Introduction

If you are new to options trading then I recommend you go watch these videos here. Tastytrade's is an excelent educational channel for options trading and trading advice in general. If you want something with a little more humor and some good examples of how to place option strategies then I recommend you watch these videos here. This guys is very good at explaining some of the more technical things in ways that make sense.

In this article I will go over the strategy that has worked for me so far. I am by no means a "professional trader" but I have had decent success in the past year trading. That being said, this article is also meant to be a thought excercise for myself to help me think through different senarios as I talk about the things that I have applied to my trading strategy. So please feel free to comment on anything that doesn't make sense or that you disagree with. This is a work in progress.

1. Choose an industry that you are passionate about!

The general rule of investing is to diversify your portfolio, and I couldn't agree more. Diversification is very important, however, when it comes to PCS's that rule doesn't apply equally. In a regular portfolio you want to diversify the risk of your assets by being invested in many different industries (but not too many) to decrease the chances of losing too much at once. For example, if you are only invested in oil companies then you run the risk that tomorrow the whole world changes to renewable energy sources and very cheap electric cars hit the market. This is clearly an exaggeration but you get the point. This would be catastrophic for the oil industry and would lead to a MAJOR loss in your portfolio. Now, if you are invested in tech, gold, oil, and pharmaceuticals then even if that happened the loss from the oil companies would be minimized by the gains of the tech industry and vice versa.

When it comes to PCS's we want to take a different approach. By choosing an industry that you are passionate for, you will hopefully choose something that you are naturally very interested in and have a great deal of knowledge on. This knowledge is critical when trading PCS because being up to date on the latest news in that industry can be harder to do when you aren't naturally involved with the topic.

For example, as a computer science major and a software engineer I am very interested in the tech industry. I am always researching the latest and greatest things that come out. This gives me a slight advantage over the average investor because by understanding the industry so well I can better gauge the impact that news will have on the stock price. In the case of Apple, their yearly WWDC event is sometimes overlooked by many investors. I look at that conference and see a roadmap for Apple’s future plans. By seeing what they are investing in for their developers I can make better predictions for Apple’s future plans. This allows me to make better evaluations of the company's growth potential.

This type of understanding becomes increasingly more important when trading PCS because you typically want to focus on 2 - 5 companies at a time. That’s roughly the range of companies that are manageable for a new investor in case anything goes wrong. Remember that the point of trading PCS is to minimize our risks and create a steady flow of cash with very low probabilities of losing. Emphasis on “Low probability” I am not saying that the risk is taken out completely, but we can make sure that the odds are in our favor and focusing in one industry helps us get there.

2. Choosing the companies

Remember that when you trade a PCS you are betting that the market will either go up, stay the same or will not decrease below a certain price. Once you have a good understanding of the industry, you want to choose companies that clearly have a lot of growth potential. Now, you might ask yourself "If I know that this company is going up why don't I just buy the stock and hold it?" Well the answer is simple because you can make a lot more money trading the PCS, and you minimize your risk by not having to hold the asset for an extended period of time. This gives you more flexibility to do other trades and manage your risk. Also you can use less leverage (initial amount of money investment) and achieve higher returns with PCS.

While choosing your companies you want to look for the following characteristics

• Companies that you understand very well
• Companies that are “Too big to fail”
• Companies with relatively high stock prices or larger market caps (This leads to better profit opportunities)
• Companies that are leaders in their industry
• Companies with clear growth potential
• Companies that invest into their R&D (Research and Development) department
• Companies that constantly innovate or release new products

Nvidia and Apple are good examples of such companies in the tech industry. Although AMD is similar in some respects, it doesn't offer enough flexibility in it's option pricing chain due to its lower stock price.

These are all generally good indicators of companies that are leaders in their industry, can sustain their evaluation and are less likely to tank from one day to the next, and that have a lot of growth potential.

3. Technical indicators and choosing the strike price

Once you have identified the stocks that you feel comfortable trading you can proceed to the technical analysis part. Technical analysis isn't perfect, but it does help us identify potential movements in the market. In this case we wan't to make sure that we are able to identify windows of low volatility. So typically we wan't to avoid opening positions around earnings announcements or any other type of event that can cause a strong reaction in any direction.

This is typically true for beginners. As you become more familiar with how the market moves and reacts you can start to leverage these reactions to profit even more, but it is riskier and remember that our goal here is to reduce risk.

Indicators

1. MACD
2. RSI
3. Bollinger Bands
4. Volume

My favorite analysis tool at the moment is thinkorswim. To use their tools you need to have a brokerage account with no minimum deposit, but it is definitely worth the hassle considering how many tools you get for free. Some good alternatives are TradingView and FactSet.

