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
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.
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.
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.
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!