Dear Friend,

This week we will discuss three investment concepts that you probably never heard of. If you understood them, they might just change your investment returns for the rest of your life.  Surely, it will be worth your time to read about them.  

Terry

Contango, Backwardation, and VXX

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.

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) 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). 
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.  Check out its graph since it was first created in January of 2009.        


 Have you ever seen such a dog?  (Maybe you bought stock in one or two of these, but I suspect no matter how bad they were, they couldn’t match VXX’s performance). On two occasions (November 9, 2010 and October 5, 2012) they 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 (note: 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 becomes important.
 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 percentage in the same direction. If the next day, VIX falls by 10%, it goes down by 2.20 (10% of 22).  At the end of the two-day period, VXX will end 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 summary, because of the predominant condition of contango as well as the way VXX is constructed, it is destined to go down consistently every month.  Coming soon, we will discuss option strategies that can prosper from this phenomenon.

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Any questions?   I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.

You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here.  Why wait any longer to make this important investment in yourself?

I look forward to having you on board, and to prospering with you.

Terry

Have you seen the VIX lately?  15.4%? Seriously?

Well, some of you asked for another rally and now look what you get in return - low options premium.
 
Sellers of options need volatility, we thrive on volatility. Volatility is our friend.

But after a short spike, volatility as seen by the VIX, is once again back down to levels seen over the past few months.  For the bulls, low volatility raises hopes that a calmer market will bring in more investors. However, as I stated in last week’s report, I thought we would see a short-term bounce up to the 1400 level in the S&P 500 followed by another leg down.

 “Lower volatility is like a security blanket for retail investors. It allows them to invest for the long term,” said Ben Schwartz, chief market strategist at Lightspeed Financial, the retail broker. “Investors remain nervous about the Eurozone crisis, fiscal cliff, etc. but money is beginning to trickle back.”

Investment banks and their institutional clients are not convinced that volatility will remain low. Because, low volatility equates to a low-price hedge against a sharp market decline.

“With VIX levels so low, this is a good time for investors to put on hedge positions,” said Pankaj Khandelwal, a senior VIX trader at Barclays Capital.  “Even if you have a bullish view on the market, you can buy downside protection for your portfolio at low prices right now,” said Pankaj Khandelwal, a senior VIX trader at Barclays Capital.

And the smart money or commercial hedgers (among the largest traders in the market) have gone net short on Nasdaq, Dow and Russell 2000 futures.
This is telling.

Because when commercial hedgers move net short the market typically witnesses a correction shortly thereafter.

Whether or not we see a decline soon is THE hot question right now.

As I discussed before, the S&P 500 made it back to strong overhead resistance (1400) in three trading days and the major market benchmarks are back in a short-term overbought state. Typically when we see this type of reading (overbought coupled with strong overhead resistance) in all of the benchmarks a short-term reprieve is to follow.

Has it been a bear trap all along?

As the Wall Street adage goes, “never sell a dull market”. And that is exactly what we saw during the holiday shortened week. So I am somewhat skeptical of the sustainability of the latest rally.

But one thing IS for certain, with the market back at these elevated levels and volatility hitting strong support the risk is to the upside. Trade accordingly.

This year has been good, thanks to Terry's Tips.  I am involved in an investment club.  I told them about your service. One of the guys has recently signed up.  Thanks so much.  ~ Jerry

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Sincerely,
Dr. Terry Allen
Terry's Tips