Options Strategies and Trades

• It is not enough to do your best; you must know what to do, and then do your best. —W. Edwards Deming

Preferred strategies – Sell cash secured puts for stock you want to own at low extremes.  We will also sell covered calls on stocks once we own them.  Don’t trade until the technicals and the fundamentals both agree – then you can act with authority, and with certainty, and patiently sit tight.

Cash Secured Puts: The option math favors selling slightly out-of-the-money (higher IV than ATM, but still high time value), shorter-dated options (highest Theta burn).

• Stocks you want in your portfolio, but don’t currently have. Use stock screens for these evaluations – some examples are listed below.
• IV – elevated. The ideal timing to sell options on stocks is when the VIX is above twenty and the company’s stock has just experienced a short-term negative shock.
• Best used when Total Market is Neutral to slightly Bullish if you want the stock. Ok in a strongly Bullish market for income.
• Directional bias is flat to bullish on the Stock.
• Only sell Puts when there is a well-established base (support level).
• Sell the Put slightly below the base – delta .30 to .40.
• You should be targeting an effective price well below the stocks intrinsic value – need a Margin of Safety.
• Be careful to monitor early exercise risk – should have at least $0.10 time value remaining – watch out for Dividends.
• Edge: Fundamental analysis on what stocks you want to own – buying with a Margin of Safety. Collecting the volatility risk premium to increase the Margin of Safety.

One word of caution:   Naked put writing is a bullish strategy and does not do well in bear markets.

Covered Calls:  The option math favors selling at-the-money (higher IV than OTM and highest time value), shorter-dated options (highest Theta burn).

• Best used on stocks already in your portfolio that are trading above their intrinsic value.
• Directional bias is flat. For stocks in your portfolio you think are going to rise – you would be taking profit off the table.  For stocks in your portfolio you think are going to fall – best to simply sell them.
• Be careful to monitor early exercise risk.
• Sell the Call at the base – delta .50
• Consider rolling in the money options you have sold to the next Month for additional revenue.
• Edge: Fundamental analysis on what stocks you own. Collecting the volatility risk premium. 

Tools:

• Stock Screeners – to select Stocks or ETF’s based on established set-ups (i.e. Trading below fair value )
• Charts to establish support and resistance levels.
• Trading Journal – keep track of each trade, why you place it, and how it did – this feedback loop is essential to your success.

Making Trades:

• When considering a selling or buying strategy, valuation and implied volatility should be your guide.  Buying in high volatility/high valuation market or selling low volatility/low valuation market should be avoided.
• It is best not to sell premium with a VIX under 20.
• For stocks and ETF’s – research all available news including earnings announcements, dividends payouts, etc… to evaluate their effect (if any) during your trade term.
• For put sales – confirm the strike price you are selling less the credit you receive is below the stocks intrinsic value.
• For covered calls – confirm that there is no strong trend, or that the trend is losing strength.
• Have a complete plan – before you place the trade. Since your timing will never be perfect, the market will be against you at some point – this is your last chance to think clearly about the trade.
• When you take a trade off, select the best new trade available, given the new market environment to replace it.

Stock Screens:

Our stock screens should not only help us select companies with signs of a durable competitive advantage and a margin of safety but also help us pay as low as possible from a valuation and enthusiasm standpoint, creating a behavioral advantage that should increase the probability for outperformance.

• Stocks to Own Screen:  Based on the Book: The Five Rules for Successful Stock Investing by Pat Dorsey

1. 1. Morningstar analysis available.
   2. Low fair value uncertainty.
   3. Wide moat.
   4. Morningstar rating 4 or more stars.
   5. Financial Health Grade >= B.

• 52 Week Low Screen:  Based on the book: The 52-Week Low Formula by Luke L. Wiley

1. 1. Morningstar analysis available.
   2. Less than 5% above its 52 week low.
   3. Greater than or equal to narrow moat.
   4. Free cash flow/enterprise value greater than 3% (should be above what the 10 Year Treasury Bond is yielding).
   5. Financial Health Grade >= B.
   6. Forward P/E <= 20.
   7. For candidates that have passed all the filters, review the individual stocks Return on Invested Capital (ROIC) for the previous 10 years to select the best long term candidates.

• High Dividend Stock Screen:  Based on the book: Get Rich with Dividends by Marc Lichtenfeld

1. 1. Morningstar analysis available.
   2. Dividend Yield % > = 4.
   3. Dividend Growth % Past 5 Years > = 10.
   4. Payout Ratio Trailing 12 Months < 75
   5. Morningstar rating 4 or more stars.
   6. Financial Health Grade >= B.
   7. Forward P/E <= 20.

Notes:

• For High Dividend Stocks, it is best to sell cash secured puts right after the current ex-dividend date. The stock price usually discounts the amount of the dividend and the naked put premium will increase for the seller.  Also, we would want any cash secured puts we sold to expire before the next ex-dividend date.
• Your covered calls on the other hand, are best placed before the current ex-dividend date. If it has already expired, make sure the covered call you sell expires after the next ex–dividend to lock in the dividend payment as a stock holder.
• Idea – for High Dividend Stocks, consider buying 500 shares of the stock a few days before it goes ex-dividend and then sell 5 at the money calls and 5 out of the money puts 3 Months out. If everything goes perfect, you get the call premium, the put premium, and the dividend.  Worst case, you end up owning 1000 shares of a stock just before its next ex-dividend date – so you can sell 10 more covered calls.  Also, you can think about selling the initial puts after the ex-dividend date.