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:

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?

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!


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 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.
  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:

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.