How a Little-Known Indicator Led to a 93% Win Rate

Last week, I shared some research with you that I submitted to the Market Technicians Association (MTA). My paper, "Fixing the VIX: An Indicator to Beat Fear," earned me the 2015 Charles H. Dow Award, and I'm headed to New York City this week to accept that great honor.

In my paper, I presented research on a metric you may have heard me mention before, the Income Trader Volatility (ITV) indicator. Between Sept. 20, 2013 and Sept. 26, 2014, the period covered in the research I submitted to the MTA, I recommended 183 trades based on ITV and 93% of those trades were winners.

This week, I want to show you exactly how I use this indicator to recommend trades to my subscribers. But before I do, let me do a quick recap.

Most traders are familiar with the Volatility S&P 500 Index (VIX), which is helpful in finding turning points in the S&P 500 index. In general, traders look for high VIX levels as a sign of a market bottom and low levels as a sign of a potential top.

But VIX is not useful in finding turning points in specific stocks. ITV is similar to VIX but can be calculated for any stock, ETF or security that's traded. The rules for this indicator are the same general rules that traders apply to VIX. I expect high levels in the indicator to be associated with bottoms and low levels with tops. 

However, peaks and troughs in VIX are visible only in hindsight. ITV, on the other hand, utilizes a 20-week moving average (MA). When volatility falls, ITV crosses below the MA, which we use as a buy signal. Sells are given when ITV rises back above the MA.

Below are three stocks currently issuing an ITV buy signal. As you can see, ITV (gray line) has fallen below the 20-week moving average (green dotted line). 

These charts also show several previous signals, which can help you evaluate how successful signals were in the past.

I have used ITV with great success to help me time option trades, specifically put selling trades. If you are not familiar with this strategy, that's OK. I have put together an eight-minute training video that walks you through put selling step by step using examples of my actual trades. It's one of the clearest explanations of options selling I've ever seen published. One of my readers actually described my strategy as "easy as pie." You can click here to watch it now.

Basically, selling a put obligates you to purchase that stock from the put buyer if it falls below a specified price (the option's "strike price"). When you accept that obligation, you receive instant income upfront known as a "premium." However, if the stock remains above the put's strike price, the option expires worthless and that income is yours to keep free and clear.

Options premiums increase when volatility is high, making it the ideal time to sell options. Unfortunately, that is also among the riskiest times to sell options. By adding a moving average to ITV, the market action can tell me when volatility had reached a short-term peak, and that signal allows me to balance the potential risks and rewards of options selling.

Each Friday, I provide readers of my Income Trader newsletter with up to three put selling trades based on the ITV indicator's buy signals. These are bonus trades in addition to the regular weekly options I recommend.

This week, when I ran my ITV screen, the following three options emerged as potential trades:

Now, the returns may look small, but let's walk through the first trade to give you a better idea of the profit potential.

Selling the April $118.57 puts on Apple (NASDAQ: AAPL) will generate immediate income of about $54 (each contract controls 100 shares). This put will obligate you to buy AAPL at $118.57 a share if the stock trades for less than that on April 17, the last day these options can be traded.

Buying 100 shares of AAPL at $118.57 each would cost $11,857. To initiate this trade, your broker will likely require you to deposit a percentage of that obligation in your account, like a down payment on a house. This is called a "margin requirement." It usually runs about 20% of the amount it would cost you to buy the shares. This AAPL trade would require a margin deposit of $2,371.40 (20% of $11,857). 

The table includes the probability that the suggested options will expire worthless. This is found with an options pricing model and it is only a probability, but it is a good way for you to evaluate risk. Options I recommend always have at least a 70% probability of expiring worthless, which means there is only a 30% or less chance the put will be exercised at expiration.

Assuming the AAPL put expires worthless, like 93% of my recommendations have, you would keep the premium and make a profit of $54 on $2,371.40, or 2.3%, in just 24 days. That works out to an annualized return of 35%. 

If you're interested in getting trades like this each week based on the ITV indicator, you can sign up here.

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