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"Let's Get Naked" Part 2

 “Let’s Get Naked”

Part 2

“Wealth is a product of a man’s capacity to think.”

-Ayn Rand

 

 

Retrain your BRAIN!!!

Hopefully, Part 1 started the slow process of programming your mind to look at stocks a different way.  This is a hard concept to grasp.  Most traders or investors look at a stock and say, “I think it is going here”, or “my research tells me it’s going there.”  Guess what?  As an option seller you don’t care where a stock is going!  You only care where a stock IS NOT GOING!  This thought process does not come to you overnight; however, eventually you will start to look at the world of equities in a completely different light.  Before you know it, oversold, high premium, quality stocks will be your drug of choice, and you will know if a stock is right for you in a matter of minutes.  But, for that to happen, you must first “RETRAIN YOUR BRAIN.”

Selling puts on stocks is often compared to an insurance company.  The goal of an insurance company is to collect premiums each month for accepting the insurance contracts to cover the risks of those they insure.  As an insurance underwriter, you would find a low risk individual and insure their home, car, office furniture, et cetera, in return for collecting a monthly premium.  If no claim of loss is ever made, then you keep the premium and repeat the process. 

Following this business model month after month is how insurance companies make billions of dollars each year.  The key to their success is they make educated bets that their clients will not crash their car, burn down their house, or throw their business computer out the window. This educated bet is based on how these individuals have performed in the past; and just in case they do break, crash, or burn something, the insurance companies spread their risk out over multiple clients.  Pretty smart huh?  Well, this is exactly what we are going to do with our put option portfolio.  Traders will pay us a premium to accept the downside risk of an underlying stock for a short period of time.  They need protection in case the stock drops 15% in the next 30 days and we know the odds are in our favor that it won’t.  The best news of all is we pick the stock. So, just like insurance companies don’t like teenage boys, we don’t like small, cheap, unpredictable companies that we cannot properly evaluate.  We evaluate a certain number of companies each month and sell puts against those companies, spreading out our risk and collecting our premiums with a smile. 

Screening stocks and controlling our risk

Sounds good in theory, but what stocks do you use to set up a put option portfolio?  The following is a checklist we run through every time we sell a naked put; I recommend you do the same.

1.       How strong is the company?  We have no intention of owning these companies, but selling puts on fundamentally and technically strong companies put the odds of predicting their future in our favor.  Yes, insurance companies don’t like teenage boys because they are wild and crazy, but the bigger reason is they have no history, they don’t know what they will do in certain situations.  Your view on stocks should be the same.  We want stocks with a strong history to help us better predict how they will perform in the future.  Start with the top 10 stocks in each sector; they’re in the top ten for a reason.  Starting there will help you establish your own universe of stocks to sell puts against multiple times per year.

2.       Which month do I sell options in?  Always look to the next month out, or options with less than 45 days left until expiration.  Time (Theta) is always on your side, so you want to sell options during their time period of maximum decay.  This time period of maximum decay is the last 30 days of an options life.  I extended the time period from 30 to 45 days because it is hard to find any premiums in a stock with only 2 weeks left until expiration, so you must look to the next month out, which is usually about 45 days away.  If you go further than that, you’re going rogue and you’re on your own. 

3.       How far out-of-the-money (OTM) should my strike price be? As far out as you can go while still collecting a good premium.  I typically don’t sell less than 10% OTM.  If a stock’s price is at $50, the minimum strike price I would sell a put on is $45.  Note: the more volatile the stock has the farther OTM your strike price should be.  Again, I want the odds in my favor.  If I sell a put 10% OTM, that stock has to drop at least 10% in value in the next 30 days before I’ve made a bad trade.

4.       Is this a good premium? Keep in mind, the higher the premium the better chance it will hit your strike.  Strike prices 2% OTM have much higher premiums than strike prices 10% OTM because the odds of the stock going there are quite high.  It’s no coincidence a Porsche 911’s insurance premiums are higher than a Honda Accords, insurance companies know which one you are more likely to wrap around a tree.  A rule of thumb is the $0.50 premium or better, however this is subjective based on the price of the stock, implied volatility, and days to expiration.  The target we use is the premium should return 1% per month on average, or over 10% annualized.

