The Key To Options Trading, From Bollinger Himself

October 16, 2013

"Always be in a position to trade another day."

Those were some words of advice John Bollinger gave Income Trader's Amber Hestla as they sat at a dinner table at Ted's Montana Grill in Denver two weeks ago.

"John, like Amber, has made a career out of trading options. It was his initial work with options back in the '80s that led him to develop the Bollinger Bands®, a technical indicator used by analysts the world over to identify when an asset may be overbought or oversold."

Given his contributions to the profession and his accomplishments as a trader, it's safe to say John has had considerable success navigating the options market. So when Amber asked him what the key to that success has been, she wasn't surprised to hear his answer:

"Always be in a position to trade another day."

As any good trader or investor knows, you should always have capital preservation in mind when taking a position -- especially when it comes to options.

According to our research, nearly 80% of people who buy options lose money in the process. With those kinds of statistics, it's not hard to see how some options traders can turn a large fortune into a small one in no time flat.

But just because the odds are against you, that doesn't mean you can't safely make money in the options trade...

Since Amber launched her premium newsletter, Income Trader, earlier this year, all 25 of her closed trades have been profitable, giving her (and her subscribers) an average gain of 8.6% every 48 days.

What's been the key to her success?

For one, Amber insists on selling options, not buying them. Since 80% of options buyers are losers, then 80% of options sellers must be winners. By limiting herself to selling puts, she is significantly stacking the odds in her favor.

But Amber also has another defense mechanism, and it's similar to one that Bollinger has used throughout his entire 40-year investing career. As he went on tell to her at their dinner together, "I only take trades that offer a high margin of safety."

If you have ever read anything published by Amber, you've likely heard that phrase before. That's because she puts safety at the forefront of every one of her recommendations. In fact, for her to even consider taking a position it has to have a margin of safety of at least 70%...

For a put seller like Amber, that means only selling options with at least a 70% chance of expiring worthless (when a put expires worthless, the seller gets to keep the premium they collected from selling the option as pure profit).

That's why she only sells puts on stocks she thinks are undervalued. The more undervalued the stock is, the less likely shares are to descend below her recommended strike price -- the price the stock has to fall to until the put option is no longer profitable.

Let me show you an example...

In July, Amber recommended selling puts on Humana (NYSE: HUM), the nation's second-largest provider of Medicare benefits in the United States.

At the time, the stock was trading at $83 a share. But Amber thought the company's fundamentals supported a higher price point. As she told her readers:

Right now, (Humana's) price-to-earnings (P/E) ratio of 9.7 is well below the insurance industry average of 14.1.

And in addition to the low P/E ratio, HUM has historically enjoyed a better-than-average return on equity and less debt as a percentage of equity than its competitors. These ratios indicate that HUM is a well-managed company that should be able to navigate upcoming changes in the industry.

If the most pessimistic analyst is correct, HUM is still a buy. The average P/E ratio over the past seven years for insurance stocks is 12.2. Using that ratio and the lowest EPS estimate of $7.85 for 2014, HUM should be worth at least $95.      

In other words, at $83 a share, Amber thought the company was undervalued by 10.7%. As a result, she told her Income Trader subscribers to sell August puts on Humana with a $75 strike. Given the company's strong fundamentals and discounted valuation, Amber estimated there was an 83% chance that the price of the stock would not trade below $75 by Aug. 16 -- the day the option expired -- meaning the put would expire worthless.

Her assessment was spot-on. In the two months the trade was open, Humana gained 10.3% -- closing at $91 a share Aug. 16. As a result, Amber got to keep the $95 in "Instant Income" she collected from selling the puts as a 100% profit.

But even if the stock had fallen below the strike price and Amber would have had to buy the shares... she would only have to purchase them for $75 -- $20 below what she thought they were worth.

That's the benefit of selling puts on stocks that you think are undervalued. Even if the price of the underlying stock falls below the strike price and you have to buy the stock, you're simply buying shares of a great company that you already think is trading at a discounted valuation.

In our opinion, this conservative approach is the key to being a successful options trader. By limiting your trades to those with only the highest margin of safety, you're able to take advantage of the lucrative nature of the options market, while also reducing most of the risk.

Of course, restricting yourself to high-probability positions means you could miss out on big gains in other riskier corners of the market. But for Amber, that's not a problem. After all, her goal with Income Trader is to generate safe, reliable income. While that means she may miss out some trades with "10-bagger" potential, at least she's comfortable knowing she'll be around to trade another day.

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