Tuesday, December 29, 2009

Jan 2010 Trade Update - Watching JOYG

JOYG is finally heading back down towards support and our three qualifying indicators are all moving towards flashing the green light to pull the trigger. Just a little more patience is needed.

The beauty of the three qualifying indicators (Williams %R, Probability and Percent Profit) is that they act as a set of checks and balances to help determine the proper strike price. For example, let's take a look at the current status of JOYG which is currently our top trade candidate. Notice that the probability for the $50 Put is only 67.9% (we need 70% or higher to qualify), so we need to drop down to the next lower strike price $49. With 17 days left to the Jan expiration date we simply cannot achieve all three qualifiers if JOYG drops more in price the success probability for the $49 Put we drop even lower. We now have to look at the $49 strike price which qualifies with a 75.2% probability of success rate, and has a %5 buffer to give up if the price of JOYG drops further.

We still have to qualify for being oversold enough, and of course we want to meet our 2% monthly profit target. If one of the three indicators has to give a little I prefer to be conservative and take less profit by letting the profit percent slide a little.



If the price of JOYG drops a little more we should see its oversold rating drop below 80 and the price of the $49 Put option should go up to $1.00 to get our 2% profit. Our other four top trade candidates are not close to knocking JOYG out of the #1 position.

Monday, December 21, 2009

Jan 2010 Top 5 Trade Candidates

Here are the top 5 trade candidates for the January option expiration month.



Last months trade of the JOYG $49 Put was another 100% successful option income trade that produced a 3.6% return for the month of December (43% annualized) more on this in next post.

Sunday, September 20, 2009

The CAT Jumped! - Sept Trade Results

Last Friday was options expiration day and our option premium collection strategy which generates monthly income worked flawlessly. We wanted CAT to stay above $42 by Friday Sept 18 and boy did it ever! CAT jumped 12 points since we traded our option closed at $53.42 Friday well above our strike price.

The big jump reminds me of the day I bought some piping hot Kentucky Fried Chicken for lunch, you know the 3 piece lunch box with mashed potato's and gravy, coleslaw and a biscuit with butter and honey. I took my lunch over to my Sisters house to eat and visit with my nephews. The second I sat down to eat my Sister's cat caught a whiff of the Colonel's 11 herbs and spices original secret recipe steaming hot chicken and went MAD! It screamed with one of those famous cat screechy Rrreeeeeeooww calls and thrashed wildly at me scratching me with its claws! I made a reflexive move to half stand up in my chair and quickly grabbed my box of chicken as it started to fall toward the floor with the cat tearing at my arms. Without hurting the crazed cat I quickly flexed my arms straight and the cat popped off of me when my elbows snapped.

Seeing the cat turn towards me I sensed it would strike again! At that very moment (and not a second before) I decided the sacrifice of one piece of chicken would be worth keeping the cat a bay, so I quickly reached in the box and grabbed the first piece that my hands touched flipped it backhand out of the box aiming for it to go over the cats head so that it would see the chicken and retreat away from me. My throw was dead on and the cat did a 180 turn away from me and headed for the chicken. (Thank heavens I grabbed only a drumstick.) The cat now chomping on my drumstick was appeased and I sat back down, let out a huge sigh of relief and gave my Sister a "what the hell is going on here" look.

Apparently my Sister was trying to teach her Son's a lesson. She told them that they had the responsibility to feed the cat, because it was their cat and she was no longer going to feed it. Oh yes, then she yelled at the boys "I told you last week you had to feed the cat, you feed her right now!"

Okay with that fun little cat jumping story off my chest (and arms) back to this months trade results...

If you recall my September 1st post 'Shooting the CAT' when CAT dipped below -80 on the Williams %R indicator which signaled the stock was oversold; I sold a Put
on the $42 strike price option at 95 cents per share ($95/option contract) for a 2.26% return. With the objective to have CAT close above $42 eighteen days later on expiration day, so I don't have to purchase (assigned to me) any stock.

Before - 9/1 Trade Entry Date to 9/12:



After - 9/18 Expiration Day:


As you can see this CAT really jumped
during the 18 days that we held the option it broke through the $49 resistance level to close at $53.42 on expiration day. This was 12 point higher then our strike price and 10 higher then when we entered our trade. A huge margin of safety, so the lesson here is about timing and how using the Williams R% indicator to buy when the underlying asset is deeply oversold helps us stay above the strike price and reduce the risk of being assigned the stock. Now are account in safely back in all cash and we can rent out our money for more income next month!

Related links of interest see: Timeline History of KFC

Monday, September 14, 2009

Barron's Bearish on Realty Income

Well I guess everyone is entitled to their opinion. This explains why the sudden sell off early this morning...



Barron's released a bearish article about Realty Income. Interesting how the stock was bought back strongly at the end of the day by the institutional buyers. Apparently they (the smart money) were not fooled by Barron's Bearish take on 'O'. I wouldn't be surprised if they had some short action in on O this morning. By the looks of the short squeeze (run up back on the price during the day) they created when shorts were covered during the day.

