By: Michael Vodicka of Street Authority
In all my years in the market, I've never heard of such an incredible track record.
The IPO prospectus from high-frequency trading firm Virtu Financial reveals that in the past four years, the company has lost money in exactly one of 1,238 trading sessions.
J.P. Morgan didn't have a single losing day in 2013. Bank of America notched a perfect performance of its own in the first quarter of 2013.
Clearly, Wall Street trades and invests its own money a lot differently than the "buy and hold" strategy it preaches to its clients.
One of the best-kept secrets they use is selling options.
Does that sound scary? Intimidating?
If it does, there's a very good reason for that: That's exactly how Wall Street wants it.
Wall Street works very hard to keep one of its most powerful income strategies out of the hands of regular investors.
Because what most investors don't realize is that selling puts isn't just one of the most conservative options strategies... it's one of the lowest-risk investment strategies in the entire market -- more conservative than owning individual stocks and bonds or even mutual funds and ETFs.
The conservative strategy of selling options is driven by a fact you might find shocking: About 80% of options expire worthless. That means whoever sold those options gets to keep the full premium collected as income from their sale 4 out of 5 times.
And these aren't small premiums. They're annualized yields of 36%... 47%.... even 87% from well-known, trusted companies like Microsoft (Nasdaq: MSFT) and Verizon (NYSE: VZ).
Despite Wall Street's best efforts, well-informed investors are embracing selling options as an important source of portfolio income. In fact, this is what we do every week in my premium newsletter service, Income Multiplier.
But deciding to sell options is only half the battle. Learning how insiders increase their returns and win ratios is the other. That's why I'm sharing these 5 insider tips that provide a basic framework for understanding how Wall Street insiders increase the probability of winning trades.
1. Only sell options on stocks you want to own.
Selling a put offers two potential outcomes.
The first is that the options expire worthless and the put seller keeps the entire premium generated from the sale. This is a powerful income strategy and the most desirable outcome when selling an option because we keep this premium as pure profit.
The second potential outcome is that shares of the underlying stock fall below the strike price on the date the option expires. This obligates the put seller to take ownership of the shares.
Although that's a low-probability outcome, it's the reason why it's so important to sell options only on stocks you actually want to own. In the event that the put seller is put shares, you want to own a great company with plenty of long-term potential that will quickly rebound from a temporary pullback.
2. Avoid long-dated expirations.
All options contracts have an expiration date. Some options expire every week; other options expire after several years. Options that are dated far into the future have a higher premium value because a longer time allows significant price swings or unexpected events to occur. That could be a macroeconomic event (like a recession) or a company-specific event, such as earnings falling short of expectations.
Conversely, options that expire in just a few weeks or a month are much less susceptible to price fluctuations. Think of this like a baseball player hitting a bunch of singles and doubles as opposed to an occasional home run with lots of strikeouts.
3. Sell puts more than 5% out of the money.
Every options contract carries a probability of expiring worthless. Some options contracts have a 90% probability of expiring worthless; others have a 50% probability. It all depends on the variables of each individual contract.
One of the biggest factors impacting the probability of a worthless expiration is an option's strike price. Options with strike prices that are far away from the underlying stock's current share price have a lower probability of assignment than those with strike prices that are close to current prices.
Selling puts with strike prices more than 5% away from the current share price greatly increases the chances that the puts you sell will expire worthless.
4. Diversify.
Regular stock investors should always diversify their portfolios. Holding stocks from different sectors and regions of the world is a great way to reduce volatility and short-term price risk. Stocks from different sectors and industries tend to have a lower correlation with each other.
That same concept of diversification holds true for selling options. As an options seller, it's important to avoid highly concentrated positions in sectors, stocks or themes with a high correlation. This reduces the probability of one single event triggering assignments on multiple open put positions.
5. Don't increase the size of positions too quickly.
This is the No. 1 mistake made by new options traders. It's also a familiar theme across any asset class. A novice investor experiences great results early in the game with a new investment strategy. Gaining confidence, the investor begins to quickly ramp up the size of their position, increasing risk significantly. When the size of the investor's trades has grown out of proportion to the value of the account, one small miscue can have serious implications.
This is a recipe for disaster. The value of any individual put-selling position should be calculated as a percentage of overall account value. That makes actual results and the growth of an account the primary drivers of position size as opposed to a bout of short-term confidence driven by a bull market.
The unprecedented track records that Wall Street trading firms are racking up are due in large part to successful strategies like these.
But I think it's time that regular investors got in on the wealth-building opportunities that these traders are so set on hiding from the public.
In the past year, Street Authority recommendations on individual stocks have gained +72%, +26% and +60% all in less than six months... and recently, their trades could have made you +26% in 42 days and +42% in less than one month. Click here to get the free trading advisory -- Trade of the Week.
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