Investing

When Being Wrong Turns Out to Be Right (And Profitable!)

By Lee Lowell  |  July 31, 2018

Have you ever been wrong in your bullish call on a stock?

How often have those trades turned a profit?

Probably not enough times, right?

I mean, how can you make money if your directional assessment is off?

And I’m not talking about waiting 10 years for a “trade” to finally break your way.

That’s just silly.

I’ve spent a lot of time highlighting amazing option-trading strategies in The Rich Investor.

This time, I’ll delve into why “option-selling” is so forgiving when you’re wrong.

Cushion for Error

My favorite option strategy is to sell put-option contracts on high-quality, blue-chip stocks.

My Instant Income Alert service is devoted to just that.

But how does selling put options give you a “cushion” for error?

In previous examples, I’ve used Amazon (Nasdaq: AMZN) as a target.

It’s currently trading near $1,820 per share. Expensive, right?

I’ve shown how you can sell put-option contracts with strike prices that are well below AMZN’s current quote.

Selling put options allows you to potentially buy any stock you want at below-market values.

Even better, you can make money by collecting the up-front payments.

If you sold an AMZN put option with a $900 strike price, you’d immediately deposit the going rate for it into your trading account.

In exchange for that payment, you agree to buy 100 shares of AMZN at $900 apiece.

But this obligation would be exercised if and only if AMZN trades below $900 by the expiration date.

If the stock doesn’t fall that far by the option’s expiration date, you keep the up-front payment as your consolation prize.

Those up-front payments can add up to tidy sums over time!

I’ve also shown in previous articles how the chances of AMZN falling that far are practically nil.

But how does that relate to directional cushion?

When selling put options for income (and not necessarily to buy the stock), your main goal is for the shares to NOT fall to the strike price.

In other words, you want the stock to stay flat or move higher.

In option-selling, the plan isn’t to figure out where the stock is going; the plan is to figure out where the stock isn’t going.

That’s a big difference – one that many investors never think about – and understanding this difference can help you make money.

The best way to make money from selling put options is by trading in and out and collecting the up-front payments you receive.

You see, when stocks go up, put-option prices go down.

And if you sold a put option at one price, you can book profits by buying it back at a cheaper level.

That’s how put-option sellers make money – we sell first and buy back second.

So, the goal is to NOT have AMZN drop to $900 per share. If it doesn’t, a put-option seller would realize the full gain on the option trade.

But what if AMZN does sell off?

Well, at the outset of the trade, you’d have over $900 of cushion (50%)… and you’d still walk away a winner.

Talk about a forgiving trade!

When was the last time you turned a profit on a stock that moved $900 against you?

Not often, I’m sure.

But let’s take a look at a more “reasonably” priced stock like Intel Corp (Nasdaq: INTC) to see how this strategy can give us a nice cushion for error.

INTC currently trades near $47.50 per share.

You could sell a $35 put option and collect the going rate for it.

In exchange, you agree to buy INTC at $35 per share sometime in the future, if and only if the stock trades below $35 at that time.

You could also make a profit on this trade as long as INTC stays anywhere above $35 per share. If that happens, you get to keep the full up-front payment you received.

Because you want INTC to remain flat or rise in price, you’d still have a $12.50 cushion (26%) for directional error.

INTC could give up $12.50 per share, and you’d still win on the trade!

I don’t know of many trades that would be profitable if the stock fell 26%, let alone 50% (in AMZN’s case).

Smart stock traders typically set stop-loss orders at 20% to 25% below their buy-in levels.

And when the stop is hit, they lock in their losses.

Many option-selling trades offer a downside cushion of anywhere from 30% to 70% – and that’s even before losses would kick in.

The bottom line here is that with put-option selling, picking the correct direction of the stock isn’t going to make or break the trade.

Success with put-option selling hinges on whether the stock will fall too far.

If you pick option strike prices that are situated far enough away from the stock’s current quote, you allow for normal fluctuations in the share price.

This “profit zone” is where you want to be.

In most cases, a stock trade lives or dies on getting the direction right.

Option selling is extremely forgiving.

In my opinion, it’s also a much easier way to make money.

Lee Lowell

A former Wall Street insider and floor trader, Lee Lowell has worked in the market for nearly 30 years now. He began his option trading career in 1991on the floor of the New York Mercantile Exchange (NYMEX) in New York City.Full Bio