Monday, June 8, 2015
Today, we're sharing a couple secrets for making high-income trades without taking big risks.
They're especially important to understand in today's market...
In an essay last week, we showed you that stock market volatility has been low for the last couple months. It still is... And this affects our favorite safe-income strategy, which we call "trading for income."
This strategy involves selling options. And when volatility is low, option premiums – the cash payouts we earn for selling options – are low, too. (If you're not familiar with the idea of selling options – puts and covered calls – you can learn more about how these strategies work here and here.)
This leaves option sellers in a tough position. A position that can lead to major trading mistakes... and big losses.
In order to avoid these mistakes, which we'll outline below, you just need to follow two simple guidelines. They'll allow you to earn safe, double-digit annual returns by selling options.
The first mistake some option sellers make when volatility is low is to accept smaller returns... because that's what the market is offering. Don't make this mistake. If you want to be successful in the markets over the long term, you need to make sure your potential reward is worth putting your money at risk... on every trade.
We do this with our trading-for-income strategy by only selling options when we can earn at least a 12% annualized payout. Annualized returns give us an "apples to apples" way to compare option trades across different time frames.
For example, if an option that expires in three months pays 3%, that's 12% annualized...
12 months / 3 months = 4 | 4 x 3% payout = 12% annualized
Or, if an option that expires in two months pays 2%, that's also 12% annualized...
12 months / 2 months = 6 | 6 x 2% payout = 12% annualized
By sticking to a minimum annualized return of 12%, we ensure our reward is worth putting our money at risk in the market.
Returns are important... But it's far more important to minimize risk. A big loss can quickly wipe out lots of hard-earned income.
The second mistake folks make leads to big losses. When volatility is low, it often leads people to sell options on riskier, more volatile stocks. The options for volatile stocks have higher prices... So it's easier to find 12% annualized payouts.
But when you trade risky, low-quality businesses, you run a greater risk of the company running into trouble and suffering a large share-price drop. You might collect a large, 5% premium with a risky stock, but that's a small consolation if you suffer a 20% share-price drop.
We avoid this mistake by only selling options on great companies that trade at good prices.
Great companies grow and improve over decades. They dominate their industry. They bring in huge amounts of cash, year in and year out. And they usually reward shareholders by paying steady and growing dividends.
We showed you a great example of this last month in health care and consumer goods giant Johnson & Johnson.
There are lots of ways to measure a good price. We like to compare the price of a stock with its earnings and cash flows. We look at how those compare with its own history and other stocks in the market.
Lots of investors like to use the price-to-earnings (P/E) ratio and the price-to-cash-flow (P/CF) ratio. These are freely available and work well in a lot of cases. But two metrics we like to look at instead are the enterprise-value-to-EBITDA (EV/EBITDA) ratio and the enterprise-value-to-free-cash-flow (EV/FCF) ratio.
As a general guideline, an EV/EBITDA or EV/FCF ratio of 10 is a bargain price for a great company. (If you want to find these numbers and calculate the ratios, we've unlocked a past DailyWealth Trader Q&A for you, which shows you how.)
In sum, when market volatility is low, there are more pitfalls for option sellers. You can avoid them by accepting only large income payouts... and by trading only great companies at good prices. They're two of our top trading-for-income secrets to success.
Brian Hunt and Ben Morris
You can find more recent research from Brian and Ben right here:
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