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!

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