One of my premium Income Trader readers asked some very important questions this week, and I want to share the answers with everyone.
For those of you who are unaware, our whole mission over at Income Trader is to use the power of options to safely earn extra income. If you know how options work, or if you've ever dabbled in options, then you may have asked similar questions before.
Her question began, "I am very nervous about selling put options after being assigned multiple stocks that declined in the last three months of 2018. Because of my negative experience with put selling last year, I am wondering if you could give me guidance on a few questions."
Below, I am going to share the specific numbered questions followed by answers.
Question 1: "In Income Trader, what is the general strategy to deal with stocks that experience sharp declines after we sell a put? Is it to accept assignment and then sell covered calls?"
Answer: This will sound a little flippant but please don't take it that way. My general strategy is to avoid stocks that are at risk of a sharp decline and I select trades with that in mind.
In general terms, I look for a combination of safety and income. The reason my screening rules start with safety before considering income is because the cost of a losing trade can be significant.
When looking at safety, I screen for stocks that have a higher-than-average probability of rising in price and options that offer higher-than-average value. I even developed the Income Trader Volatility (ITV) indicator to specifically identify trades like that.
When looking at income, I target the maximum amount of safe income. We could receive significantly more income in dollar terms by using different options. But I want safe income, so I accept less income in dollar terms while still achieving annualized income that is usually 20% or more.
For example, if we have a position open when the company announces earnings, we have a high level of risk. Other traders understand that, and the options price reflects the risk. We could obtain high income by selling those options.
When earnings are announced, there is about a 75% probability the company will beat analysts' estimates and the stock is likely to rise on the news. There is a 25% chance the company will miss expectations and the stock could sell off on the news. To me, risk of 25% is too high and I will pass on that trade, no matter how much income is available.
Occasionally, the unexpected does happen and the option will be subject to assignment. I will usually recommend closing the trade rather than accept assignment. When doing that in the past, closing the position a day or two before expiration, the costs have been relatively low.
But here's the thing to keep in mind... Overall, the income from the winning trades more than offsets the occasional loss in my experience. Accepting assignment and selling covered calls ties up capital that could be used for short-term trades and in the long run, accepting assignment is rarely the best strategy.
Sometimes, it may be best to accept assignment and if I believe that is the case, I will fully explain my rationale for that position. But to sum up, my strategy is to avoid assignment and we've been able to do that with a high degree of consistency.
Question 2: "I notice in the past, many trades you recommend are priced near $100 and even higher. That means if we are assigned, those positions will require significant capital. Why do you select those stocks?"
Answer: I prioritize safety. Although I wish there were safe puts to sell on $20 stocks, there rarely are. There are often trades that look attractive based solely on potential income, and that is why selling puts on low-priced stocks can be so appealing. But the risks will generally outweigh the rewards, and, by prioritizing risk, these trades don't meet my requirements.
Question 3: "With the uncertainty regarding possible market corrections, why do you believe selling put options can still be a profitable strategy?"
Answer: I believe my strategy is safe in all market environments. But that's not necessarily true of selling puts in general.
I have read hundreds of times that selling puts is the key to success because most options expire worthless. Some articles claim more than 75% of options expire worthless, or 80%, or more than 90%. The articles conclude that Wall Street firms are benefitting from all these trades, so individuals should sell options to be on the winning side of Wall Street.
Absolutely none of that is true. I tracked down the source of this claim. There was a study that found that three out of four options held to expiration, on average, expire worthless.
I found the data that was used in the study and calculated that when all of the data is properly considered, just 5.5% of options expired worthless. The reality is that generating income by selling options is one of the more difficult tasks in the investment world.
That's where my strategy comes in... Years ago, I understood that I needed something different if I was going to succeed at this strategy, and I put in the time to study the market and developed the ITV indicator. I've been using that indicator in real time with great success, in up and down markets. I've also tested the indicator on more than 20 years' worth of data and demonstrated its value. (In 2015, the Market Technicians Association recognized my research and development of the ITV indicator with its prestigious Charles H. Dow award.)
I believe my strategy is profitable, but I don't believe put selling, in general, is profitable. I apologize if that sounds arrogant. I just believe in my strategy because I have worked so hard to develop it and it has delivered excellent results for years.
Question 4: "From the record of closed trades, it seems that you did not experience many losses or have options assigned as the market declined at the end of last year. Is that correct?"
Answer: That is correct and that is why I strictly follow my rules. I work very hard to generate income from short-term trades so that we can continually compound gains. My record shows my approach is as safe as I can make it.
Action To Take
Like I said, if you're familiar with how options work, then hopefully you found some of these answers beneficial. Now, I know there are probably more questions that some of you may have, and I'm here to help. I will do my best to answer as many as possible.
In the meantime, if you're not already an Income Trader subscriber, then I encourage you to learn more about our strategy by visiting this page.