Ah, but that is mere speculation. Let's look at the fundamentals and facts - where in my opinion I respectfully disagree with Barron's article:
  1. Realty Income has a 40-year track record of level or rising dividends. Two words: Impressive and experience.
  2. Realty Income builds in a margin of safety as taught by investing greats Benjamin Graham and Warren Buffett in two ways: First, into its sale-leaseback transactions with retailers by purchasing its tenants' most profitable stores. This ensures that they will still be able to cover rent payments with cash, even if store performance deteriorates. Second, they carry a large buffer of cash to make dividend payments if a short-term cash flow problem ever did arise.
  3. Unlike their competitors (who derive property values from store profitability) Realty Income takes care to pay no more for real estate than those individual properties are worth, so if a property does go vacant they can re-lease or sell it without taking a big hit.
  4. Realty Income has an average of 4% of its total rental revenue up for renewal annually over the next five years, which should provide some protection if rents fall over the near term. The other 96% has built-in rent bump increases tied to inflation.
  5. Realty Income is overvalued? Maybe, or maybe not that's a tough call. Historically it has commanded a higher P/E ratio value over other comparable REIT's due to the quality of the company.
  6. Insiders get paid from the sale of company stock and stock options all the time. The CEO selling 20% of his stake is more likely due to the overall market coming back 48% from the March lows. He's probably worried the market will correct (and take 'O' down with it and so he's taking some off the table.
Near Term Trading Outlook
We might see increased volatility and selling that pushes the price back down to the $24 suport range in the next few days. In my mind that would be a good opportunity to sell Oct $22.50 Puts which would be out of the money and well below support.

Monday, September 7, 2009

How are we doing?

Before we take a look at our year-to-date performance let’s look at the track record of some of the greatest investors and speculators of our time. Here are their annualized returns and length of time that it was achieved:

Warren Buffett 21% - 42-years
George Soros 30% - 30 years
Benjamin Graham 20% – 20 years
Peter Lynch 29% - 12 years

That’s right the all time greats are in the 20%-30% range! Frankly a few years ago when I was looking into this I was surprised. I thought the returns would have been higher probably because of all the people selling gimmicks claiming to get 50-100% returns. The reality is that over 80% of mutual fund managers cannot beat the S&P 500, which is the benchmark that all money managers and funds are measured against. The S&P 500 has a 25 year annualized return record of 9.6%. Therefore a 20-30% annual return average over a minimum 10 year period of time is phenomenal! The long track record is the key component that establishes legitimacy - the longer the period, the stronger the credibility of the record - it also weeds out the one-hit wonders.

Okay here’s our results - drum roll please…



Year to date we are up 20.2% (31% annual) assuming we can keep up the same pace for the rest of the year. We might be even higher if I had not gotten a late start by missing January and February trades.

What does this say about the Option Income system and its early results? Well we certainly have not yet stood the test of time, however the early results are promising and on track. Each successful year will bring added credibility to the system. To me it says that this system is right in the sweet spot. That 20-30% range that has been and can be achieved. Any higher has not been proven to be sustainable and is subject to too much risk, and any less would not be maximizing our capital’s potential. Oh and did I mention doubling our money every 3 to 4 years!

Tuesday, September 1, 2009

Shooting the CAT

I would never shoot a cat. When I was a kid I did shoot our dog with my BB gun. Don't worry, it was one of those weak air-pistol types. Heck, I could shoot it into my hand and it barely stung.

The funniest thing I ever saw a cat do was take a swim in the neighbor's pool. Hmmm... I better explain (cat lovers this is your fair warning not to read the next two paragraphs). You see a funny thing happened once when the neighbors were on vacation and we were watching over their yard. We came up with this great idea. We wondered what would happen if we brought my dog (a beautiful, lightning fast Australian Shepherd) into the neighbors' back yard, closed the gate and then put the cat in the pool for a little swim. Cats do love to swim don't they?

We really didn't know what to expect, but we sensed it would be a good show. Our expectations were exceeded beyond all measure. The dog immediately charged toward the cat (which was now in the pool) and abruptly put the skids on and stopped at the pool's edge. The cat seeing (and hearing) the dog did a wide, slightly banked 180 turn in a full cat-paddle
swim to the opposite side of the pool to make its escape from both the dog and pool.

However, the dog seeing the cat advance to the far side of the pool, ran around to the other side at full tilt to meet the cat. You know what's next don't you? Right! The cat did a 180 slow turn in the pool and headed back to the other side, and the dog? Yep. It ran around the pool to meet the cat on the other side.

This cat-and-mouse dog game, was a sight to behold for us kids and put us all on our knees, our sides aching with laughter. We finally got the dog back out through the gate, which allowed the cat to climb out of the pool. No harm in the end, just some well-exercised pets and a unforgettable childhood memory made.

Today I did however, pull a trigger on CAT
(Caterpillar) and purchased (sold) a minor position on the $42 Put option (CATUC). The steep $1.47 pullback to $43.84 in CAT today sent the Williams %R indicator above 80 (oversold) signaling a green light to place a trade. The premium for the $42 option was 95 cents for a 2.26% return (0.95/42=2.26%) which was above our 2% profit target. At the time of the trade I ran the probability calculator and it came in a little above 70% success rate, so all indicators flashed the green light!

