large post-earnings moves grabbed headlines. But I prefer stocks that have smaller, off-the-radar moves that have a lower likelihood of reversing. One such stock is Charles Schwab (SCHW), which is no stranger to these pages (you may recall I had a few issues with the TD transition in September).

SCHW reported before the open on Monday, so we had a whole week’s worth of post-earnings price action to digest. The numbers were mixed, with net income coming in slightly ahead of expectations while revenue fell a bit short. However, both numbers fell far short of last year’s figures. I won’t bore you by parsing through all the individual data points (bank deposits, net interest revenue, TD migration, new brokerage accounts, etc.). Analysts seem to feel that SCHW still faces several short-term hurdles that have buffeted it all year, though the longer-term prospects are encouraging.

Speaking of analysts, their reaction was much like SCHW’s earnings … mixed. There were no ratings changes while target price changes went both ways. But analysts are clearly bullish on SCHW, giving it a solid buy rating on average. The average target price is near $70, which is around 35% above Friday’s close. This fits into the struggle now, prosper later narrative I mentioned above. But since we’re looking ahead only a few weeks, the bearish case makes more sense.

On the chart, the stock reacted positively to earnings, popping 6% in Monday’s trading before settling for a 4.7% gain. But that was the high close of the week, as the shares tumbled more than 5% after Monday. It’s notable that the 20-day moving average provided staunch resistance throughout the week, containing the initial Monday burst and then sending the stock lower through the week’s end. The 20-day has done a solid job keeping the current decline intact since it rolled over in May. I’ll also note that the stock enjoyed a massive 12.6% spike after its previous earnings report in July, only to give it all back during the subsequent month.

If you agree that the stock will continue its downtrend based on the resistance from its 20-day moving average, consider the following credit spread trade that relies on SCHW staying below $53 through expiration in 6 weeks:

Buy to Open the SCHW 1 Dec 56 call (SCHW231201C56)
Sell to Open the SCHW 1 Dec 53 call (SCHW231201C53) for a credit of $0.75 (selling a vertical)

This credit is $0.09 less than the mid-point price of the spread at Friday’s $50.87 close. Note that I’m giving a little extra room on the entry credit. Unless SCHW falls sharply at the open on Monday, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $73.70. This trade reduces your buying power by $300, making your net investment $226.30 per spread ($300 – $73.70). If SCHW closes below $53 on Dec. 1, the options will expire worthless and your return on the spread would be 33% ($73.70/$226.30).

Here’s this week’s trade …

Low Voltage

We had another spread expire worthless on Friday, but it made us sweat. Adobe (ADBE) was looking great, which was saying something as our only open bullish position. It hit an annual high on Oct. 12, putting the short put nearly 15% out of the money. Then the falling market tide grabbed the stock and pulled it down to within eight points of the short strike at Friday’s close. Another day and it might have moved into the money. But it didn’t and we bagged a gain of over 30% for our eighth winner of the past nine closeouts. That leaves us with five open positions, all bearish call spreads.

I’d love to add a put spread this week, but I can’t make a case for fighting the bearish tape. Maybe next week. For this week, I had way too many earnings plays to choose from, as this was the busiest week of the season. Frankly, I stopped looking after an hour, realizing that I could have spent all day analyzing dozens and dozens of top names.

I settled on General Electric (GE), which may seem like an odd choice given that it had a blowout report and had its best post-earnings day in years. The company easily beat earnings and revenue estimates and raised earnings and revenue growth guidance for 2023. The stock responded with a 6.5% pop on Tuesday, its largest gain after earnings since Jan. 2020. What’s not to like, right?

Well, analysts didn’t seem overly excited. In fact, only two weighed in with target price increases of $1 and $2. That’s it. The average target sits near $126, which is around 19% above Friday’s close. I’ll also point out the last time GE saw $126 was six years ago. There were no ratings changes, which were already heavily slanted toward the buy level. This does not seem like a hearty endorsement of a stock that just had as good an earnings report as you’ll see.

While the shares enjoyed a big gain on Tuesday, the rest of the week didn’t go well. In fact, the stock closed out the week below the pre-earnings close. The dual resistance of the 20-day and 50-day moving averages were in play, as the stock closed the week below both. These trendlines have rolled over into declines, a bad sign given that the stock doesn’t stray far from either. Another factor to note: GE had a big pop of more than 6% after the previous earnings release, but the stock drifted lower after that first day and has never closed a day higher since.

It seems that the earnings effect lasted all of one day and the stock has resumed its downtrend that’s been in place for six weeks. This trade is a bet that the trend will continue, especially in light of the broader market’s weakness. Note that the short call strike sits above Tuesday’s close and the mid-October peak.

If you agree that the stock will continue its downtrend based on the resistance from its 20-day (blue line) and 50-day (red line) moving averages, consider the following credit spread trade that relies on GE staying below $114 (green line) through expiration in 6 weeks:

Buy to Open the GE 8 Dec 116 call (GE231208C116)
Sell to Open the GE 8 Dec 114 call (GE231208C114) for a credit of $0.40 (selling a vertical)

This credit is $0.05 less than the mid-point price of the spread at Friday’s $106.35 close. Note that I’m giving a little extra room on the entry credit. Unless GE falls sharply at the open on Monday, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $38.70. This trade reduces your buying power by $200, making your net investment $161.30 per spread ($200 – $38.70). If GE closes below $114 on Dec. 8, the options will expire worthless and your return on the spread would be 24% ($38.70/$161.30).

Good luck with these trades,

Remember to click here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off.

Any questions? Email Jon@terrystips.com. Thank you again for being a part of the Terry’s Tips newsletter.

