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An Options Strategy Designed to Make 40% a Month:
First of all, we need to say a few words about our favorite underlying, SVXY. It is not a stock. There are no quarterly earnings reports to push it higher or lower, depending on how well or poorly it performs. Instead, it is an Exchange Traded Product (ETP) which is a derivative of several other derivatives, essentially impossible to predict which way it will move in the next week or month. The only reliable predictor might be to look how it has performed in the past, and see if there is a way to make extraordinary gains if the historical pattern of price changes manages to extend into the future. This price change pattern is the basis of the 40% monthly gain potential that we have discovered.
SVXY is the inverse of VXX, a popular hedge against a market crash. VXX is positively correlated with
vix (implied volatility of SPY options), the so-called fear index. When the market crashes or corrects, options volatility,
vix, and VXX all soar. That is why VXX is such a good hedge against a market crash. Some analysts have written that a $10,000 investment in VXX will protect against any loss on a $100,000 stock portfolio (I have calculated that you would really need to invest about $20,000 in VXX to protect against any loss in a $100,000 stock portfolio, but that is not a relevant discussion here.)
While VXX is a good hedge against a market crash, it is a horrible long-term holding. In its 7 years of existence, it has fallen an average of 67% a year. On three occasions, they have had to engineer 1-for-4 reverse splits to keep the stock price high enough to bother trading. In seven years, it has fallen from a
split-adjusted $2000+ price to today’s under-$30.
Over the long run, VXX is just about the worst-performing “stock” that you could possibly find. That is why we are so enamored by its inverse, SVXY.
Deciding to buy a stock is a simple decision. Compare that to SVXY, an infinitely more complicated choice. First, you start with SPY, an ETP which derives its value from the weighted average stock price of 500 companies in the S&P 500 index. Options trade on SPY, and
vix is derived from the implied volatility (IV) of those options. Then there are futures which are derived from the future expectations of what
vix will be in future months. SVXY is derived from the value of
short-term futures on
vix. Each day, SVXY sells these
short-term futures and buys
AT the spot price (today’s value) of
vix. Since about 90% of the time,
short-term futures are higher than the spot price of
vix (a condition called contango), SVXY is destined to move higher over the long run – an average of about 67% a year, the inverse of what VXX has done. Simple, right?
While SVXY is anything but a simple entity to understand or predict, its price-change pattern is indeed quite simple. In most months, it moves higher. Every once in a while, however, market fears erupt and SVXY plummets. In October, for example, SVXY fell from over $90 to $50, losing almost half its value in a single month. While owning SVXY might be a good idea for the long run, in the
short run, it can be an awful thing to own.
Note on terminology: While SVXY is an ETP and not literally a stock, when we are using it as an underlying entity for options trading, it behaves exactly like a stock, and we refer to it as a stock rather than an ETP.
We have performed an exhaustive study of monthly price fluctuations (using expiration month numbers rather than calendar month figures). Our major finding was that in half the months, SVXY ended up more than 12% higher or lower than where it started out. It was extremely unusual for it to be trading
AT the end of an expiration month anyway near where it started out. This would suggest that buying a
straddle (both a
put and a
call)
AT the beginning of the month might be a good idea. However, such a
straddle would cost about 10% of the value of the stock, a cost that does not leave much room for gains since the stock would have to move by 10% before your profits would start, and that occurs only about half the time.
A second significant finding of our backtest study of SVXY price fluctuations was that in 38% of the months, the stock ended up
AT least 12.5% higher than it started the expiration month. If this pattern persisted into the future, the purchase of an
AT-the-money
call (costing about 5% of the stock price) might be a profitable bet. There are other strategies which we believe are better, however.
One possible strategy would be to buy a one-month out vertical
call spread with the lower strike about 6% above the current price of the stock. Last week, with SVXY trading about $75, we bought a Dec-14 80
call and sold a Dec-14 85
call. The
spread cost us $1.11 ($111
per spread, plus $2.50 in commissions
AT the special thinkorswim rate for paying Terry’s Tips subscribers). This means that if the stock ends up
AT any price above $85 (which it has historically done 38% of the time), we could sell the
spread for $497.50 after commissions, making a profit of $384 on an investment of $113.50. That works out to a 338% gain on the original investment.
If you bought a vertical
call spread like this for $113.50 each month and earned a $384 gain in the 14 months (out of 37 historical
total) when SVXY ended up the expiration month having gained
AT least 12.5%, you would end up with $5376 in gains in those months. If you lost your entire $113.50 investment in the other 23 months, you would have losses of $2610, and this works out to a net gain of $2766 for the
total 37 months, or an average of $74
per month on a monthly investment of $113.50, or an average of 65% a month. Actually, it would be better than this because wouldn’t lose the entire investment in many months when the maximummum gain did not come your way.
But as good as 65% a month seems (surely better than the 40% a month I talked about
AT the beginning), it could get better. Again using the historical pattern, we identified another variable which could tell us whether or not we should buy the vertical
spread AT the beginning of the month. If you followed this measure, you would only buy the
spread in 17 of the 37 months. However, you would make the maximummum gain in 10 of those months. Your win rate would be 58% rather than 38%, and your average monthly gain would be 152%. This variable is only available for paying subscribers to Terry’s Tips, although maybe if you’re really smart and can afford to spend a few dozen hours of searching, you can figure it out for yourself.
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Of course, this entire strategy is based on the expectation that future monthly price fluctuations of SVXY will be similar to the historical pattern of price changes. This may or may not be true in the real world, but we think our chances are pretty good. For example, for the November expiration that ended just one week ago, the stock had risen a whopping 34%. In the preceding October expiration month, it had fallen by almost that same amount, but
AT the beginning of the month, our outside variable measure would have told us not to buy the
spread for that month, so we would have made the 338% in November and avoided any loss
AT all in October.
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