The big price swing today raised CAT's implied volatility, so at the close of the day with the higher volatility % my probability is now a little lower at 65.2%. That's okay it's normal for the volatility % to go up when the underlying stock price swings more than usual.



I'll wait and see if the market will drop some more before committing more capital. Both the S&P500 and DOW Williams %R are only at 68 and 62 which is just slightly oversold. I would prefer above 80 on the overall market as well, if we can get it.

Go CAT! Swim, baby, swim!

Monday, August 31, 2009

Checking Up On the Top 5

What a difference a day makes! Well three day's really when you count the weekend. Here's what our closing numbers looked like last Friday, Aug 28.



Now take a look at the numbers for our candidates at the close of Monday, Aug 31. Note that I added an extra row for 'CAT' and 'O' for alternate strike prices to watch (more on that later).



With the S&P500 pulling back 0.81% some good things happened to our prospective Put positions. For one thing the premiums and profit percentages naturally went up. Alternately, the lower stock prices moved closer to our strike prices, so naturally the probability of them staying above the strike price 18 days from now went down. More importantly the Williams R% indicator moved closer to the oversold side, which is what we need to time the entry of our trade for the best deal (less risk, lower strike price and higher profit). In fact, Nike (NKE) registered our first green light in the group as it went above 80.

So what's currently the best deal? Personally, I like the $43 strike price on CAT (circled in red). Why? Because although the probability and profit are not in the green zone they are both extremely close to it.

The problem is CAT is still not oversold enough with a Williams %R of 64, so while the timing is close and we have our finger on the trigger, we're not close enough to pull the trigger. I would much prefer being closer or above 80.

This is why I added the next lower strike price for CAT (and O) because as their stock price drops the probability of the higher strike prices (i.e.: $44) moves out of the 70% favorable range. Dropping down to the lower strike price gives us back our margin of safety cushion, and of course a lower purchase price if we get assigned the stock. So the qualifying indicators act as a system of built-in checks and balances to help you choose the best deal.

I know, I know... for us geeks it's the coolest thing since the IBM PC Jr. came out! Well for us finance geeks anyways. (For my Son it would be the Apple IPOD Touch.) Remember geeks rule!

Sunday, August 30, 2009

Statistics! You’ve got to be Kidding

My college roommate used to joke around and say: “I liked the class so much I took it twice!” At least I always thought it was a joke.

Every semester my final exams would get stacked up on the first 3 days of the week. It made the cramming harder, but it was nice to get it over with and go home early. However, my junior year was different I had one exam each day of the week. My last final “Statistics” was scheduled for Friday. I went to the testing center at the usual time to take the 4 hour exam. During the exam everything was going great I felt I was doing well when 1.5 hours into the test I heard the PA systems crackle and a recording announce: “the Testing Center will be closing in 15 minutes.” What! 15 minutes! I didn’t even think to check when the center closed, because it had closed at 9:00 PM all week. Talk about your major 'opps' there sports fans.

I explained what happened to the professor, but he wouldn’t let me retake the final even in his office. Blast! Failing the final gave me a C- in the class, so you guessed it… I liked the class so much I took it twice! The upside was that I aced the class the second time around, and the GPA boost helped me get accepted into the School of Business Management program. I also learned something from the "classes" that I use today, which is that statistical probability is a powerful ally to have on your side.

Okay so just how do you determine the probability of an option contract? With the help of online calculators it’s quite easy. To illustrate I’ll run the numbers for our current top trade candidate which is Caterpillar (CAT).

First go to the Optionistics probability calculator at:
http://www.optionistics.com/f/probability_calculator


Then fill-in the following fields:



  1. Symbol = CAT. Now click 'Load Data for Symbol'
  2. Lower Bound = 44 (this is the Put strike price under consideration).
  3. Upper Bound = 0 (we don’t need an upper bound, but I always enter zero which makes the results easier to read)
  4. All of the other fields are entered for you. Now click ‘Compute’.



The results show that as of today (21 days to expiration day) CAT has a 70.6% of closing above our Put strike price of $44. The probability will change each day as two variables 'stock price' and 'volatility' change. The one constant 'Time' works on our side. With each passing day the odds increase in our favor as we near the expiration date! This is also called time decay and it works against the buyer of an option and for the seller (us). Give the probability calculator a whirl on a few stocks, you'll see it's really easy.

Oh you might have one other question. Why did I choose the $44 strike price? Two reasons really $44 is at Caterpillar's near-term support level and the premium for the $44 option gets us above our 2% or more profit target. Getting the hang of this?


Saturday, August 29, 2009

A picture is worth a 1000 words - maybe more!

Future stock prices can go anywhere, up, down sideways who knows? According to technical analysis theory the past can help narrow down the possibilities, or should I say help draw some more likely possibilities.

Case in point - let's take a look at the stock chart of Realty Income 'O' which was last months trade. I'm no technical wizard but here's what the past performance tells me is more likely to happen then not. There's clearly new resistance developing at the $26.60 level and the old resistance level of $22.90 has become the new support level. The swapping of old resistance becoming new support is actually a common reoccurring pattern, which is what charting is all about.