5.       Is the stock above its 200 day Moving Average and/or sitting at its technical support?  It is statistically proven by your Draconian team that stocks have a much better chance of going up when they are above their 200 day moving averages, and/or sitting at their technical support levels.  Screen for stocks that have both of these parameters and again, you will put the odds of winning in your favor.

6.       How is the stock’s volatility?  To understand volatility, is to understand options.  I will write a “Trade School” that focuses entirely on volatility, but for now, know this: when a stock’s implied volatility (current volatility) is higher than its historical volatility that is the prime time to sell options.  Why?  Because the higher a stocks volatility is, the more premium you will receive for selling an option against it.  So, check the stocks volatility out for confirmation before you sell an option against it.  For more insight, send me an email at Kyle@DracoFund.com.

7.       Are there any earnings or news announcements on the stock in the next 30 days?  I have set up the perfect option trade, only for it to be ruined by an earnings announcement.  So the rule is, stay away from stocks that have any kind of news that can surprise the market.  There are plenty of stocks to sell puts against, so move on.  You can go to www.yahoo.com/earnings to find out the next expected earnings announcement on any stock.

8.       How much margin will this trade tie up in my account?  Naked puts require margin, which means you need to have a decent size trading account before you can write puts on any stock.  Most brokerages take 50% margin out of your account every time you execute an uncovered or naked trade.  I prefer you do what we do and write only cash secured puts, which means if every trade in your account went to zero, you would have the cash in the account to cover without getting a margin call.  However, you should know how the margin is calculated in your account so you know what is available for other strategies.  This is what the margin calculation looks like using the standard 50% for your brokerage’s margin requirement:

Margin = ((50% x Stock Price) + Option Price (Stock Price Strike Price)) x # of contracts x 100)

Plug this formula into a spreadsheet or calculate it on a trade by trade basis so you know exactly how much margin is being used when your write a naked put and how much is left for other strategies such as covered calls.

 

Let’s do a real life example:

Cash Requirement: $6,500 per contract sold.  (We will sell 3 for this example)

One of the companies that is a part of our core group of stocks that we continuously tap for profits is Freeport McMoRan Copper & Gold Inc. (NYSE:FCX).  Our research on FCX tells us that FCX has consistently performed better in March than any other month out of the year for the last 20 years,  but to make sure it is appropriate for our portfolio of options this March lets go through the checklist from above.

FCX Check List:

1.       FCX is a strong mining company that has been around for over 23 years.  It is one of the largest capitalized and most successful stocks in the Materials sector (NYSEARCA:XLB).  This meets our criteria for only writing puts against quality stocks. 

2.       February option expiration is this Friday, which means there are no quality premiums available, so it’s time to move out to March expiration which is only 31 days away.  This meets our criteria for selling options with 45 days or less until option expiration.

3.       FCX is currently trading at $75.94. The $65 strike price is yielding a nice premium.  The $65 strike price is 14% below the current price of FCX.  This meets our criteria of selling puts at strike prices 10% or more out of the money. 

4.       For being 14% away from its strike price of $65, the $1.02 premium FCX is yielding is great.  Our rate of return until expiration day is 1.57% or 19.09% annualized.  This meets our criteria of selling premiums that on average return more than 1% until expiration, or 10% annualized.

5.       FCX is above its 200 day moving average and is coming off its technical support.  It is not at its technical support , but is coming off of a recent low, which is great confirmation that the short-term trend is reversing.  This meets our criteria of stocks above their 200 day MA have a statistical better chance of making a move to the upside.

6.       FCX implied and historical volatility levels run pretty close together traditionally, however there is a slight separation between the two volatilities right now.  Implied is not high enough to be the sole reason to do this trade, but it does agree with the rest of our analysis.  This meets our criteria for checking the volatility levels of every stock we sell options on.  (See option section of your online brokerage to find volatility charts.)

