As I have repeated over and over again, we sell calls or puts to leverage a particular underlying security to generate cash flow. This being the case, as conservative investors we have now thrown the odds dramatically in our favor compared to the ordinary shareholder. On top of that, because of strike price selection and position management, we can control the outcome of the trades we set up. If a complete technical breakdown occurs, we are able to respond to this event. Don't be that type of investor who sells an option and prays for a happy outcome or massive rebound if your position is unsavably underwater. That's not what we're all about! So, I'm definitely here to pound the table for proper technical and fundamental analysis. In 80% to 90% of all trades, you won't need to take action when it's as easy as riding a bicycle downhill. But it might at first seem way too easy if everything turns out as planned. That's why our whole arsenal of exit strategies should assist us in determining whether we have to quit a particular trade, take our chips off the table or stay in the game by using another security. This article will provide a coherent answer to that trilemma.
Anticipating Before Getting Hit Is Critical To Successful Option Selling
It's always far better to anticipate something than overlooking possible events you could have foreseen (with hindsight of what I saw on the chart technicals, it would have been better to lower my strike prices or my one-month objective). Never forget the following rule: prefer capital preservation over uncertain one-month profits. We're in this to generate a consistent cash flow, not to lose money because we neglected warning signs in order to earn a few additional percentages driven by greed.
* Assessing The Chart Technicals
Technical analysis is one of my favorite tools to measure market sentiment and potential U-turns in short-term behavior. Let me highlight the following real-life example for you.
Negative divergence with a breakdown backed by increasing volumes is something that I'm looking for when evaluating the technical conditions of major indices. Most of the time, this chart pattern indicates WEAKENING MOMENTUM. This is quite important to notice since we're active option sellers. Despite the fact that because of selling options and receiving a generous premium, we can't overlook that negative momentum may eventually turn into a negative adventure for our portfolios that particular month. So in order to maximize our profits, we have to keep a keen eye on a changing market environment (trade war, poor technical conditions, interest rate environment) to shape a solid portfolio which is less prone to potential drawdowns in the stock market. Now, let me stop here for a moment and tell you that although negative divergence is a trustworthy indicator that makes us aware of weakening momentum, there's no guarantee of a declining market the following days/weeks. It's just something that helps us determine which strikes to select to still meet our objectives.
Besides digging into the technical chart, there's way more you can track to determine whether market rallies are very likely going to cool or persist in the short term. One of favorites is the Put/Call Ratio which indicates how bullish or bearish investors are. More often than not, the first spikes tend to forecast a deeper correction through the next 1-2 weeks before starting to mean-revert. In other words, when the Put/Call Ratio is rather low it means very few professional investors are anticipating a correction. In combination with negative divergence in short-term momentum indicators that may create an opportunity for us to become a little more conservative in our stock and strike price selection.
* Screen For The Best Sector SPDRs
Before screening for the best stocks based on fundamentals, it's worthwhile checking which ETFs are outperforming the broader market and how they fared over a longer time frame. This is of vital importance to cherrypick the best candidates eligible for our option selling system. In other words, tracking the performance of different types of ETFs can bear fruit in selecting the most robust sectors at a specific point in time. To give you an example, as of August 2, 2019 the PPH ETF but also the SPLV ETF showed resilience compared to the broader US Equities ETF. Nonetheless, having the damaging market correction of last year in the background , many investors looking for strong ETFs and thus best performing stocks may take a look at the Vanguard Utility ETF that tend to withstand multiple drawdowns, but unfortunately there are times when this ETF lags the broader market especially when markets rally. Once you've figured out what things work well for your own personal risk tolerance, you can then explore various option chains of individual stocks.
* Taking Your Chips Off The Table
Another choice being left to us is exiting all of our trades. Admittedly, in a low interest rate environment and inflation eating into our purchasing power, that may be the last and most radical option you'd think of, but it's a powerful tool when your returns exceed the market's. Moreover, are you still considering putting cash to work when nearly every security is being dragged down by market sentiment although it's grossly exaggerated? I'm not a proponent of risking my hard-earned money while keeping in mind the odds of a winning trade are stacked against me. It's part of the game most investors believe, but I'm rather a big proponent of winning by not losing especially when I'm sitting on a hefty return... To illustrate this phenomenon, let's focus on the following graphs.
Negative divergence is such a powerful tool and when utilized in conjunction with moving averages it gets as close to the sweet spot. Take a look at the SPY way back in September of last year when everything was still quietly uptrending before taking a major hit. Let me highlight the following price actions you need to understand before entering your option selling positions.
When the price of the underlying security starts dropping below the SMA 20, it's a short-term warning sign that indicates wearing momentum which means you shouldn't consider entering a short-term options position. When the price dips below the SMA 50, the security should be bumped from your watchlist since an underperforming stock will harm our chances of trading profitably. In essence, even when the technicals we're strong when you've entered your position, you should make a non-emotional decision as to when to exit your losing trade. When the markets sold off dramatically in October, there were some noticeable rebounds, though the medium-term trend (SMA 20 < SMA 50 and both declining) remained down and that's the main reason why we shouldn't participate in volatile markets and hope for a lucky reversal.
In the following graph, I'd like to refer to the percentage of stocks above their SMA 50. When that figure reaches 20% or less, it may not be worth checking out whether there are stocks that are 'reasonably' sound from a fundamental perspective and offer strong technicals. It's quite elusive to assume you will find great stocks when the baby is being thrown out with the bathwater.
Again, all of this could have been at least partially avoided by being prepared to exit the market, cut small losses and avoid they'll turn into huge financial disasters for your entire portfolio.
How To Position Your Option Trades Through Volatile/Bearish Times
In case you're not afraid of selling options through extremely volatile periods, it may be worth considering the following steps to improve your risk/reward profile, some of them have already been discussed in the previous topics. Other topics related to exit strategies are discussed in our in-depth articles supported by our calculators.
Low-Beta ETFs to gain sufficient industry diversification
Lowering your one-month objectives (for instance, targeting one-month returns of 1% instead of returns in excess of 2%)
Bringing down your overall exposure to the stock market
Implementing rigorous exit strategy execution on existing positions (Rolling Down, Unwinding)
Utilizing the collar strategy (selling calls and buying puts)
Selling deep OTM puts assuming assignment takes place and then selling deep ITM calls
Removing naked puts
Completely exiting the market
Anticipating possible negative outcomes is basically what will set you apart from the average retail investor and option seller, especially since timing the markets is too difficult. In essence, I'm not telling you that I know into which direction the markets will very likely be heading over a short time frame. I just want you to know that by selling options we create a substantial edge and we don't want it to be wiped out because we were blind to potential threats that eventually hurt our portfolios.
So far this year, my option portfolio is up 39.6% which means I'm off to a very good start of the second half of 2019. But my no. 1 rule remains the same: capital preservation over return. We can break that rule down into two parts. First and foremost, proper asset allocation is critical to sleep well at night, which means that I've allocated 48% of our initial funds to conservative long-term high-quality stocks I'd like to own for a very long period of time, not to mention the vast majority of those companies operates a very predictable business. The more active part of my portfolio, namely option selling, is growing rapidly because of a continued income stream which helps my parents pay their living expenses easily. This being the case, option selling gives me an enormous amount of flexibility to profit from countless scenarios I will inevitably face. And that's why I've decided to compose this article to let you know how I'm concisely and consciously re-thinking my investment strategy every at the beginning of a new options cycle. We have different 'options' to choose from and there's no one size that does fit all or right or wrong. We can take our chips off the table when technicals are radically challenging and making good strategy execution almost impossible.