Based on the chart here are my two observations that may occur:

  1. It will retest $26.90 resistance and if a clear break occurs (say above $27) it will move up into the $28-29 range.
  2. It will continue back to support around $23-24 after last weeks failed second attempt. It may even retest $26.60 and if it fails to break away it will then trend back down to the $23-24 support.
With the current overbought condition of both the market and Realty Income I would lean toward #2. Time will tell.

Okay so that's my 2 cents. What's yours?




http://optionincome.blogspot.com/

Friday, August 28, 2009

Narrowing down the prospects

Now that we have qualified our list of prospects to choose our stock from using fundamental analysis our next step is to narrow down the list. To use a Baseball analogy, we need an easy way to know who the best players are and get them to the top of the batting order. Then we need to know what a fat pitch looks like and time our swing to ensure the best odds to hit it out of the park!

STEPS

1. Use fundamental analysis stock screener to build your prospect list. Ultimately this should be a list of stocks you would want to own right now at their current price. You may want to make some adjustments. For example, personally I don’t have a high enough confidence level to own financial sector stocks just yet, so if my screener returns any I remove them.

2. Use option and technical analysis to disqualify prospects
  • Stock Price – Cannot be outside of $15-70 range. Stocks outside this range are either too risky (below $15) or are more difficult to produce good option premium returns (above $70).
  • Options Traded - Are options traded on the stock? If not remove them from your list
  • Open Interest - There needs to be a minimum of 100 options 500 is preferable
  • 3-4 Month Downtrend - Stock trend is not downward (trend must be sideways or up)
  • Earnings Report Date – Release date cannot be during the term when you would hold the Puts (prior to expiration date). This reduces the risk of bad or unexpected news causing the stock to drop sharply.



3. Sort remaining stocks by Implied Volatility to find expensive Puts. (I use Optionistics.com probability calculator to find Volatility and Probability.)
  • Divide the top five stocks with the highest volatility from those with lower volatility.
  • The top 5 is your Watch List of “At-Bat” candidates. You’ll select your trade from this group!
  • Stocks with lower volatility are “On-Deck” this is your list of farm cluber stocks looking to move up to the major league list.
4. Use analytical tools to qualify the best timing and stock candidate for your option trade
  • Down Market Day - Purchase Puts only on down market days (when both the DOW and S&P500 are down)
  • Williams %R - Enter trade when stock is oversold to get best premium and minimize option assignment (below -80 is preferred)
  • Probability >70% - Seek a 70% or more probability that when you enter your trade the stock price will be higher than the strike price on expiration day (Put expires worthless you keep premium and don’t have to buy stock at the strike price)
  • Profit >2% - Seek monthly profits that average 2% or more in terms of premium per share vs. strike price. When implied volatility is very high you can often collect 3% to 4% per month.
RULES
  1. Sell out-of-the-money Naked Puts only (premium collection strategy)
  2. Sell near term expiration (40 days or less to expiration).
  3. Never trade on margin only on actual cash
Our stock tracker below shows how to track and identify opportunities across a range of stocks. We carefully watch a small concentration of the best stocks that not only will produce the highest premium returns, but minimizes risk by entering the market when it’s oversold. We also, use statistics to reduce risk by identifying the probability of success before we make a trade decision. We only place a trade when the odds are high in our favor!

We are seeking the best case of green lights all the way across the row. In the case of the Williams %R indicator shown below the overall market is overbought (as indicated by the red cells, bright red is extremely overbought). The higher the number the better, the 50-79 range is shown in yellow for moderately oversold. Bright green (80 and above) is extremely oversold which is our preferred market entry condition!



Switching the channel to... World Poker Championships. You know the ones where they show the odds of the players poker hand. Seems like the odds are never close between the last two players. There’s always one player with an 85% chance of wining the pot and another sucker with all his money in the pot with only a 15% chance of winning. I don’t know why maybe it’s human nature, but I always root for the underdog with a 15% chance, and guess what? He never wins! Have you noticed? It’s always the player with the high odds in their favor that wins! Well guess what? We get to choose the great hand and we know the odds!

Hummm... If I mix the two themes it kinda sounds like Pete Rose?? Doh!

Monday, August 24, 2009

A Silky Sullivan Finish! - August Trade Results

If you've never heard of Silky Sullivan you're in for a real treat. Watching this video will also let you know how my August trade turned out. More on the trade later... Go watch the video!



Last Monday, Aug 17th, my $25 Put trade on Realty Income (O) looked like Silky Sullivan (on the backstretch) to finish above $25 as it dropped from $26 down into the $23.50 range. However, it was oversold and came roaring back to finish above $25 on Friday, the August option expiration day, at $25.14. Hey a win is a win whether it's by a nose or 41 lengths!



Results: 2.2% monthly gain (26% annualized) and we are back in all cash (who said Finance was boring?)

Having our (sell-to-open) Put expire so we get to keep the premium income is our primary goal, but what is our strategy if the stock was below $25 Friday and we get assigned (have to purchase) the stock at $25? Well first of all our #1 rule is to always buy stock in fundamentally strong companies that we would be willing to buy anyways. In this case, because of our 55 cent option income premium our cost basis would have been $24.45 ($25-0.55).