7.       The news is out on FCX!  It’s earnings announcement on January 21st is what brought the stock down to its current support level, it has been rallying steadily ever since the first of February because many traders feel like it is oversold.  Keep in mind that stocks like FCX are strongly tied to the commodities markets, so it is worth taking a look at gold and copper to complete your analysis.  This meets our criteria of researching predictable news stories that can ruin our trade. 

8.       If we had to buy FCX at our strike price $65 it would cost us $6,500 per contract with cash, however the margin requirement is only $2,800 per contract.  This allows me to see how much margin is still available for other options and/or strategies.  You need to know this number to complete your risk management.

 

SURPRISE!  FCX passes the 8 point check list.  Let’s execute it.

Item

Stats

Comments

Company

FCX

Freeport McMoRan

Stock Price

$75.94

 

Put Strike Price

$65

The next technical support level

Days to Expiration

31 Days

Always sell options w/ ≤ 45 days

Premium Received

$1.02

Return of 1.57% for 31 days

Contracts

3

1 per 100 shares

Cost if put to us

$19,500

$6,500 per contract

Margin Requirement

$8,397

See formula above

Return on Margin

3.64%

Premium / Margin Requirement

Downside Breakeven

$63.98

Strike Price – Premium

Stock Acquired At

Any price below $65

You always keep the premium

Maximum Gain Stays Above $65

$306

Premium x # of Contracts x 100

Maximum Gain Drops Below $65

$306 + Increase in FCX

Premium + Stock Price Increase

Maximum Loss Stays Above $65

No Loss will occur

 

Maximum Loss Drops Below $65

$306 – Decrease in FCX

 

 

Once you enter the trade it is your job to monitor the position over the next 31 calendar days.  We set ourselves up for success, so even if the trade moves towards the downside we will receive our full premium as long as the stock stays above $65 by March 19th; option expiration day. 

It is important to remember that trades can always go against you no matter how great they look on day one, so you need to have a plan if FCX drops below $65.  The main objective in Part 2 of this “Trade School” is to generate income month after month without using too much of the cash in our accounts.  So, if FCX were to drop below $65, you have two options; close the trade out, or roll the trade to April, because we do not want to own it.  By rolling the trade to April you essentially take your loss now, but give yourself a chance to win it back the following month.  In this case, if FCX drops below $65 before March 19th, I would roll out to the April $60 strike price and use the premium I received to offset any losses I incurred in March.  Option 2 makes things really easy.  Get out if you don’t like what the stock is doing and move on.  A rule of thumb that I often use is, if a premium doubles I am most likely wrong, so I will exit the trade at that point.  With FCX if the premium for the March 65 goes to $2.04 ($1.02 x 2) then I’m out and on to the next stock.  Following these two rules will keep you out of trouble and illuminate the unlimited risk label that naked options have.  This is all part of trade management and it is important no matter what the strategy is.

In this two part series you have learned how to earn income while you wait to acquire stocks for your portfolio at an attractive price, and how to research and establish a naked put option on a stock for the sole purpose of generating monthly income. You may want to follow the 8 steps above and write multiple puts per month and establish an entire portfolio of naked puts, or you might want to write a few here and there to generate some extra cash.  Either way, the naked option strategy above will add another level of experience to your repertoire of trading strategies. 

I hope you can see why we think the naked put strategy is such an important tool for the individual trader to implement.  The flexibility and short term nature of the strategy can really benefit those traders/investors who cannot sit in front of their trading screen all day.  However, position management is crucial and it is important to know the risk of your overall portfolio.  Having said that, the next part of our mission of building a better trader is going to focus on the use of spreads in your option trading.  Spreads reduce your risk and provide you with a road map of your maximum gains and losses as soon as you enter the trade.   So, take a minute and congratulate yourself, because the knowledge you have learned in these first three schools puts you head and shoulders above the rest and all I can say to that is, “Get use to it.”



Disclosure: no positions in the stocks mentioned