subject: High Probability Trading. Generate Income From Your Portfolio Today [print this page] How do you place trades for profit, even if it's with that $2,000 or so that's sitting in your brokerage cash account earning no interest? First, let's break a trade down to its fundamental purpose: To make money. So when traders purchase a stock, there are two basic results that can happen.
The stock goes up.
The stock goes down.
While we like to think we will always pick winners, the odds are simple based on Standard Deviation.
Stocks that pay dividends put the odds slightly more in your favor as dividends can offset some capital losses.
With high probability trading, you can put the odds more in your favor. Depending on your time frame and risk tolerance, you can control the returns and the downside protection. Your trade could look like this:
How is it done? Here is a look at a stock, Discover Financial Services (DFS), that I've been using to generate income for my portfolio. Executing a BUY-WRITE. Buying the stock, and writing an ITM (in the money) covered call simultaneously. The trade would look like this (based on Friday's closing price). .
Remember, while it's got a higher probability of success, there is still the chance it moves against you. In the 4th quarter of 2008, and 1st quarter of 2009, during the peak of the credit crisis, I saw this strategy quickly turn against me as the markets were falling. The good news is, that if the markets fall, you're option value will too. So instead of holding the option, I was buying the option back for pennies on the dollar and issuing new options for more income. Point is, you can adjust your risk/reward during the 5 months of this trade if the environment changes. While it may seem complex to new options traders, the best way to learn is to start by selling a covered call on a stock you're holding above the current price. Remember 1 option = 100 shares of the underlying stock.
Questions I ask myself before Executing a Buy-Write
Would I buy the stock if it fell to $12.87? (using the example above. DFS: $14.77)
Does the option premium, time frame, and return warrant the risk?
Do I like the fundamentals of the underlying stock?
Am I prepared to hold this trade longer (or play defense by rolling over the option) if the stock moves below the Break Even Point?
If the stock price moved to $15.90 would I be a seller of (DFS)?
The most common mistake I see when executing this type of trade is that if the stock moves up, people tend to regret or rush to cover the option at a higher price. This can cost you money and is not the purpose of the trade. Patience is the most important element to trading a buy-write, and the hardest human emotion for most investors to control. Markets will move in your favor and out of your favor as you hold this trade. As long as you are comfortable with the questions above, then you should stick to your trade and not panic. For Buy-Write ideas on your favorite stocks, check out Market Intelligence Center and search the ticker symbol for ideas on stocks you like.
High Probability Trading. Generate Income From Your Portfolio Today
By: Kevin Monaghan
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