Now that we own the stock we can either
hold the stock for a week or two and sell it for a profit, or generate income by selling covered calls at or above the $25 strike price while collecting O's healthy 6.5% dividend until 'O' comes back to $25 and we decide to sell it. Either way we continue to generate monthly option income! Fun huh!

Saturday, August 15, 2009

Hey, Ho… Killer Content to Go!

My lovely wife told me about an interesting blog post about the Ramones (we love these guys) and what their style of music can teach you about writing killer content.

I saw the Ramones at the Santa Monica Civic Auditorium in the late 70’s, there’s nobody like this band – they’re true originals! Pure non-stop energy! From the moment they hit the first power cord of their first song they didn’t stop until the concert was over! It went something like this… Joey would give a countdown "1234!", song, 1234, song, 1234… they kept up a non-stop pace for nearly 2 hours without even a pause! Each song was catchy, fun, and to the point. After the concert I was satisfyingly exhausted, and I was just watching!

So I'm taking this to heart on the traditionally boring subject of Finance, let's keep it to-the-point, catchy and fun. Did I mention I like a challenge?

Gabba, Gabba, Hey!

Sunday, August 9, 2009

August trade is in - Finally

Up up and AWAY!

The market continues to climb the wall of worry. Since the July expiration date I have been trying to sell an out of the money Put on Realty Income (O) for a 2% return that has a 70% or more chance of expiring. With the near-term overbought state of the market as well as 'O' I was waiting for a pull back so I could get in on the $20 strike price Puts. But 'O' and the market just kept climbing which of course lowers the price of a Put and our premium. Possible trades with a Put premium of 2% and a 70% or more probability of expiring did not occur for the $20 and the $22.50 options. However, as O's stock price climbed past $26 the option income planets aligned and I was able to sell the $25 Puts for 55 cents for just over 2% (.55 / 25.00 = 2.2%). By the way, the option symbol for the Aug $25 Put is OTE. With only 14 days left to the August expiration O's price had reached $26.12 which gave it a 72% chance of expiring out of the money (above $25), so I executed my trade for this month.

This trade isn't as good as my previous trades, I would have liked to gotten in a week or two ago with a higher premium and at lower strike price, but it meets my criteria. Time will tell if I get my $55 per option contract without having to buy any stock or if I'm required to purchase 'O' for $25 when the market price is below $25. Note that $24.45 is my true break even cost bases due to the .55 cent option premium that I receive whether the price of 'O' is above or below $25 at the close of August 21. This may seem complicated and time consuming to the newbie but once you get some experience it is very easy. I'll soon explain how to run the free online option calculators to show you how easy it is to determine the odds of your trade succeeding.

Hope to hear from you! Drop me a comment: http://optionincome.blogspot.com

Friday, August 7, 2009

August Trade

Up up and AWAY! The market continues to climb the wall of worry. Since the July expiration date I have been trying to sell an out of the money Put on Realty Income (O) for a 2% return that has a 70% or more chance of expiring.

Tuesday, July 28, 2009

Prospect List Results

As you can see my current screening criteria could use some adjusting since it only returned 16 stocks. Ideally we would like around 20 to work with, so I need to soften my search criteria a little. I suspect that since the DOW has recently climbed back over 9000 some of the stocks that used to come up on the list have dropped off because their dividend yield has dropped below 2% which is not uncommon as the overall market trends up and down. So the most common adjustment is to raise or lower the dividend yield. In this case I softened the criteria by 0.25% to 1.75% and two more popped up on the list. Now we have 18 to work with that puts us in the ballpark. Usually only one adjustment is needed.

I also added three other quality stocks that I like although they don't meet the standard prospect list criteria. Our handy criteria has successfully weeded out thousands of stocks and produced a solid list of quality stocks to work with.

Prospect List Screening Results
ABT Abbott Laboratories
ADP Automatic Data Processing
AVP Avon
CAT Caterpillar
XOM ExxonMobil
FII Federated Investors
GD General Dynamics
JNJ Johnson & Johnson
MDT Medtronic
NVS Novartis AG
PAYX Paychex
PEP PepsiCo
RHHBY Roche Holding AG
PG Procter & Gamble
VMC Vulcan Materials
WMT Wal-Mart

New Prospects from lowering the Dividend Yield to 1.75%
CTAS Cintas
NKE Nike

Prior Prospects & Other Quality Stocks I Like
O Realty Income
UNP Union Pacific
UPS United Parcel Service

Next up: Step 2 - Narrowing down the prospects

Building Your Prospect List

Step 1 – Build Your Prospect List

Selecting the right stock is the most important and critical aspect of investing. If there is one thing that you want to get right above everything else – this is it! That is why I believe in only trading options against the best and safest stocks for generating option income. After all we need to be okay with purchasing and owning the stock. Also, the biggest risk to the option income system (and to investing in the stock market in general) is that your stock(s) suddenly plunges in price. In the option income case where you have sold Puts, we don’t want the stock to drop way below our strike price and have the stock assigned to us at a significant loss. However, if it does we are okay with owning the stock and will employ our stock ownership strategies, but the less it drops below our strike price the better and easier for us manage and profit on the ownership side.

