Options Bootcamp: Sell First, Buy Later

One of the first lessons I learned when I began studying technical analysis was “to know what everyone knows is to know nothing.”

At first, I thought it was a Yoda quote from Star Wars. But as I analyzed charts, I realized how important this idea was.

“To know what everyone knows” is to rely on standard indicators like the 200-day moving average or RSI with default parameters. These indicators are easy to add to a chart, so they are widely followed.

Because they are widely followed, they can’t possibly be that profitable.

I know that’s a bold statement. But if a widely used tool was actually profitable, we’d all be trading from our own private islands.

From talking to a number of traders, I’ve learned the key to success is creating your own indicator.

The indicator I created focuses on volatility, but with a twist…

It’s actually designed for strategies that sell options.

I’ve written about how to use options to benefit when the market moves up or down. Now, I want to share a way to reverse the process — by selling first, and buying later…

A Better Way to Short

You may have heard of “shorting a stock.” If you think a stock is overvalued at $100, you can sell it short. Your broker lends you the shares, you sell them for $100, and now you owe your broker those shares back.

You repay this loan by buying the stock later — ideally after its price has dropped. If the stock falls to $90, you can buy at that price, send the shares to your broker, and pocket $10 a share.

Sounds simple enough, but shorting stocks comes with high risk. There’s no limit to downside when shorting stocks. If the stock jumps to $200, say, you’d be out $100 a share. And it could go higher.

Unlikely as this is, shorting stocks can quickly blow up an account in the wrong hands. Thankfully, there’s a lot to like about shorting options.

With options, you can also sell to open your trade and then buy to close it later. Since options expire, you can even profit without having to close the trade if the value of the option falls to zero at expiration.

Strategies that sell options can also be risky, for the same reasons as shorting stocks — uncertain and uncapped downside.

But my indicator is designed to limit that risk. With it, I can see when volatility is falling from an unusually high level — a good time to sell put options.

Let me show you…

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SPDR S&P 500 (SPY) gave a buy signal on my indicator last week. That’s shown at the bottom of the chart (green indicates a buy signal).

Most traders would see this and buy calls to profit, expecting SPY to go up. But you and I know we could also sell a put option to generate some income.

With SPY trading near $453, we could sell an Apr 11 $440 put for about $0.50. Each contract covers 100 shares, so this trade will result in a $50 credit to your account. You will then be short one contract.

If SPY closes above $440 on Monday, the put expires worthless. You keep the $50 and the contract is removed from your account. That’s a win.

If SPY closes below $440 on Monday, though, that’s a loss.  

Let’s assume an extreme scenario. Say SPY closes at $420 next Monday. At that price, the option would be worth $20. You could buy the option, pay $2,000 to close the trade, and lose $1,950.

Or you could accept shares of SPY. Your broker will exercise the contract and you’ll be obligated to buy 100 shares at $440. This will cost $44,000.

This is another important part of selling options. You need to have the balance in your account to handle a transaction like this. Brokerages generally require that your account value be worth about 20% of the underlying value of the security at the strike price. In the case of this SPY put, that’s about $8,800.

Being put the SPY shares means an immediate loss of $2,000. But if you wanted to add SPY to your account, exercising sold puts is one way to accomplish that. Even the legendary Warren Buffett used this strategy to acquire millions of shares of Coca-Cola in the 1990s.

Personally, I wouldn’t bet on that happening with this trade. My risk-management model shows there is only a 4% probability SPY will close below $440 on Monday.

That means this trade has a 96% probability of delivering $50 in income per contract in less than a week. Brokers generally require small margins for these trades, which means selling short-term options can generate significant income.

Selling puts isn’t for everyone. But it’s a strategy to generate income that could be right for many investors in a low interest rate world.

Regards,

Amber Hestla
Senior Analyst, True Options Masters

Chart of the Day:
Fade the Elon Musk Twitter Hype?

By Mike Merson, Managing Editor, True Options Masters

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It seemed like a belated April Fools headline…

On Monday, word got out that Elon Musk acquired over a 9% stake in Twitter (TWTR) and would join its board of directors.

The stock jumped about 30% that day, and tacked on another 9% in yesterday’s session before giving most of it back. That puts it at its highest valuation since November.

Musk clearly has some ideas about how Twitter should operate as a platform. He’s already teasing the long-requested edit button.

Regardless of whether Musk’s involvement will help Twitter as a business for the long haul, I would stay away from this trade right now.

The price is purely headline driven for the moment. Even if Twitter is overbought here (it is) and you want to fade the move, all it takes is a fresh headline merely mentioning “Elon Musk” and the word “Twitter” together to cause another spike higher.

Regards,

Mike Merson
Managing Editor, True Options Masters