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Options Trading: How to Avoid Chasing Prices

With the market, or at least the Russell 2000 and Nasdaq Composite, back at all-time highs, investors are starting to get that old FOMO (Fear of Missing Out) feeling. But rather than chase prices higher, savvy investors should consider options trading as a way to stake a moderately bullish position, generate income, and establish a price level at which they’d be happy to buy the actual shares.

Kirk Spano has a good primer on how he prints money by selling puts.  Here is his take:

When you see something interesting on the menu that you think might taste great, do you ask a few questions and then try it, or, do you say, “Nahhh, I might like it and then I’d want more, so I better not try it.”

Options are like that new dish on the menu for a lot of people. Unfortunately, many never will try the dish. And, they’ll never get to experience what regular option traders have come to understand: Options, used properly, can reduce risk, generate income, and increase total returns.

Having talked to hundreds of people about options trading, I know the question that gets asked by almost everybody: “…but aren’t options risky?”

The answer is that options trading is only as risky as you want it to be, and in most cases, less risky than actually buying the underlying stocks. In fact, the reason options were invented was to manage risk.

Whether you are seeking to build growth positions while mitigating risk or a retiree who wants both income and growth, this simple strategy can be a core staple to your investment process.

Selling Cash-Secured Put Options

One of my favorite options trading strategies is a very simple trade that generates portfolio income and reduces equity risk. Namely, selling a cash-secured put.

I am going to work through several examples of trades that I have on right now to demonstrate why this simple strategy is so effective. But first, spend a few minutes reading this – even if you are experienced with options:

If you are a beginner, go back to that article early and often.

 Related: This is a Risky Part of the Business Cycle – Here’s How to Protect Your Portfolio. 

 

The key takeaway you should have is that when you sell a cash-secured put, it’s a lot like setting a limit order to buy a stock. A big difference however is that you get paid to sell a cash-secured put. You get nothing for setting a limit order.

To make the point clear for you, here are some examples for stocks that are on the Very Short List (of companies that can lead in the next decade) at my investment letters. I’ll work through this example in full and you can apply to the stocks on the chart below.

CenturyLink (CTL): If you have been reading me, then you know that I like CenturyLink’s future due to the expansion of communications in the “smart everything world” that is developing.

Right now, the stock is trading at about $18.32 and the 200-day moving average is at $17.76. Interestingly, the 50dma is just making a “golden cross” above the 200dma, making it a pretty attractive stock technically.

I already own some stock, but if I could buy it a bit lower than today’s price, I’d be inclined to buy more. I could set a limit order at the 200dma of $17.76, which is normally a pretty good price to buy at when a stock is starting to move up (or in an established uptrend). My other choice would be to sell a cash-secured put that generates income and gets me an even lower cost basis on a new batch of CenturyLink stock.

In this case, I can sell the CTL July 2018 $18 put for about 80¢. What does that mean?

Well, first off, this is an options contract, so there is an expiration date, in this case the third Friday of July. Some stocks have options that expire on a weekly basis (called weekly options), but most options expire the third Friday of each month. So, the CTL July 2018 $18 put expires on Friday, July 20th.

Between now and the expiration date, if the price of the stock is under $18, the person who bought the put from me, can make me buy their CenturyLink stock for $18 (the strike price). I am cool with that idea. I’m especially cool with it because, remember, they already paid me an 80¢ premium, meaning my net cost on those new CenturyLink shares would be $17.20, which is far below today’s $18.30 and even the possible limit order I would have put in at $17.76.

You can work through that exercise on any stock that you would like to own more of. The very cool thing about selling cash-secured puts is that it becomes recurring revenue. Why? In my experience, by using the 200dma as your target area for setting strike prices on stocks that are in a neutral or positive price trend (this is important, we don’t want to try to catch falling knives, more on this later), about 3/4 of options simply expire without assigning you any stock.

 Related: This Options Trade Can Hedge Your Bets in a Risky Market. 

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