But, our first objective is to have our stock stay above the strike price and expire so we get to repeat our income generation strategy again the next month.

The first step to select a high quality stock is to use a stock screening tool to build a prospect list of about 20 strong, stable, high quality companies to choose from. I prefer using Morningstar’s premium stock screener which is a paid service, but there are other free stock screening tools on the internet that you can query for similar criteria. For example, MSN has a powerful stock screener in its MoneyCentral investing section.

Using Morningstar’s premium stock screener build your prospect list using the following search criteria:

Fundamental Analysis
• Market Cap > 1B
• Morningstar Economic Moat = Wide
• Morningstar Fair Value Uncertainty <= Medium • 3-Yr Revenue growth rate > 8%
• Consecutive Years of Dividend Growth Increases > 10 years (longer the better)
• Dividend Payout Ratio (DPR) <>= four stars

Here’s a brief explanation of each criteria:

Large Cap Companies

This is the value (or “capitalization”) of the company’s stock (stock price multiplied by the # of shares). Large companies with a value of more than $1 Billion are more stable than smaller companies due to competitive advantages, deeper pockets, track record, economies of scale, etc.. They usually have multiple if not hundreds of different revenue streams that balance out their overall revenue and sustainability; unlike a smaller business where there may only be a few shoes and when one drops it sends their stock reeling.

Wide Economic Moat

According to Morningstar this is the strength and sustainability of a firm's competitive advantage over other companies. Here are some of the attributes that can give companies economic moats: huge market share, low-cost producer, patents, copyrights, or governmental approvals and licenses, unique corporate culture, and high customer-switching costs. Again this provides stability, on-going profit potential and the likelihood of the company staying in business and growing its dividend.

Fair Value Uncertainty

To generate Morningstar Fair Value Uncertainty, analysts consider factors such as: How predictable are the firm's sales? Does the company's operating profit vary widely with changes in sales? How strong is the company's balance sheet? Is there a nonfinancial issue that could materially affect the company's fortunes? Analysts then classify stocks into one of several uncertainty levels: Low, Medium, High, Very High, or Extreme. I look at this as the quality of the company’s financials. We only want to accept companies that have medium or lower uncertainty rating on them so we have more trust and confidence in the overall rating of the company.

History of increasing revenues

High quality large companies are supported by consistently producing moderate revenue (sales) growth over long periods of time. For earning to continue to grow they must be supported by sales growth and not just cost cutting measures. I like a minimum of 8% sales growth because for large companies it is the “just right” amount; high enough to keep earning positive, but not too high so that it is sustainable. High growth rates cannot be maintained and when they drop the company’s stock takes a nose dive.

Currently pays a minimum 2% dividend yield

This helps in two areas: one as a stock price falls the dividend yield goes up which helps create what I call a soft floor. The rising yield attracts income investors who come into the market and purchase the stock. This provides a floor to form where the higher the yield (price falls) the stronger the support (new buyers) to keep the stock from falling further. This helps reduce the downside risk of the stock. This is based on the assumption that the dividend is not at risk of being cut. Secondly, it shows current commitment by management to distribute some of the profits to its shareholders in the form of cash dividends.

History of increasing dividends

Most people look at dividends for their income, but what most don’t consider is that a company’s ability (and willingness) to pay dividends and especially their history of growing their dividend is probably the best single indicator of a company’s financial health. Dividend growth that continues to increase year after year is a sign of future growth prospects and a signal that management has confidence in the company’s continued earnings power.

Safe dividend payout ratio

Payout ratio is calculated by dividing dividends declared for the indicated 12 month period by net income for the same period of time. This helps ensure that the company is making enough profit to continue to pay their regular dividend and not be forced to cut them. Safe payout ratios can vary depending on what industry the company is in, but a good rule of thumb is less than 60% of their net income is distributed in the form of dividends.

Morningstar rating

The final criterion that I use is Morningstar’s 1-5 Star rating where 1=Low, 3=Medium, 5=High, which they describe as follows: “The Morningstar Rating for Stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value.”. The higher the star rating the better the value of the stock and the higher the expected return. We are looking for 4 to 5 star ratings which indicate price of the stock undervalued compared to fundamental fair value of the company. I use this as a broad technical or timing indicator, because when the stock price is undervalued it is “more likely” to trend sideway or up rather than to trend down.

In Morningstar’s stock screener the criteria looks like this:

Market Capitalization (mil $) >= 1000
Morningstar Economic Moat >= Wide
Fair Value Uncertainty <= Medium Revenue Growth % - 3 Year >= 8
Dividend Yield % >= 2
Dividend Growth % Past 5 Years >= 8
Payout Ratio - Year 5 <= 60 Morningstar Rating >= Four Stars


Is this the end-all-be-all criteria that should be strictly adhered to? True this is an investing system, but it is not a pure mechanical system. Why? Because the stock market is a dynamic evolving marketplace where human analysis and judgment are needed to modify and tweak the system to adapt to market changes. The objective of our prospect list is to identify the top 20 or so stocks at any given time. If we are in a bull market and the overall market is overvalued this criteria may only return 10-15 potential stocks. In that case I will lower the criterion until I get close to 20 prospects to choose from. Likewise if we are in a bear market where stocks are generally undervalued, we might return 30 stocks, in this case I slowly ratchet up the criteria quality until I get back to around the best 20 stocks again.

