Put Selling Trade Selection

What's Most Important When Selecting and Setting Up a Short, Naked, or Cash-Secured Put Position? Fundamentals, Technicals, or Valuation?

In one of our Secret Seminars - The Key to Successfully Writing Puts - we covered the concept of "Limited Downside Situations."

It's the organizing principle we use for all our short put trades (i.e. naked puts, cash-secured puts, etc.). It's the foundation we use for our trades and one of the crucial reasons for our success.

The Key - Limited Downside Situations

Our whole whole premise for writing or selling puts is to identify what I call Limited Downside Situations.

Ideally, we're looking for multiple reasons why a stock is unlikely to trade lower, or lower by much, in the near term.

So we evaluate the quality and fundamentals of the underlying business, we look at the technicals, we consider the valuation, and we also keep an eye out for any special situations.

The more of these factors that line up in our favor - no surprise, I suppose - the better our trades tend to go.

But the question naturally arises - of these various factors, which one is the most important?

Again, we're ideally looking for multiple reasons, but in my experience, one of these factors does carry more weight than the others.

The Extra Safety Net - Valuation

It's easy to go overboard on technical analysis, and the higher the quality of the underlying business, the less chance there is that your trade will ever completely melt down on you.

But valuation, I have found, is a sort of secret safety net.

You don't exactly know where it is, or when it's going to kick in, but there comes a point where, no matter how much negative sentiment is baked into a stock, Mr. Market simply can't push the shares any lower.

I love stocks that have been beaten down hard but where the underlying business is still profitable.

Not firing on all cylinders, mind you, and not making as much money as investors wish or had become accustomed to, but still reporting profits nonetheless.

That's because I know the company is in no danger of going out of business, the premium levels on the options are likely very high, and much, most, or nearly all of the damage has already been done.

This is a classic value investing principle, what Ben Graham called giving yourself a margin of safety.

Selling Puts on Dirt Cheap Stocks

We had a ton of success doing exactly this throughout 2016.

Such as when we sold puts on MS (Morgan Stanley) inside The Leveraged Investing Club.

So back on April 7th, 2016 with MS trading @ $23.76 (or just 7-8 x forward earnings), I wrote a single MS June 17 2016 $22 put for $0.82/contract, or $76.50 after commissions.

[Yes, this is a small amount, but this was also a very small trade (requiring just $2200 in cash-secured capital.)]

If held until expiration, and assuming the stock was still trading at or above $22/share at that point, I was looking at very respectable 17.88% annualized returns locked in over an extended 71 day period.

(I personally target 15-25% annualized returns on my trades.)

Now, re: the trade, how much lower could the stock realistically trade?

MS had its problems, but the stock was also dirt cheap.

When a stock can't trade any lower, it has no place to go but up.

And that's exactly what it did - just one week later the stock was trading above $26/share, and I exited the trade early and ended up locking in more than half of the trade's potential profits in less than 10% of the original expected holding period.

Is It Repeatable?

It wasn't just MS, although I was able to re-enter the trade again later in June (2016) when the stock briefly fell back to those dirt cheap levels and the same thing happened.

Within three days of entering the trade, the shares had rebounded and I was able to lock in a majority of the trade's potential gains in a fraction of the expected holding period.

(The rates were definitely skewed by the short holding period of just 3 days, but my final results were 387.18% annualized.)

By the end of the year, the stock was trading above $40/share.

But the whole "way beaten down" theme worked for us throughout 2016 - even as a lot of these stocks couldn't be considered "high quality" - such as AAL (American Airlines), CAR (Avis), and GME (GameStop.)

And when a stock is high quality and gets way undervalued, those are situations you want to jump on ASAP.

Such as with TROW (T. Rowe Price), another one of our 2016 trades where we walked away with 70.69% annualized returns over 17 days.

Originally, it was supposed to be a 2 month trade, but when you write puts on a stock that subsequently spikes - and that's exactly what happened with TROW in the wake of the 2016 post U.S. presidential election rally - it makes a lot of sense to close a trade early and scoop up the majority of the potential gains in a very abbreviated time period.