When Being Wrong...Turns Out To Be Right (And Profitable!)
Have you ever been wrong in your bullish stock prediction and still have your trade turn out to be a winner?
Probably not enough times, right?
I mean, if your directional assessment is off, how could you make money?
And if you said yes, I don't mean having to wait 10 years for a trade to finally turn around.
That's just silly.
I'm talking about trades that go in the wrong direction and never turn around to become winners.
Well, just as I've been telling you about amazing option trading strategies in this blog, I'm going to peel back a bit more about why "option-selling" is so forgiving when you're wrong on direction.
Option Selling = Cushion For Error
As you know, my favorite option-selling technique is to sell put option contracts on high-quality blue-chip stocks. My Smart Option Seller newsletter is devoted to just that.
But how does selling put options give you a "cushion for error"?
In previous examples that I've given, I've used Amazon stock as a target.
It's currently trading near $1,720 per share (as of 10/8/19), and I've shown how you can sell Amazon put option contracts with strike prices that are situated well below Amazon's stock price.
Selling put options allows you to potentially buy any stock you want at below market values, while making money by collecting the upfront payments.
If you sold an Amazon $900 put option, you would immediately deposit the going rate for it into your trading account.
In exchange for that payment, you've agreed to buy 100 shares of Amazon stock at $900 per share, if and only if, Amazon trades below $900 by the expiration date. If it doesn't fall that far by the option expiration, you keep the upfront payment as your consolation prize. Those upfront payments can add up to tidy sums over time.
I've also shown in previous articles how the chances of Amazon falling that far (down to $900) are practically nil.
But how does that correlate to directional cushion?
When selling put options for income (and not necessarily to buy the stock), your main goal is for the stock to NOT fall to the strike price level. In other words, you want the stock to stay flat or move higher.
In option-selling, the plan isn't to figure out where the stock is going, the plan is to figure out where the stock isn't going. That's a big difference, one that many investors never think about, and it's a great source for making money.
The best way to make money from selling put options is by just trading in and out the upfront payments you receive.
You see, when stocks go up, put option prices go down. And if you sold a put option at one price, you can book profits by buying it back at a cheaper price.
That's how we as put-option sellers make money - we sell first, buy-back second.
So, the goal is to not have the stock drop to $900 per share, in Amazon's case. If it doesn't, a put-option seller could realize the full gain on the option trade.
But what if Amazon does start to fall?
Well, at the outset of the trade, you have over $800 of cushion in which Amazon can fall, and you'd still walk away a winner. Talk about a forgiving trade!
When was the last time your stock could move $800 against you and still produce a winner?
Not often, I'm sure.
But let's take a look at a more "reasonably" priced stock like Intel Corp (INTC) to see how we could still get a nice cushion for error.
Intel is currently trading at $50 per share (as of 10/8/19).
You could sell a $35 put option and collect the going rate for it.
In exchange, you agree to buy Intel stock at $35 per share sometime in the future, if an only if, Intel is trading below $35 at that time.
You could also make a profit on this trade as long as Intel stays anywhere above $35 per share. If that happens, you get to keep the full upfront payment you were paid.
Considering you want Intel to remain flat or rise in price, you would still have a $15 cushion (30%) for directional error. Intel could fall $15 per share and you would still win on the trade.
I don't know of many outright stock trades that would be profitable if it fell $15, let alone $800 (in Amazon's case). Smart stock traders typically set stop-losses at 20%-25% below their buy-in levels. And when the stop is hit, they lock in their losses.
Many option-selling trades have anywhere from 30%-70% downside cushion.
The bottom-line here is that with put-option selling, picking the correct direction of the stock isn't going to make or break you. It's whether it won't fall too far that will determine the outcome.
If you pick quality, stable stocks and option strike prices that are situated far enough away from the stock's current price, you allow for normal fluctuations and create a "profit zone" in which to operate under.
In most cases, trading stocks lives or dies on getting the direction right. Option-selling is extremely forgiving. In my opinion, it's a much easier way to make money.
Until next time...