Rule 2: Aim for singles, not homeruns Of course, even casinos lose money occasionally. And sometimes those losses can be significant. The same thing applies to selling options. So, I generally like to reduce my risk even further by selling short term options - those expiring within a week to a month - with a very high probability of expiring worthless. This happens when the options contract is out of the money (OTM). To use a baseball analogy, this approach aims to hit singles rather than doubles, triples, or home runs. Your potential returns will be smaller, but your chances of success will be much higher. That's Rule 2. That is one of the areas where Options360 - TradeSmith's powerful suite of options trading tools - really shines. Specifically, Options360's proprietary Probability of Profit (POP) metric provides the most accurate assessment of how likely a trade is to succeed that I've ever come across. When selling options, the POP indicates the probability that a particular option will expire OTM (worthless). Here's an example of an option with a high Probability of Profit and a 2% potential return found by our algorithm. (Note that this isn't a recommendation, just an example.) For this example, Petco (WOOF) stock was trading at about $4 in June, and the strike price of this put option was $2.50. If WOOF stayed above $2.50 through expiration on June 21, this put option would indeed expire out of the money, and therefore worthless. If you were a seller of this option, that means you would keep the $5 in premium for selling the option, then move on to the next trade. And Options360 sees a 99% probability that it'll work out like this. I generally look for trades with at least an 80% POP, but 90% or greater is ideal. However, if you're not an Options360 subscriber, you're not entirely out of luck. You can use an option's "delta" in a pinch. If you're unfamiliar, delta is one of the five so-called "Greeks" - along with theta, gamma, vega, and rho - that measure various aspects of an option's price. Delta measures how sensitive an option is to changes in the price of its underlying stock. However, you can also use it to estimate a short-term option's probability of expiring in the money. Specifically, you'll generally want to target short-term options with deltas between 0 and 0.10 when selling covered calls, and 0 and -0.10 when selling puts. It's not perfect, but these ranges should roughly equate to a POP of 80% or better in our system in most cases. Rule 3: Stick to high-quality companies for an extra measure of safety However, even if you strictly follow the first two rules, there is always a tiny chance the option you sell will expire in the money. If you were selling covered calls instead, this isn't necessarily a problem. It just means the underlying stock may be called away from you, and you'll be forced to sell. But when selling put options, you may be put (required to buy) shares of the underlying stock. So, my third rule is to sell options on high-quality companies that you would be happy to own for a time if necessary. These stocks tend to perform better and be less volatile, which means you're less likely to suffer a significant, permanent loss of capital even if you're required to buy shares for more than their current price. I hope this breakdown helped show you how powerful an options-selling strategy can be in the right hands. So long as you put the odds on your side by being a seller, targeting high-probability trades, and sticking to quality businesses, then you're trading options far better than the 99% of traders who simply use them to speculate. Like I said, you can study all about delta and the other Greeks if you want to start doing this yourself. But before you do, I recommend checking out what our comprehensive options-analysis software, Options360, has to offer. This software helps you create that 1%-per-week trading plan that can outperform the market even in hugely positive years like 2023 - and what 2024 is shaping up to be. To learn more about Options360, check out my "Brokerage Bonus Cash" Summit on Tuesday, August 27, at 8 p.m. ET with Chief Investment Strategist Alexander Green and Chief Income Strategist Marc Lichtenfeld. The event is entirely free to attend. Simply click here to save your seat. All the best, Keith |
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