This prospect list will generate the best and strongest stocks for the option income system to start your selection process. Newbies to investing and this system should stay close to the list. But are these the only good companies to consider? Not necessarily as you gain more experience you will be able to include other high quality stocks that are worthy of consideration and you can add them to your prospect list as well. The key is to weed out the thousands of lower quality stocks so that the best 20 for this system bubble up to the top!

Next post: The results of our prospect list search criteria.

Monday, June 29, 2009

Some Prerequisites

Before you get started there are a few basic tools that you will need to do the job. If you don't already have these tool you can start to set them up while waiting for my posts to start rolling in.

• Computer with internet access and a spreadsheet program like Excel
• An online brokerage account with Tier 3 trading privileges
• A subscription to Morningstar, or access to other online stock screening tools

I know the Morningstar subscription costs money, but it is the best service that I have found to do the Option Income system, because of its proprietary ranking system and focus on high quality value stocks. However, if you need to keep your costs down while you are starting out and learning the ropes there are several free online websites that screen stocks for fundamental analysis, such as MSN's stock screener, which is located at:

http://moneycentral.msn.com/investor/finder/customstocksdl.asp

Next up... A multi-part post on: "How to identify and track opportunities across a range of stocks?"

Tuesday, June 23, 2009

July's WAM (walking around money) Trade

Disclaimer: The following post is getting the cart before the horse, but is for those of you who are wanting to get started right away trying out this system. I will be breaking down the process in future postings so that you can easily do this on your own with a little research and, of course, application of the Rules.

With the June options expiring last Friday June 19th (stock options expire on the 3rd Friday of the month) we are now in a position to place our next trade for July. Let's suppose you have $6,000 and you are looking to earn a little WAM this month! You are looking for a trade with a high probability of success that will generate a 2% return for the month (24% annual). You don’t necessarily want to purchase stock, but should that occur you want to ensure that you're investing in a company that you would be willing to purchase because the company is fundamentally sound, has great management, and has a strong record of commitment to sharing the company’s profits with its shareholders in the form of dividends.

Okay, that said here is July’s WAM trade:

Order Type: Sell-to-Open
Contracts: 3
Symbol: OSD (July $20 Put)
Price Type: Limit
Limit Price: 0.40
Term: Good Till Cancelled

Your order would read: “Your Good until Cancelled (GTC) Sell-to-Open order for 3 OSD July 20 Puts at a limit price of $0.40.”

What does this mean?

You are going to sell (not buy) three July $20 strike price Put option contracts (the ticker symbol for the option contract is OSD) against your $6,000 cash. The underlying asset (stock) is Realty Income (O). Since you are selling (or writing) the option contract you immediately receive $120 in option premium from the buyer (less commission cost of course). The $120 breaks down to $40 per option contract 3 x $40 = $120 of instant WAM!

The option contract (the deal) that you have just entered into is that you are now contractually obligated to purchase 300 shares of Realty Income (O) stock at $20 per share if the price of the stock is at or below $20 per share on July 17 (July’s option expiration date). Even if the price of 'O' is $18.50 on July 17 you still have to buy it for $20 per share. The stock is automatically assigned to your account.

However, if the price of ‘O’ is above $20 per share on July 17 your option contract will expire worthless (worthless to the buyer that is) not you as the seller nothing happens to you. Your $6000 is still cash in your account along with the $120 premium WAM.

Do the math!

Before we enter into the deal we have to make sure that the odds are in our favor. Our trade entry requirement is a minimum 70% statistical probability of success. Because we are on the selling side of the trade time is on our side! The odds of success will increase with each passing day that draws closer to the option expiration date due to the time decay value of options. More on time decay and how to do the math in future posts.

Here are the numbers:

Stock: O (Realty Income)
Current Price: $22.24 (6/23/09 close)
Days to Expire: 24 (7/17/09)
Volatility %: 36.3
Dividend Yield: 7.68%
Risk free interest rate: 2%
Result: 85% probability of stock finishing above $20 on 7/17/09

Getting In

The trickiest part of selling Options is executing the trade. The 85% success probability is great for 24 days until expiration date, almost too good. This is due to the stock trading so far above $20 (our strike price). With Puts, the higher the stock price the lower the premium (less risk, lower reward). With Realty Income trading above $22 the option premium is only in the 0.20 to 0.30 cent range and we would really like to get 0.40 cents per share for a 2% return. We could make well over a 2% premium by moving up to the $22.50 strike price, but that would lower our success rate below 50% which breaks our rule of at least 70%.

You have to decide whether you're getting in now for a lower return or waiting a few days to see if the price of 'O' drops which will raise the premium. I like to do a little of both, drop our limit order down one notch to 0.35 cents and wait a few days for 'O' to drop. We can afford to wait a few days (3-5) without losing too much to time decay, but past that it is not worth it. The worst case is that 'O' continues to go up and you don’t get in this month.

