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"An Approach to Successful Stock Trading Combining Company
  Fundamentals with Chart Technicals"

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TSM Investment / Trading Lessons

 The TSM System of Stock Trading and Cash Investment is Described here in a Series of Trading Lessons.
TSM Lessons
Lesson #6 - The TSM Deep Out of the Money Short Put

    

Hi everyone.  This is Ric Miller again talking about TripleScreenMethod’s investment and trading strategies.

 

I’m going to spend the next few minutes describing my favorite strategy:  selling deep out-of-the-money Puts for income.

 

It’s a conservative strategy designed to give one a consistent return on a pile of money – something that you’re not going to find with many other vehicles today.

 

Let’s say you have $1 million dollars saved that you hope can provide income for the rest of your life.  As I speak, you could buy a 1 yr CD that yields 1.1%.  That vehicle would provide you $11,000 to live on for the year.  Not many of us could live off of just that interest so what happens?  You start to eat your capital, and before you know it you’re broke.

 

That’s why I’ve combined TSM stock picking, based on stock fundamentals and value, with an option approach that will provide conservatively a 10% plus return on your pile of cash:  or here, $100,000 to $150,000 a year on your $1,000,000.

 

In this presentation, I’ll explain the strategy and its metrics (annual yield and % downside protection) and show you how to calculate them.  Further, I’ll show you how I select the ones I personally trade.

 

In later lessons, I’ll discuss ways to minimize a loss when the trade goes bad, which occurs ~ 5% of the time.

 

So lets get started with just what is a Put?  Well, a Put is one of two types of options, and they are available on nearly all TSM stocks and trade just like the stocks themselves do.

 

When you sell a Put (a contract usually on a hundred shares), you give the buyer of that Put the right, but not the obligation, to put his shares to you at the Put’s strike price.  And he or she can do this at any time up until that options expiration date.  In effect, you become an insurance policy for his stock blowing up.  And for that he pays you a premium.  The Put buyer’s actions are very similar to his buying insurance for his home where he pays a premium for protection from it burning down: the strike is the insured price of the home and the expiration date is the life of the policy.  Think of my short-Put strategy as you becoming the insurance company. 

 

My rules of thumb for the short Put trade:  (1) I use Puts for TSM stocks which have both good fundamentals and good value remaining, to ensure lots of institutional support as a safety net; (2) I only sell Puts that have 30 days or fewer before their expiration to minimize my risk exposure; (3) finally, I expect at least a 10% annualized return though often I get much more than that.  Quality underlying stocks, risk control and a good return on my pile of money.

 

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Click to get the Poweropt set of Puts for the TSM screen.

 

So how do I find the specific Puts that I’m looking for?  Good question.

 

I use a powerful option screen.  First, I provide it a listing of all the TSM stocks for the week and the expiration month that I’m interested in, always what’s called the front month.  In real time, it then gathers data on all the available Puts for these stocks and rank orders them by their risk control measure, something that I call % downside protection and the screen calls % break even.  Expressed as a percentage of price loss, it tells me exactly how much the underlying stock for a particular Put can fall before I experience any loss.

 

Here’s an example of the screen that I ran end of day on 5/30/14.  Let’s spend a little time talking about the various columns of information, what they mean and which ones I consider important.  Note, I provide this screen every evening in the TSM daily report, and I email specific Put plays that I’ve just made during the day.

 

-the first two columns identify the underlying TSM stock involved and its end of day price with change from the prior day;  SYNA was the top stock on the list Friday.
 

-the third column identifies a particular Put for SYNA (one of many that it has), specifically its $60 Put expiring on the third Saturday in June, that’s in 22 days from now;  note, selling this Put (called writing this Put in the option world) would obligate me to buy SYNA shares (100 shares per option contract) at $60 a share anytime the seller wished to sell them to me over the next 22 days;  and why would the owner of the Put contract want to sell his shares to me?  One reason, his shares have fallen below $60 during that time.  We protect ourselves from that situation by dealing exclusively with TSM stocks characterized by strong fundamentals and by limiting our exposure to 22 days, but even so, about 5% of the time, this will happen, and we’ll get shares put to us that we’ll have to deal with in our stop loss strategy, but that’s a subject for another video.

 
-the next two columns show this Put’s option premium spread and its bid price:  the first is a measure of the Put’s liquidity (I limit the screen to finding Puts where this spread is 25 cents or less), and the second is the minimum premium that I could expect to take in when this screen was run (I always try to get the mid price between the bid and ask values; here the ask price would be the 50 cents plus the 15 cent spread);
 
-the next six columns deal with this Put’s specifics:  Delta tells me how much the premium will change when the underlying stock goes up $1, e.g., if SYNA goes up $1 on Monday, I could expect its 50 cent premium to drop by 11 cents;  Delta is also the approximate probability that SYNA shares will finish below $60 over the next 22 days (an approximate 11% chance here);  the exact probability calculated from a number of factors that I won’t go into here is a 87.8% chance that SYNA shares will finish above $60, and I will just keep the premium; I prefer delta to fall below 0.15; note too, that these probability estimates do not consider technical factors, e.g., where areas of support and resistance might lie.  Technical factors, I believe, are the reason that less than 5% of these get put

    to me, even when the delta would predict more than that.