In this example we see how the MACD was trending high above the zero line for the last couple of days, but began to gradually converge back towards zero. This is a good indicator of the bullish trend begining to slow down. However, even though there were some strong sell signals in there, the RSI indicates otherwise. Also, keep in mind that this was a couple of days after earnings so there was a general positive impact from beating the expectations. Again this can still be a profitable trade if you know how to manage it properly. In this case I sold puts two weeks out at a strike of $415/$412.5 The time I sold is indicated by the vertical orange line in the picture. The indicators were showing a slowing of the stock movement which can mean two things, the stock price is stabilizing or going back down. I felt pretty confident that Apple wouldn't drop another $15 - $20 in the next week, and luckily my prediction was right.

In the picture above we can see how Apple behaved in the following couple of days. Roughly a week later my position had gained more than 50% profit from the initial credit received. I used that opportunity to close in some gains and sold three of my five positions. Later in the post I will talk about picking the right time to close positions because you don't necessarily want to hold the PCS to expiration.

How to look at the indicators

I recommend looking further into these indicators but this is generally how I use them.

1. MACD: I use the MACD chart to get a general sense of how fast a stock is moving in either direction. When selling PCS we wan't the stock price to stay above our strike price, so the MACD can help us identify whether the stock is behaving relatively stable or if it has the potential to accelerate in either direction. It is normal to see the MACD line fluctuate around the zero line. You should be concerned when the MACD line generates a strong sell signal or is way below the zero line and does not look like it is reverting soon. This could be a sign of a lower price adjustment. Although it is rare it can happen.
2. RSI: When analyzing the RSI I typically look for stocks that are fluctuating between the 70 and 30 region. I like to set my RSI to a range of 10 days because I typically trade bi-weekly PCS although that changes quite often depending on the state of the market. I like to look at the RSI as a reinforcing indicator for my initial prediction. If I notice that the MACD and the RSI are both giving strong sell signals simultaneously for the last couple of days I might reconsider my strike price if I haven't opened a position, close the position and take my losses or gains if it's already open, or consider a different stock given the uncertainty.
3. Bollinger Bands: The Bollinger Bands help me decide two things, when to open a position, and around what price I should be setting my strike price. Generally speaking when the Bollinger Bands are wide it is a good time to sell PCS because volatility is high and the premiums pay more for the same amount of collateral.
4. Volume: This is good in general because it allows us to have an idea of how much of the stock is being traded in comparison to other instances in the past. Generally a spike in trading volume can be a good thing if managed properly, however, it also means that there is an increased risk of a potential strong shift in one direction or the other. So to summarize an increasing volume should be an alert to be more active and pay attention to what the stock and spread are doing so that you can minimize your losses if things go wrong, or take a profit while you can if you fear a down move.

4. Picking a strike price to sell at

This is where the Bollinger Bands can come in very handy. I typically look for two things when choosing my strike price

1. The lowest price in the last 5 days, 10 days, and 30 days. This helps me get an idea of what price region I want can play around with.
2. Look at the technical indicators, even if the stock is in a down turn you can potentially enter a PCS that expires in the next two days with a strike price right around the border of the lowest low for the week.

Know your stock, look back and see how big the largest move in either direction was and then check how often that tends to happen. This should help give you an idea of how likely the stock is to move x amount again in a period of time.

5. Managing your position

When trading PCS you have two options. 1) Ride the PCS to expiration and collect the full credit. - OR - 2) Buy to close the PCS before expiration once you have gained 20% - 50% profit. You might be asking yourself why would I close my position to receive less credit? Well when you close your position and walk away with 20% - 50% you can free up your collateral sooner to put in another PCS and keep that money working with lower risks. Remember that the longer you are exposed to an open position the more risk you are taking that things go south. However, this all depends on your trading style. Some people like to sell PCS a month or two out and ride the position all the way to the very end. When you do this thoug, you will go through periods where you might have very large negative balances. That is nothing to be afraid of (unless you are close to expiration) because you will hopefully have enough time for the position to recuperate, break even, or walk away with a small loss if the price comes back near your strike price.

One thing to keep in mind is that when you open a PCS your broker might show a negative balance even though the stock price is above you strike price. This is because when the stock goes down the probability of your strike price being hit is higher, therefore making the put more expensive. All this means is that you theoretically lost money because you missed out on the opportunity to sell it at a higher price, but your initial credit is still there nothing has changed.

Conclusion

Like I mentioned before, this is not a professional guide to trade PCS, but it is the formula that I have been using so far and that has proven to be quite profitable. PCS are a great financial tool to create a steady source of income that has low risk and is relatively easy to manage. It is a great way to put your money to work for you, by putting it up as collateral and selling the puts instead of buying them you essetial go from being the person gambling at the casion to the casino itself. Casinos profit a lot because they have the odds in their favor. The same applies when trading options. Trade responsibly!