How To Reliably Pick A Winning Options Trade

Includes: AMZN, NFLX, TSLA
by: The Mad Hedge Fund Trader


You’ve spent vast amounts of time, effort, and money to become an options trading expert. You know the difference between bids and offers, puts and calls, exercise prices and expiration.

And you still can’t make any money.

Now what?

Editor's note: This article was originally published March 23, 2016.

Where do you apply your new found expertise? How do you maximize your reward versus your risk?

It is all very simple. Stick to five disciplines I am about to teach you and you will suddenly find that the number of your new trades that are winners takes a quantum leap, and the money will start pouring into your trading account.

It's really not all that hard to do. So here we go!

1) Know the Macro Picture

If you have a handle on whether the economy is growing or shrinking, you have a major advantage in the options market.

In a growing economy, you only want to employ bullish strategies, like calls, call spreads, and short volatility plays.

In a shrinking economy you want to executive bearish plays, like puts, put spreads, and long volatility plays.

Remember the only thing that is useful is a view on what the economy is going to do next. The government only publishes historic economic data, which is for the most part useless in predicting what is going to happen in the future.

Remember, the options market is all about discounting what is going to happen next.

And how do you find that out? Well, you could hire your own in-house staff economist. Or you could rely on economic research from the largest brokerage houses that all have their own economist.

Even the Federal Reserve puts out its own forecasts for economic growth prospects. However, all of these sources have notoriously poor track records. Listening to them and placing bets on their advice can get you into a world of trouble.

2) Look for Great Industry Fundamentals

Do you want to give yourself another edge?

There are over 100 different industries listed on US stock markets. However, only about 5 or 10 are really growing decisively at any particular time. The rest are either going nowhere, or are shrinking.

In fact, you can find a handful of sectors that are booming while others are in outright recession.

If you are a major hedge fund, institution, or government, you may want to cover all 100 of those industries. Good luck with that.

If you are a small hedge fund, or an individual working from home, you will want to conserve your time and resources, skip most of US industry, and only focus on a handful.

Some traders take this a step further and only concentrate on a single high growth, volatile industry, like technology or biotech, or a single name, like Neflix (NASDAQ:NFLX), Tesla (NASDAQ:TSLA), or Amazon (NASDAQ:AMZN).

How do you decide which industry to trade?

Brokerage houses pump out more free research than you could ever read in a lifetime. Government reports tend to be stodgy, boring, and out of date. Big hedge funds keep their in-house research confidential (although some of it leaks out to me).

The Mad Hedge Fund Trader solves this problem for you by limiting its scope to a small number of benchmark, pathfinder industries, like technology, banks, energy, consumer cyclicals, biotech, and cyber security.

In this way, we gain a handle on what is happening in the economy as a whole, while lining up rifle shots on the best options trades out there.

We want to direct you where the action is, and where we have a good handle on future earnings prospects.

It doesn't hurt that we live on the edge of Silicon Valley and get invited to test out many technologies before they are made public.

3) The Micro Picture is Ideal

Once you have a handle on the economy and the best industries, it's time to zero in on the best company to trade in, or the "micro" selection.

It's always great to find a good target to trade in because positions in single companies deliver double or triple the returns compared to stock indexes.

That's because the market will pay a far higher implied volatility for a single company than a large basket of companies.

Remember also that you are taking greater risk in trading individual companies. One single stock is subject to far greater risk than a basket.

If the earnings come through as expected, everything is hunky dory. If they don't, the shares can drop by half in a heartbeat. Large indexes buffer this effect.

Of course there are gobs of market research out there from brokers about individual companies. Some of it is right, some of it is wrong, but all of it is conflicted. Recommendations are either "BUY" or "HOLD".

Brokers are loath to issue a "SELL" recommendation for a stock because it will eliminate any chance of that firm obtaining new issue business. Who wants to hire a broker to sell new stock with a "SELL" recommendation on their stock?

And brokerage firms don't make their bread and butter on those piddling little discount commissions you have been paying them. They make it on new issues business. In fact, a new issue can earn as much as $100 million from a new issue for one firm.

I have been following about 100 companies in the leading market sectors for nearly half a century. Some of the management of these firms have become close friends over the decades. So, I get some really first class information.

When markets rotate to sectors and companies that I already know, I have a huge advantage. Needless to say, this gives me a massive head start when selecting individual names for options Trade Alerts.

4) The Technicals Line Up

I have never been a huge fan of technical analysis.

Most technical advice boils down to "if it's gone up, it will go up more" or "If it's gone down, it will go down more."

Over time, the recommendations are accurate 50% of the time, or about equal with a coin toss.

However, the shorter the time frame, the more useful technical analysis becomes. If you analyze intraday trading, almost all very short-term movements can be explained in technical terms. This is entirely how day traders make their livings.

It's a classic case of if enough people believe something, it becomes true, no matter how dubious the underling facts may be.

So it behooves us to pay some attention to the charts when executing trades.

Talk to old time investors and you will fund that they use fundamentals for long term stock selection and technicals for short term order execution.

Talk to them some more and you find the best fundamentalists sound like technicians, while savvy technicians refer to underlying fundamentals.

Get the technicals right, and you can provide one additional reason for your trade to work.

5) The Calendar is Favorable

There is one more means of assuring your trades turn into winners.

According to the data in the Stock Trader's Almanac, $10,000 invested at the beginning of May and sold at the end of October every year since 1950 would be showing a loss today.

Amazingly, $10,000 invested on every November 1 and sold at the end of April would today be worth $702,000, giving you a compound annual return of 7.10%.

Of the 62 years under study, the market was down in 25 May-October periods, but negative in only 13 of the November-April periods, and down only three times in the last 20 years!

There have been just three times when the "good 6 months" have lost more than 10% (1969, 1973 and 2008), but with the "bad six month" time period, there have been 11 losing efforts of 10% or more.

Yes, it may be disturbing to learn that we ardent stock market practitioners might in fact be the high priests of a strange set of beliefs. But hey, some people will do anything to outperform the market.

It is important to remember that this cyclicality is not 100% accurate, and you know the one time you bet the ranch, it won't work.

So there we have it.

Adopt these five simple disciplines and you will find your success rate on trades jumps from a coin toss to 70%, 80%, or even 90%.

In other words, you convert your trading from an endless series of frustrations to a reliable source of income.

If a potential trade meets only four of these five criteria, please do it with your money and not mine. Your chances of making money have just declined. And I bet there are many options traders executing trades all the time that meet none of these criteria.

Get the tailwinds of the economy, your industrial call, your company pick, the technicals, and the calendar working for you, and all of a sudden you're a trading genius. It only took me a half a century to pull all this together. Hopefully you can learn a little bit faster than that. I hope it all works for you.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.