Remember rule #1: “The purchase should meet ALL of the requirements.”
Rule #2 is: “See rule #1.”


Not getting in is okay and perfectly acceptable! You should only get in when everything is right and all of the planets are aligned. If not, drop it and move on to find another worthy stock where all the planets are aligned.

Monday, June 22, 2009

The July WAM (walking around money) Trade

With the June options expiring last Friday (June 19th) we are now in a position to place Let's suppose you have $6,000 and you are looking to earn a little WAM this month! You are looking for a 2% return during one month (24% annual) for a high probability of success

Friday, June 19, 2009

Advantage #1 - It’s a System

First of all the fact that this is a system is an advantage. A good business system has requirements, rules, is clearly documented and repeatable. The same reasons that make McDonald’s or Subway a good franchise is that they can replicate the exact same quality of product and its business systems in every location. I believe my system can be repeated by others, but it has not yet been tested and verified repeatable. One of the objectives of this blog is to create a forum to allow others to test the system and determine if it is repeatable.

Unfortunately the terms “Stock Market” and “System” are oxy-morons, they just don’t go well together. At least in terms of pure mechanical trading systems, as far as I know there has never been a mechanical system that has continued to work. Oh by the way, don’t be fooled by those that claim their mechanical systems beat the stock market. They might for awhile but eventually the market has a way figuring them out and changing enough to make them null and void. So that is the irony of good stock market systems they are a combination of rules and procedures that eliminate emotion and yet are flexible enough and necessitate a certain amount of human analysis and judgment that is taught from mentor to an apprentice (i.e.: see Graham and Buffett).

System Requirements

The system shall…
1 …generate positive returns every year (no years with a loss)
2 …generate monthly income in order to utilize the power of compounding
3 …consistently produce 20 to 36% annual returns (reinvested doubles every 2 to 4 years)
4 …not take more than a few hours per month to execute (once learned)
5 …not require constant monitoring or supervision (can take a week Caribbean cruise, no internet)
6 …allow you to know how much you will make going into the trade
7 …put time decay value on your side
8 …have a 70% to 90%+ statistical success rate for each trade using mathematical probability models (minimizes risk)
9 …trade only the very best most fundamentally sound companies as the underlying asset
10 …minimize exposure to market risk by staying in cash the majority of the time
11 …be repeatable by anyone who understands how stock options work

Next up advantage #2:

Tuesday, June 16, 2009

Introduction

The key concept of the Option Income system is vastly different then most investing premises. Traditional investing seeks a positive capital gain the old “buy low and sell high” or “buy and hold” and wait for your portfolio to hopefully increase in value. Whereas the Option Income system seeks to generate positive income every month! This system uses and treats cash and stock like hard assets, in fact we treat them very much like real estate rental property! We use cash or stock as the underlying asset (real estate) and rent out the use of your asset each month to generate income (rent).

You wouldn’t sell your rental house at the first inkling that the property dropped in value would you? No! Why? Because it generates positive monthly income! Well guess what if your stock market investment is generating 2-3% income monthly (that’s 24-36% annually) you don’t have to sell your stock when the price is down. How does this compare to the traditional advice given by so called Wall Street pros or your stock broker? They would have you sell it! Dump the losers and let the winners run. The typical stock market philosophy is that it is okay to sell for a loss. Sure that’s easy for them to say it’s your money and they still get their commission! Whether you are a short-term trader trying to time the market; or a long term investor trying to gut out the 5 to 20 year wait for your portfolio to become profitable again after that last huge market down swing. Knowing when to buy and when to sell for capital gains is a tough physiological game to win at and most don’t. It’s a fact that even 80% of the professional mutual fund managers do not beat the S&P 500 market average.

Next post advantages of the Option Income system...

Introduction

The key concept of the Option Income system is vastly different then most investing premises. Traditional investing seeks a positive capital gain, the old “buy low and sell high” or “buy and hold” and wait for your portfolio to hopefully increase in value. Whereas the Option Income system seeks to generate positive income every month! This system uses and treats cash and stock like hard assets, in fact we treat them very much like real estate rental property! We use cash or stock as the underlying asset (real estate) and rent out the use of your asset each month to generate income (rent).

You wouldn’t sell your rental house at the first inkling that the property dropped in value would you? No! Why? Because it generates positive monthly income! Well if your stock market investment is generating 2-3% income monthly (that’s 24-36% annually) you don’t have to sell your stock when the price is down. How does this compare to the traditional advice given by so called Wall Street pros or your stock broker? They would have you sell it! Dump the losers and let the winners run. The typical stock market philosophy is that it is okay to sell for a loss. Sure that’s easy for them to say, it’s your money and they still get their commission! Whether you are a short-term trader trying to time the market or a long term investor trying to gut out the 5 to 20 year wait for your portfolio to become profitable again after that last huge market down swing, knowing when to buy and when to sell for capital gains is a tough psychological game to win at and most don’t. It’s a fact that even 80% of the professional mutual fund managers do not beat the S&P 500 market average.

Next post the advantages of the Option Income system: