Today I am going to continue my series on selling options. Here are the topics I have previously covered:
I have made my case to why selling options is in your best interest as an investor. As an investor I am not looking for thrills or a quick dollar. I want consistent profits in order to grow my wealth and it is my belief that one of the best strategies to accomplish this is through selling puts in the stock market. If you need a refresher read the articles above.
Let’s get straight to the strategy!
When you sell a put you are taking on the obligation to potentially own the stock. Therefore I never sell puts on a stock I am not willing to own.
When looking for candidates to use in my put selling strategy I take 4 things into consideration:
- Cash Flow / Book Value (Fundamental Analysis)
- Support Lines
- P/E Ratio
- Trend (Technical Analysis)
Cash Flow & Book Value
A short and quick way to analyze a company fundamentally is to determine their Free Cash flow (Operating Company) or Tangible Book Value (Asset Company). Microsoft and Cisco are considered operating companies while Wells Fargo and Bank of America are considered asset companies. I never want to pay a premium for a stock, I always want to own a stock at a discount to its value. Therefore for operating companies I typically look for companies trading between 8 – 10 times free cash flow and for asset companies I look for companies trading under book value.
Support Lines
I like to sell puts as close to the support line as possible. This doesn’t always need to be the case but I have found the closer the stock price is to the support line coupled with positive technical indicators, the higher the rate of success.
P/E Ratio
Always take into consideration the industry average for P/E Ratio but for simplicity here are the basics for P/E ratios:
- P/E Ratio of 10 = Undervalued
- P/E Ratio of 15 = Fair Valued
- P/E Ratio of 20 = Over Valued
Typically I like for P/E Ratios to be under 12, as always this metric is not the end all be all indicator but it helps me paint a picture to the stocks current value.
Trend
When selling puts you have to ensure you are not trying to catch a falling knife. I look for a positive trend and positive indicator before initiating my trade. This is imperative in reducing your risk substantially.
Real World Example
Back in early 2012 MGM Resorts suffered a significant sell off which resulted in 33% of its value evaporating in a matter of months.
I monitored every bit of this massacre. The first thing I always do is conduct a quick fundamental analysis of the company. As a casino gaming company I deemed it an operating company. At the time MGM had free cash flow of $1.20 per share, that let me know my maximum target price was $12.
The next thing I did was identified significant support lines.
As you can see the stock found footing around $9/share for the last two years. Please make no mistake support lines can always be broken but it gives you a price action barrier for the stock. At this point I knew my maximum buy up to price for MGM was $12 and the stock had the potential to trade all the way down to $9.
Working through my routine, I did a quick search of Morningstar to view MGM’s P/E ratio only to find out that they had a negative P/E Ratio. Without getting into too many details this made me take a deep dive into why the company was operating at a loss. At the end of the day remember no one indicator is king, therefore I took this indicator with a grain of salt.
So in summary I knew my maximum buy up to price would be $12, the major support line was $9, and the P/E ratio wasn’t relevant in that situation.
Now all I needed to do was wait for a positive trend to form or see a positive indicator.
I was lucky to get both in early August. If you take a look at the chart above you will see that the MACD indicator started moving upwards in June while the share price of MGM continued to decline. This is called positive divergence, which in short means a reversal may be imminent. I took this new information and coupled it with the $9 support line that I previous discovered and decided to sell a put on MGM, I had so much confidence in my analysis that I sold a put on MGM more than once.
Both trades turned out to be profitable results in consistent profits for my portfolio.
Do you have a checklist for identifying successful option trades? Specifically on selling puts?
Here’s to our Wealth!
February 7, 2013 at 2:37 pm
I need to learn a bit more about the technicals because it will help to figure out better potential entry points. I usually just look for something that will give me a 10%+ annualized return if it expires and a cost basis that is something I’m comfortable with based on my fundamental analysis. If I can find that and I’m fine owning some more shares then I’ll strongly consider selling a put. I did this with KO about 2 weeks ago. I’ll be getting a 11.80% return if it expires or a cost basis of $36.13. I wanted the cost basis to be a little lower but who doesn’t. Also, if KO raises the div by 7% then my YOC will be 3.02% which is a good yield for KO.
February 8, 2013 at 12:00 am
That’s a good strategy JC. Personally I reinvest all the dividends from my Dividend Kings and keep the rest of my brokerage account in cash specifically to sell puts on companies I would like to own. Like you I’m looking for an annualized yield over 10% in most cases I’m able to get an annualized return of 15-20%
February 7, 2013 at 7:16 pm
Marvin, this is great write up adding more metrics to reviewing the stock candidates for put selling. When I started trading options I always was worried biting my lips and hoping for not being executed, so as soon as I realized (and learned) that the best way is selling puts against companies you want to own. That gave me a great peace of mind. Now I do not care. I either get the company at quite nice discount or keep the premium and continue selling more puts. What a relief! For that I do not even watch too many other metrics, since I either get assigned, which I wanted in the first place anyway, or not, so I just evaluate whether I want the stock or not (dividend paying stock).
Also from the previous posts about MGM I couldn’t find the result of the trade, did you end up buying the stock (exercised) or not? Also thanks for stopping on my blog. I am thrilled since this weekend I will be updating my blog to a new dress…
February 8, 2013 at 12:05 am
Not worrying about owning the stock takes so much stress off of the trade. I remember being so tense I couldn’t sleep when I was trading the euro.
As for the MGM I ended up not getting put the stock and was able to keep the premium on both trades.
I look forward to seeing your new look. Keep up the great work.
February 7, 2013 at 8:02 pm
I start by asking myself would I buy the stock at that price? If the answer is yes, then I look into how potentially undervalued is the stock. What’s the PE? How is it trading against its 52 week range? It’s not as formalized as your system, but its working so far.
February 8, 2013 at 12:07 am
Great points! I take the 52 week range into consideration as well. I cannot remember a time when I have sold a put on a stock that was at or near a 52 week high. In that situation I typically sell a call.
February 8, 2013 at 10:57 am
Love reading your posts on options, and some of your technical analysis behind the transactions you end up making. Pretty new to options myself, so it is nice to have some additional resources to follow.
February 11, 2013 at 9:30 pm
Thank you for the kind words. Hopefully I can keep bringing you new ideas and strategies. Let me know if you have any questions.
February 9, 2013 at 3:47 am
This is an awesome combination of technical and fundamental analysis, so glad I’ve come across your site. I’ve signed up to your monthly newsletter
. I’m an equities freak so options is new territory for me but I’ll take a look around your site for more.
All the best
David
February 11, 2013 at 9:31 pm
Thanks David. I look forward to seeing you on the blogosphere. Hopefully by the end of my options series you’ll feel comfortable enough to start making some trades.