The Art of War Part 2: Win First, Then Fight
In Part 1 of this guide, you learned what options are and some of the fundamentals of trading them. This basic knowledge is your primary weapon, and you learned how to use it. Part 2 will show you how to become proficient in it – the next step on the path to mastery.
If Part 1 taught you how to fight, this section will teach you how to win a battle.
There are an endless number of options trading strategies. Many are complex and require an intimate knowledge of options. If you’re a beginner, however, fear not. You don’t need to be an expert to employ these basic strategies efficiently and profitably. Start using them and the other principles in this guide and you’ll be well on your way to earning profits.
Time Is Money
Time is money, the adage goes. That couldn’t be truer when it comes to options trading.
Since options have an expiration date, most people associate time with that aspect of options trading. And it’s true that the time to expiration is arguably one of the most important components of options trading and investing.
After all, once an option expires, so do your chances of making money.
Between 9:30 a.m. and 9:50 a.m., stocks trade at their most unpredictable levels of the day. This is when you can find the best opportunity – if you know where to look. Aside from some aberrations, the normal trading pattern goes something like this: Stocks react to overnight news, earnings results, geopolitical news and market pundits in the hours and minutes leading up to the open.
Then the stock market opens with a ton of investors making bets driven by nothing but news. This is impulse buying and selling.
Sure, you might want to exit a position after bad news or enter a position after good news, but know that everyone else is thinking the same way. It’s like a herd of elephants heading for a French door-sized entrance or exit. For most, it’s confusing and chaotic. However, the results can work to your advantage – if you follow along in The War Room.
The market makers – those in charge of setting the prices based on supply, demand and experience – make the prices. If they see a ton of buying, they raise the price quickly, maybe even before the shares open. If they see a ton of selling, they drop prices sharply.
That’s a look at the stock market from the inside. Now imagine what the options market is like.
It’s a market where prices are derived from the underlying stock price and trade on leverage (think of options as stocks on steroids). If a stock moves up a couple of percent at the open, the option may move up 10%.
The options pricing model incorporates several factors – the expiration date, the volatility of the shares, the volatility of the market and a couple of other lesser inputs. If any of these inputs are magnified in either direction, the effects on an option price are magnified as well.
At the market open, the pressure to price options is huge on market makers, and they are not willing to take the risk until shares prices have settled down. On a normal day, that takes about 20 minutes. On a volatile day, it could take all day.
The way you know this is to look at the spread at the open and the spread later in the day. At the open, the difference between the bid and ask could be anywhere from 30% to several hundred percent. By midday, that spread could be much smaller.
There are few feelings better than knowing you have an edge in the market over your fellow investors. Most people don’t believe you can have an edge. They believe in a market where all information is available to all investors all the time, where the price of a stock is always “perfectly” priced.
Then comes a bombshell and suddenly the rules are radically different!
It could be an accounting investigation, a positive trial from a cancer-fighting drug, a huge contract win, earnings that blow away the street, a takeover, or any combination of these or similar events. For investors, these are the holy grail of stock announcements… if they own the stocks, that is.
Others look at these announcements and wish they knew the information ahead of time. In most cases, someone does know before something is going to happen. In many cases, they know months before something happens and don’t just sit on the information. They buy stock with the information and then wait patiently for the news to come out – news that they know, most of the time, will eventually emerge.
It sounds illegal, doesn’t it? Maybe too good to be true? It’s not. It’s perfectly legal, and it happens every single day. If you know where to look, you can be privy to this type of trading as well.
It’s called insider trading, but it’s the legal type. And when an insider buys the shares of a company, they must report the purchase to the Securities and Exchange Commission within a couple of days, by law. That’s one of the “tells” that we use to decide if the opportunity is worth taking.
There are other, more important, tells that you need to know about.
Most insiders buy for one reason: They know something good is coming down the pike. Other insiders buy because they know people are watching insider buys and they buy to influence the market for their shares.
We are going to focus on the first type and a fictional character we’ll call Joe. Joe buys because he knows something is going to happen. He may not know the exact date, but he doesn’t care. He knows that the shares he buys are going to scream higher when that announcement or event occurs.
What we’re looking for is that first insider to buy, and buy in size. This means they buy thousands of shares on the open market with real money. This real money has to be in the tens – if not hundreds – of thousands of dollars. They can’t be any insider either. They have to be an executive at the company, not a director. Executives are privy to much more relevant information – the kind that can move a stock.
The next thing we look for is at least two more executives buying shares on the open market with size and at market prices. Then we want to see some director buys. In all, we want to see at least three to five insiders buy shares in size before looking at the stock. If there are only three or four, we still want a lot of size and executive participation.
Sometimes the underlying company is not doing well and is a turnaround candidate. This is the most dangerous type of insider buy, and we will note that the buy is very speculative. In this case, the returns can be phenomenal, but so is the risk. Don’t buy too much on pure speculation!
Other times we’ll look at companies in the healthcare or biotech sector. When insiders buy here, it’s usually because they have good information from clinical trials, long before the FDA or the public knows about the trial data. While not as speculative, these types of insider trades do hinge on a final outcome of a trial, so they carry more than average risk.
There might be situations where there are massive buys by insiders – in the millions of dollars. But those buys are usually by shareholders who already own a large chunk of stock. This type of buying, while attractive, also makes us wary. These are super long-term investors – value investors who can wait years.
