Friday, April 3, 2009

Mail Time

TIA asked me a few questions that I wanted to respond to in today’s post.

"Excellent resource and good examples. I not only learn from your posts but also hope I can make some dough...question for you: You like to play collecting the premiums strategy, but how do you know what stock to get into to execute this strategy? Do you also do fundamental research or let the charts do the work for you? Also do you go for stocks above a minimum price such as say $20 . Also do you go for 6months options if you want to collect the premiums and at the same time, if stock moves against you, you don't mind buying it at the strike price? (e.g. you sold a naked put)"


Hey TIA,
Thanks for the questions. See my responses below:

"You like to play collecting the premiums strategy, but how do you know what stock to get into to execute this strategy?"

I’m assuming when you say “collecting the premiums strategy” you’re referring to strategies like selling naked puts, covered calls, and perhaps credit spreads (bull puts and bear calls). My preferences for picking stocks differ on each strategy, so I’ll assume you’re asking about naked puts.

First off, I’ve already written quite a few posts on selling naked puts (click on the hyperlink if you want to see them). Here’s my naked put selling summary:

1. I only sell naked puts on cheaper stocks/ETF’s (probably around $30 or below). If it’s a higher priced stock, I’ll simply sell a put spread (bull put spread that is), to limit the risk and margin requirement.
2. I prefer selling options with 3 to 6 weeks to expiration to exploit the higher time decay
3. When choosing which strike price, I sell as far OTM as possible, but still bring in sufficient credit (around $1 for me)
4. Three reason I’ve used USO in my examples are:

a. It’s an ETF that tracks a commodity (crude oil), which I know isn’t going to $0. Selling a naked put on a financial is one thing, but using a commodity ETF is something different altogether IMO.
b. Cheap price
c. Wouldn’t be the worst thing if I get assigned.

"Do you also do fundamental research or let the charts do the work for you?"

I primarily focus on the charts. The cornerstone of technical analysis is that “Market Action Discounts Everything”. In other words, all variables that can possibly influence the price such as fundamental, psychological, political factors, or anything else- is already reflected in the price of the security. If that’s the case, then all we really need to do is analyze the price action. The following mantra has helped me in my trading, “Focus on the what, not the why!” The price action portrays the “what”, the news and market pundits try to pontificate on the “why”. Leave it to the jugheads to try to explain every little market move… to me it causes too much analyzing, resulting in second guessing when the charts have already given a solid signal.

"Also do you go for stocks above a minimum price such as say $20."

This is completely personal preference. Through your practicing you should get a good feel of what price range you want to focus on. Sometimes it depends on what option strategy you’re implementing. For my personal price filters, I tend to stay away from stocks under $20 or $15. I don’t mind trading higher priced stocks or indexes though, as they provide a lot more strike prices to choose from when spread trading. I did a previous post on the differences between stock and ETF/index options that I’d recommend taking a look at.

"Also do you go for 6months options if you want to collect the premiums and at the same time, if stock moves against you, you don't mind buying it at the strike price? (e.g. you sold a naked put)"

Not sure what prompted you to specify “6 months” vs. say 5 or 4 month options? But here’s the rationale when choosing which month to sell on a naked put. Shorter term options experience a higher rate of time decay, usually resulting in quicker profits. Another benefit of selling short term options is that not as much can go wrong. Consider this: Can a stock drop further in 4 weeks or 6 months? Some may prefer to sell 2 or 3 month puts to bring in more premium, but this is a matter of personal preference. I’d rather sell (6) 1 month puts, than (1) 6 month put.
You don’t necessarily have to sell naked puts with the mindset that you’re going to allow assignment and buy shares of the stock. It’s very easy to exit the trade prior to expiration if the stock has dropped significantly.

Tyler-

3 comments:

Anonymous said...

This has been a great site to visit daily. Know Your Options is a great site to have as a favorite to visit every day! Thanks for your insights and training. Keep up with the posts!!! I have been a personal student of yours in the past and have always appreciated your training and knowledge. Thanks for putting up the blog!

Gene

Anonymous said...

Thanks.

I might have missed it in one of your posts, but have you discussed when you favor one strategy over other?

Bull Call spread vs. Bull Put spread? (assuming you are bullish on the move)

or

Bear Call spread vs. Bear Put spread? (assuming you are bearish on the move)

Tyler Craig said...

Anonymous,

It really comes down to personal preference. In terms of the 4 strategies you mentioned, remember that bull call & bull put spreads are synthetics (have the exact same risk-reward characteristics) if you're using the same strikes. The same could be said of the 2 bear spreads. I prefer to avoid selling deep in the money options, so if I'm using strike prices above the current stock price I'll use the bull call spread or the bear call spread (b/c calls are OTM). Conversely if I'm using strikes below the current price I usually enter either the bull put or bear put spreads (b/c puts are OTM).

Tyler-