Happy trading,

Jon

Read Full Article

October 9, 2023

October 10, 2023

With earnings reports virtually dried up this week and wanting to stay on the bearish side, I had to go back a few weeks to find reports that failed to impress the Street. One name that popped up was a stock that we successfully played (28% profit) for a bullish winner back in March – Darden Restaurants (DRI), the sit-down restaurant chain conglomerate that includes Olive Garden, LongHorn Steakhouse, Capital Grille, and the recently acquired Ruth’s Chris Steak House.

DRI reported earnings a couple of weeks ago. The numbers were solid, as the company beat estimates on both the top and bottom lines. Same-restaurant sales also handily beat expectations. Moreover, sales and profits were higher than a year earlier. The only negatives were slowing growth in its fine-dining holdings and some concern over its aggressive expansion plans amid a potential recessionary environment.

Analysts seemed unmoved by the seemingly positive news. The report was met with a mix of target price upgrades and more numerous downgrades. This left the average target in the $160-170 range, well above Friday’s $137 close. With no ratings changes, analysts remain firmly in the buy/outperform camp.

Perhaps analysts should take closer note of DRI’s stock chart and post-earnings performance. After hitting an all-time high in late July, the stock is down 21% and logged its lowest close in nearly a year on Friday. I’ll point out that the S&P 500 is down just 5% over the same time frame. This slump has been perfectly guided by the 20-day moving average, a trendline the stock hasn’t closed above in more than two months. Also, for technical wonks, the 50-day moving average is crossing below the 200-day moving average, also known as the “death cross.”

This bearish trade is based on the stock’s continued slump even after the good earnings results. With analysts perhaps too optimistic, it’s reasonable to expect some target price reductions, if not some ratings downgrades that could further pressure the share price.

Finally, the 20-day resistance is hard to ignore, which is why we’re playing a call spread with the short call strike sitting just above this trendline. Note that this trade has a smaller return than most because I wanted the short strike to be above the 20-day. Thus, we have a larger cushion of safety and greater probability of profit.

If you agree that the stock will continue its downtrend based on the resistance from its 20-day moving average (blue line), consider the following credit spread trade that relies on DRI staying below $145 (red line) through expiration in 6 weeks:

Buy to Open the DRI 17 Nov 150 call (DRI231117C150)
Sell to Open the DRI 17 Nov 145 call (DRI231117C145) for a credit of $0.85 (selling a vertical)

This credit is $0.02 less than the mid-point price of the spread at Friday’s $136.94 close. Unless DRI falls sharply at the open on Monday, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $83.70. This trade reduces your buying power by $500, making your net investment $416.30 per spread ($500 – $83.70). If DRI closes below $145 on Nov. 17, the options will expire worthless and your return on the spread would be 20% ($83.70/$416.30).

Happy trading,

Jon L

**Our QQQ portfolio is up more than 70% in 2023! Our MSFT portfolio is up around 30%! Overall, we’re beating the S&P. Don’t be left behind … now you can save more than 50% on a monthly subscription to Terry’s Tips. Just Click Here, select Sign Up Now and use Coupon Code D21M to start a monthly subscription to Terry’s Tips for half off.**

Read Full Article

September 25, 2023

Cold and Soggy

There were a few interesting earnings announcements this week, even though we’re in the quiet period for earnings reports (things start to ramp up again in three weeks). In fact, I had three bearish plays to choose from. That’s a good thing since we currently have three bullish and three bearish trades open, and I feel like the bears need a little more weight after the past week’s Fed-infected price action.

The trade this week is on prepared-food giant General Mills (GIS), which owns several iconic cereal brands along with such names as Betty Crocker, Blue Buffalo, Pillsbury, Progresso, Green Giant and Yoplait. GIS reported earnings numbers on Wednesday before the open that were filled with a lot of “buts.” Sales increased 4% due to higher prices, but volume was lower. Net income beat the consensus expectation but fell 18% from a year ago. GIS executives are bullish on their pet food segment but sales for the quarter were flat. Moreover, some analysts feel that consumers are reaching their limit on rising food costs. And GIS’s CFO said that the company’s operating profit margin will not improve this year.

All in all, it was not a great report, which is perhaps why the stock was hit with a few price target cuts. At least there were no ratings downgrades. Analysts on the whole are neutral toward the stock, while the average target price is in the $70-75 range compared to Friday’s close near $65.

Perhaps analysts would be a bit more skeptical if they took a quick glance at GIS’s chart, which shows the stock plunging 30% in the past four months. This descent has been expertly guided by the 20-day moving average, a trendline the stock has closed above just four times since mid-May. This resistance was evident the two days after earnings this week, when the shares failed to pierce the 20-day with early rallies. Note that the short call strike of our spread sits above this trendline.

If you agree that the stock will continue its downtrend after an uninspiring earnings report and remain below its 20-day moving average (blue line), consider the following credit spread trade that relies on GIS staying below $67.50 (red line) through expiration in 8 weeks:

Buy to Open the GIS 17 Nov 70 call (GIS231117C70)
Sell to Open the GIS 17 Nov 67.5 call (GIS231117C67.5) for a credit of $0.45 (selling a vertical)

This credit is $0.05 less than the mid-point price of the spread at Friday’s $64.82 close. Unless GIS falls sharply at the open on Monday, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $43.70. This trade reduces your buying power by $200, making your net investment $156.30 per spread ($200 – $43.70). If GIS closes below $67.50 on Nov. 17, the options will expire worthless and your return on the spread would be 28% ($43.70/$156.30).

Read Full Article

View All Blog Posts

All About Contango

All about VXX

Market Crash Protection Insurance Choices

Further Thoughts on VXX

TERRY’S TIPS STOCK OPTIONS TRADING BLOG

Making 36%

Sign Up For The Free Options Strategy Report & Our Newsletter Now!