Increase your odds of making money from selling options

Today I want to look at a few simple ways to increase your odds of making money from selling options.

Option selling, i.e. selling cash secured puts, is my primary strategy to generate income from my trading portfolio. I talked about the details of my strategy in this post. The strategy is simple enough but obviously the success of the strategy is dependent on which stocks you choose and the strike prices for the options. It is also critically dependent on having a proper risk management strategy but I’ll leave that topic for another post.

A common way of choosing stocks and strike prices for option selling is to focus on undervalued stocks and prices in which an investor would be willing to own the stocks. This is an OK approach to start but can be improved upon dramatically. The biggest problem with focusing on value is that an investor’s estimate of value in a stock can often be quite wrong. Or just that the market’s estimate of value, even though possibly very misguided, can stay that way for a long time. Remember that the market can stay irrational a lot longer than you can stay solvent.

Fortunately, the market sends signals through price action that can guide an investor in choosing stocks and strike prices for option selling. There is an old trader adage that says that ‘price is truth’. The price action, the tape, can tell you a lot about what investors think about a stock. By learning how to read some simple price signals and investor can increase their odds of making money from selling options.

Two simple ways to increase your odds of making money from selling options:

First, the trend is your friend – pick stocks that are in uptrends. By selling options you make money when the stock goes sideways or up (or even slightly down). Selling options on stocks in uptrends will increase your odds of making money. I like to use the 50 and 200 day SMA to identify uptrends. Ideally, I’d like to see the stock above both SMAs. An even more strict criterion is to have both SMAs rising but I will accept less especially when a stock in reversing a trend. Sure, a trend can reverse but momentum is one of the most powerful forces in the market.  Lets take a look at an example where it was almost impossible to make money selling options. Below is a chart of Sprint (S). I can make a compelling argument that book value for the stock is least $5 and was through the whole time frame of this chart. And most likely I’m right but who cares? The market obviously started to disagree in late July of last year. Selling put options in this stock since then has been a futile exercise. It’s been in a persistent downtrend for a a while.

Second, identify resistance and support levels to pick the right strike prices. Stocks hit price areas where they experience resistance on the way up and support on the way down. These resistance and support levels are prices where there is extra supply and demand in the market. Ideally I want to choose a strike price for my options below a level of support. If/when those support levels hold on any pullback that will protect my options position. On the other hand, I don’t want my option strikes to be close to resistance levels. Stocks will often pull back at key resistance levels which will negatively impact your option position. Lets take a look at a very recent example of using a support level to initiate an options position. Below is a chart of Aflac (AFL). Since its Oct low the stock has been on quite a tear. Recently the stock broke out through a key level of $47 on increased volume. The $47 has been a key resistance level since July of 2011, then became a key level of support on the breakout. On Jan 20th I initiated an option position in AFL by selling Feb 12 $47 puts for $1.60. As you can see $47 has held as support since that time. What is hard for many investors with such an approach is that often waiting for higher prices in a stock increases your odds of making money. But that’s how markets work many times. Resistance levels, once broken, turn into levels of support.

That’s about it. Narrowing your universe of put selling opportunities to upward trending stocks and paying attention to key support/resistance levels can increase your chances of making money with this strategy. You can extend the approach to include technical indicators such as RSI, MACD, Stochastics, etc.. as you gain more experience but don’t get too complicated. Mastering a few indicators is much better than indicator overload. One of the best places to learn about indicators is stockcharts.com. They have a great tutorial section.