3 Tips for Earning Income with Options
04/04/2011 11:24 am EST
Selecting a proper underlying equity is the first step in carrying out any income-producing option strategy. Here are three tips and some expert insights for finding good option candidates.
I frequently get questions from option traders about how for find good optionable securities to trade. My thoughts on that are clear: I don’t have the ability to choose stocks that will perform as I hope. Thus, I trade index options. However, a recent CBOE forum post by Dan Sheridan of SheridanMentoring.com offers his advice on how to begin the stock selection process:
Many people spend lots of time researching for vehicles to trade. I like my students to spend most of their time practicing and perfecting the various income strategies. Here is a simple, three-step process I sometimes use to find good candidates for monthly income trades like calendar spreads, credit spreads, butterflies, condors, and covered call writes.
- List ten stocks you would be willing to buy 100 shares of for “little Guido’s” college fund. Typically, these are good, solid stocks you would buy in your retirement account
- Filter this list by excluding stocks under $55. This gives you stocks with a bit more time premium
- Filter the list again by only including the stocks with implied volatility levels between 17 and 27. This filters out many potential psycho stocks! This information is easily available from your brokerage platform
Here is a sampling of stocks or ETFs that have implied volatility between 17 and 27 and that are priced over $55:
This is not an exhaustive method; merely a simple one. I may expand on other methods in weeks ahead. The merits of this method are that it doesn’t require computer training or a Harvard education!
I would add to Dan’s points:
- It is always a good idea to trade stocks you are willing to own. It is true that you can exit positions prior to expiration and not find yourself owning shares after being assigned an exercise notice on a short put option, but when screening for stocks, it’s safer to concentrate on stocks you would not mind owning.
- Regarding his note about “a bit more time premium.” Why is that important? It’s not universally important. However, if you are trading a small account and trade few option contracts per position, commissions can play an important role in your ability to earn money. Thus, if you are trading one lot, it is better to collect $200- $400 for that trade, rather than $60. It’s just a matter of spending less on commissions. When using some brokers, this is not an issue.
- The advice to select less-volatile stocks is not going to be accepted by all traders. The idea behind this advice is that it reduces the risk of wild price swings and gives the trader a significantly better probability of earning a profit. Note: We are talking about income-producing strategies. That in turn means that we are selling option premium and own positions with positive time decay (Theta) and negative Gamma.
The tradeoff for this extra safety is that premium collected is reduced. Low-volatility stocks have lower option prices than more volatile stocks. To me, this is a good practice, but it truly depends on your comfort zone. Rookie traders who are near the beginning of their careers must gain valuable trading experience to avoid blowing up an account. Less-risky trades help accomplish that goal.
I understand that you feel confident and want to earn more money. I don’t blame you; but you get only one chance to be a rookie—one chance to develop good habits—and it would be a shame to go out of business before you get a chance to see how well you can trade and manage option positions.By Mark Wolfinger of Options for Rookies