We’re not interested in waiting years. Most insider trades that meet the tests we described above come to fruition in a year or less. Those are the trades we want to focus on. If options are not available or are too expensive, we’ll look to the shares themselves.
Which Companies to Sell Puts On?
Put selling should be no different from any other type of investment when it comes to which companies you are willing to own.
If you’re an aggressive trader, you’ll sell puts on companies that are highly volatile. If you’re the “buy and hold” type, you’ll choose the steadier names that have a long-term track record with slower growth. If you’re an income investor, you’ll look to a company that is a steady dividend payer or one that is growing dividends.
Each type of company will present a different set of rewards and challenges.
Growth companies, such as tech and biotech companies, will deliver large premiums upfront when you sell puts. If you catch these companies early in the cycle, you could be in for a monthly treat, as you can sell puts on these companies every month and collect income.
NVIDIA (Nasdaq: NVDA) is a good example, as its shares have almost tripled in the past year. That’s the reward. The challenge comes with volatility. Companies like NVIDIA and Amazon (Nasdaq: AMZN) can rise or fall by double-digit percentages in a week. So focusing on just the monthly income could be a huge mistake if you are not a true believer in the long-term potential of the shares.
You should ask yourself if you really want to own Amazon for $1,200 per share because that is what you might be on the hook for.
The next type of company is the steady type. Take a company like Procter & Gamble (NYSE: PG). You can expect steady, single-digit growth from this purveyor of everything consumer-related. The put premium you will receive from selling puts on Procter & Gamble will reflect that safety and low risk. Hence, the premium will be much lower than that of an Amazon-like company. On the flip side, Procter & Gamble is not going to fall or rise 10% after an earnings announcement.
The third type is the dividend-paying company. These tend to be the least volatile in a normal market and often sport very low premiums when it comes to put selling. Their downside is normally limited by their ability to pay and grow their dividends.
A steady dividend payer will have slower growth, while dividend growers may provide both upside and income. The former will have lower put premiums. Good examples of steady dividend payers are companies in the utility sector and the telecommunications sector.
Ultimately, you want to sell puts on companies that you would normally own or buy. If, for example, you’re looking to load up with tech shares “on the cheap,” you’ll pull in a ton of income knowing that the risk you’re taking is owning a lot of stock in that sector.
An important rule for put selling is that you must be willing to own the shares that you sell puts on because there is always a chance that you will have to buy the underlying shares. That’s our mentality, and we welcome the opportunity to buy great stocks on the cheap!
The Two Most Critical Times for an Options Investor
Investing in options is presumed to be more difficult than investing in stocks. So is changing your oil for the first time, or doing so without the right tools. Once you’ve done it a couple of times, however, it’s no longer daunting.
Yet unlike investing in stocks, options investing does have a unique set of rules. The rules are logical and straightforward. Consider Monument Traders Alliance as your personal toolbox!
One of the most quoted rules when it comes to buying options, whether they be puts or calls, is that when buying an option, you have the “right but not the obligation” to buy or sell the underlying stock at the strike price. That is mostly true, except for one occasion.
When options expire, they expire either “in the money” or “out of the money.” For example, if you own the right to buy AT&T (NYSE: T) at $30 and the shares close at $29.99 on the expiration, your option will expire worthless and you don’t have to do a thing. Your obligation is over.
But if AT&T closes at $30.01 at expiration and the options you own are still in your account (meaning that you didn’t sell them prior to expiration), then you’re in for a decision. Now, that decision could be pleasant or unpleasant, depending on your objective.
If your objective was never to own AT&T, then you’d simply want to let your options expire. Otherwise, you’ll be assigned the corresponding number of shares for which you hold options. So if you held 10 contracts, you will be assigned 1,000 shares. Come Saturday morning after expiration, you will see 1,000 shares of AT&T in your account and $30,000 (1,000 x $30) less cash in your account. Your broker will normally send you an email or other message alerting you to the possibility – so be sure to properly communicate your intentions.
For most people, this is not an issue since they monitor their accounts regularly and are aware of their positions. But there are occasions, especially in a volatile market, for all sorts of things to happen at the last minute. The solution is to always check your account at 3:30 p.m. on the afternoon of expiration.
There’s a second critical time for put sellers like us. When you sell puts, you are obligating yourself to buy the shares of the underlying stock at any time at or before expiration, if you can buy the shares at the strike price. Now, if the shares are trading above the strike price, you wouldn’t sell the put because you could immediately sell the shares in the market and pocket a profit.
However, and this normally occurs at expiration or a few days before, if the stock is trading below your strike price, you will be assigned the shares and you will have to pay for them.
The way out is to buy back the options that you sold if you don’t want to have that obligation anymore.
Choose the type of options strategy that’s best for you. The broker cares only that you pay for it.
[Note: Very rarely do we allow options to expire worthless in The War Room, so the section above is purely for educational purposes. By in large, this will not be something you need to concern yourself with while trading with us in the live trading room.]
“Opportunities Multiply as They Are Seized”
These strategies and principles will get you started. By the time you master them, you’ll be raking in money left and right. Once you get in there and get a feel for options trading, it won’t take long before you’re an expert yourself. Then you’ll be ready for the advanced strategies in Part 3 of this introductory report. We just showed you how to win a battle. Next time you’ll learn how to win a war.