Protect Yourself Against Every Income Investor’s Worst Nightmare

There has been a lot of talk here lately at Profitable Trading about selling options.

And with good reason. When it’s done right, options can be one of the best ways to make money in the market we’ve ever seen. It’s no easy feat to generate “Instant Income” selling options, and there are no guarantees. But our trading expert Amber Hestla, a former military intelligence analyst, has an amazing track record (52 out of 52 winners so far) — raking in thousands of dollars for her subscribers.

Recently, readers of Amber’s Income Trader, Profitable Trading’s premium newsletter dedicated to generating income by safely selling options, made $63 in “Instant Income” from a $720 “down payment” on United Continental Holdings (NYSE: UAL). That’s a quick return of 8.8% in 65 days, or 49.1% a year.

#-ad_banner-#

And back in May, subscribers collected $85 in “Instant Income” from Deckers Outdoor (NYSE: DECK) — a company that doesn’t even pay dividends — for every $1,250 they set aside. That’s a 6.4% return in 78 days, or 31.8% a year.

This is how much we made selling one contract. You can scale up as much as you want.

But, like any investment, selling options is not risk-free.

I think subscriber David W. said it best:

Hi Bob,

For those not aware of the options world, there is good information here. But what is missing is that the advice does not spell out the adverse case.

Writing puts is like selling insurance — if disaster strikes, you can lose big.

We all love a bargain. But what if the cheaper price occurs down the line because it is discovered that accounting games and fraud have turned up? Now you own a security at a cheaper price — but a price that you would NEVER buy at.

Now you could have chosen to have your decision delayed — to remain idle — and thus when the news broke about the fraud you could simply make the decision to not buy. But since you bet on the future — back when you wrote the put — you now have a loss, as it were.

So writing puts depends on forecasting (much like simply buying stock itself). What is needed to be successful — is not the vehicle (options, stocks, etc.) — but knowledge, so that one’s forecasting has a better success ratio.

The discussion should be about the risk management of your chip stack in the process of placing more well-judged (prudent to the chip stack) bets at the table.

— David W.

The scenario that David outlines in his note is every investor’s nightmare, and you don’t have to be an options trader to suffer the effects.

Just ask stockholders in Linn Energy (NASDAQ: LINE), whose shares took a sudden 15% dive in July 2013 on news that federal regulators began an inquiry into accounting procedures involving a planned buyout.

David is correct in underscoring the risks in such situations for options traders. Writers of certain put options in Linn Energy, for instance, could have found themselves looking at double-digit percentage losses literally minutes after their options’ buy price was triggered.

David is also on the mark when he mentions the importance of knowledge and risk management in any investment strategy. No reputable investment opportunity comes with any guarantees of success — and that includes the use of options.

But to take David’s chip-stack analogy one step further, it’s possible to increase the odds of success if you have sound strategies working for you.

And that’s where Amber Hestla comes into play. Here is an excerpt from a recent interview I conducted with Amber:

Bob: Amber, what is your response to David’s comments?

Amber: David is correct — risks are present no matter which trading vehicle you use, and there is an element of forecasting involved in any investment decision. We can’t eliminate risks, so my goal is to minimize them.

Selling puts on stocks I want to own helps me do just that.

I thoroughly research every stock I recommend selling options on. Research helps me avoid investment disasters. Cash flow is one of the most important fundamental metrics in my research. Earnings can be faked, as the former Enron demonstrated years ago, and sales can be “boosted” with various questionable techniques. But cash is real, and ensuring that cash flow is strong reduces the chance of buying into a fraud. Enron was cash-flow negative for several years before it imploded.

My research process continues to examine the rest of the financials to be sure that we have a solid company, and then I develop a valuation model for the stock to be sure we would pay the right price.

Could a seemingly solid company still release unexpected news that moves shares sharply lower? Absolutely.

But even if that does happen, it does not necessarily mean I’ll suffer a loss. In the past month, for example, the average strike price I recommended was 17.8% below the current price. This gives me a large margin of safety, especially compared to investors who buy shares outright and would instantly be in the red.

But let’s say shares suddenly plummet below my strike price. We’d still have time to act. Most puts are not bought by investors intending to exercise. Few will exercise the put when they can simply book a profit by selling their option when it expires.

In other words, we should be able to exit the trade without having to buy shares. If there’s a fundamental change in the company, and I no longer want to purchase shares when the options expire, I can “buy to close” the option. In that scenario, we might take a loss, but it likely would be less than what a buy-and-hold investor would suffer.

So David is correct — we could potentially have a losing trade if disaster strikes. But as options sellers, we have a margin of safety that most investors don’t. And I’m confident my system will continue to deliver winning trades, regardless of what the market does.

Bob: When you approach options trading the way Amber does, it’s easy to see how she has compiled one of the greatest trading track records I’ve ever seen. To see all of her closed trades and learn even more about how’s she perfected her 52 of 52 win rate, go here.