 

Implied volatility is an annualized measure of SYNA’s future price variation expected by the option market maker; it’s directly related to the Put’s premium, i.e., the greater the volatility, the greater the premium;  for me, the important thing is how this future volatility relates to SYNA’s past historical volatility;  the next to last column (IV/HV) shows that ratio, e.g., here at 0.95, the future volatility is expected to be slightly less than its historic volatility over the past 50 days;  Note, I would prefer this ratio to be well above 1.0 because that indicates the Put’s premium is rich relative to its historic volatility; note too, in periods of rising stock prices like we’re now experiencing in the market, the implied volatility for Puts, hence their premiums, lessen.

 

    The % implied volatility range shows how the current volatility relates to the range of volatility this option has seen over its life;  here, it’s at the 18% level; its volatility has been higher 82% of the time; obviously, we would prefer this number to be greater than 50% because that would indicate again the option was rich in premium;  further, if it were greater than 50%, you might expect the law of reversion to mean would favor the implied volatility dropping, hence its premium dropping, and that’s always a good thing when you’ve sold the option.  If this 50 cent premium drops to 5 cents, I would be inclined to buy back the Put, close the position, and look to open another position that month with richer premium.

   

     The current option volume is the number of this option’s contracts that have been traded today, and the open interest is the total number of this option’s contracts that are currently open, not necessarily traded today but open; both are measures of the option’s liquidity;

 

    While we’re talking about option characteristics, let’s talk about Theta, the last column; it’s the change expected in the option premium due to the passage of one day’s time;  remember options are wasting assets which lose their value every day, even if nothing else changes; e.g., with SYNA, I can expect its 50 cent premium to drop by 2 x 3.15 cents by Monday morning when two days will have passed. 

 

    There’s an Earnings Date provided with the number of days before that date is reached in parenthesis because that day is likely to move the underlying stock price and option premium so you need to be aware if it’s coming up in the next 22 days;  often I will write a Put intentionally to include an earnings report because the approach of an earnings’ release typically inflates an option’s premium, but when I do, I always insist on good downside protection;

 

    The final three factors are the most important to me, show stoppers if you will:  two yield measures and a % break even (or what I call % downside protection).  The % Naked Yield is the return I would receive over the 22 days, considering the premium relative to the amount of money that would be set aside in my account until this option contract was resolved;  it’s assumed that you will have to set aside the strike price times the number of shares involved (100 shares per contract); for example, if I sold 1 contract of SYNA Puts, I would have to set aside 100 x $60 per share –50 cents per share premium or $5,950.  The return would then be $50 / $5,950 = 0.84% (a little different than the 0.8% stated in the table because they do not correct the $6,000 set aside for the option premium received.  These estimates are what you would be required for an IRA account; a typical equity account would require less money be set aside in your account, hence

give an even better return. The annual return is simply the return you could expect if you made this same investment every 22 days for a year.

 

     Finally, the % break even is simply the percentage that SYNA’s price must fall before I, as the Put seller, would start losing money;  along with the chart characteristics, yield and delta, this percentage is the most important factor to me; it’s the basis for which all these options are ranked.

 

     Having said all this about SYNA, the Put that I chose to write was the second one on the list, EMES, because I liked its fundamentals and chart better.

 

 

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EMES Fundamentals

 

     After running the option screen, I look at the fundamentals of the stocks that I’m considering.  Note, each evening I also provide this fundamental data for all the Puts under consideration.

 

     EMES fundamentals are shown here.

 

     It holds membership this week in 8 of my screens:  the set of four numbers separated by dashes tells me that 2 of the screens are Vector Vest, 3 are IBD, 1 is from a variety of other sources (here Navellier) and finally, 2 are from Zacks.  The particular screens are listed.

 

     TSM ranks each of its stocks on a 1 to 6 scale, the higher the better (particular criteria can be found at the TSM site); Zacks ranks stocks on a 1 to 5 with the lower numbers the better; Zacks rankings are proprietary, based on a number of earnings criteria; they are simply the best ranking of stocks available.

 

      The target price is based on earnings valuation methodology.  Of course, I would prefer my Put’s strike price to be lower than this target price, because ultimately, I could be owning the stock at that price.

 

      PEG ratios (Price to Earnings to Earnings Growth ratios or another way of looking at it Price divided by (Earnings x Earnings Growth)) are measures of value, and the lower their value the better the value at the stock’s present price. I use two PEG ratios; the first is based on this year’s earnings growth and the second based on the following year’s estimate.

 

      For me, the important fundamentals in their order of importance:  Zacks Rank (can be a 3 if Market Cap > $10 billion) – PEG ratios – Target Price Relative to Strike Price – Price/Sales – Which source have them ranked in their Screens

 

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    EMES Chart

 

      Let’s now spend a few minutes looking at EMES’ chart.

 

      I like the fact that it has been steadily moving higher with good support from its 20-day and 50-day moving averages.

 

      I wrote the $85 Put, shown by the white line on the chart for an 80 cent per share premium and guaranteed that over the next 22 days I would buy 100 shares per contact for $85 a piece. Note, the 20-day moving average support right there.

 

      The % Downside protection is calculated as the difference between the current price and the Put’s strike price + the per share premium.  Here, the current price is $95; the strike price is $85, and the premium is 80 cents.  EMES shares would have to fall by $10.80 over the next 22 days before I would start to lose money.  That’s 11.4% relative to the current price.

 

The yield is again a simple calculation.  Here, its 15.8% annualized.