Short-term investment strategies using derivatives (especially short puts) are a highly intellectually compelling and, under certain conditions, profitable activity. I initially addressed this topic in the articles: Derivatives – Introduction, Derivatives – Part I, and Derivatives – Part II.
Investments of this type require an interdisciplinary approach and, at the same time, a narrow specialisation in many areas. In this article, I will focus on one very important element of the investment process: stock selection. My experience teaches me that smart stock selection determines over 50% of the success of options strategies. I apply a few simple rules when searching for stocks to take a short position using put options (i.e., the right to sell shares).
Rule 1 – Establish the rules of the game
Justification: Define the size and timing of planned options contracts and the total derivative exposure in light of available capital resources. Consider your risk aversion and investment goals.
- The game must be worth the candle: The option price shouldn’t be below $500, as it’s not worth risking small premiums on a single contract. In practice, this means looking for undervalued companies with share prices between $100 and $300.
- Above all, capital security: If you unfortunately have to buy shares at the strike price, it’s a good idea not to spend more than 50% of your available cash.
- Don’t get bored: Taking positions in options expiring later (60-90 days) requires a lot of patience. Depending on your resources, this problem can be solved by systematically taking positions in various options every week or every two weeks. After a while, a contract expires every now and then, leaving you with something to do.
- You plan, but fate laughs: You need a specific plan for entering and exiting trades, as well as for potential position modifications. However, you need to be flexible and occasionally exit early. The greater the volatility of stock prices, the greater the likelihood of new opportunities and threats emerging. Remember, tomorrow is another day.
Rule 2 – Avoid weak companies
The rationale is that if the share price drops below the option strike price, you may be forced to buy the shares. You don’t want to have shares of a weak company in your portfolio. This is a very important principle. Which company should be considered strong, and in what categories should this be measured? It’s worth considering this issue, at least in terms of the company’s financial condition and current valuation. You can also use AI tools, but nothing replaces your own judgment.
- Acceptable financial strength: Many brokers and specialised financial services (including free ones) provide company financial data. It’s crucial to assess key economic categories and financial indicators from a historical and forecast perspective. Any changes and adjustments to results are also important.
- Attractive valuation: current market multiples and their trends, as well as forecasted multiples: PE, PEG, EV/EBITDA, EV/CashFlow, etc. Analyst valuations, buy/hold/sell recommendations, and recommendation changes. Comparative analysis of the company’s multiples against competitors and, more broadly, market indices. News related to the potential change in the company’s value.
- Insider activities: Insiders may undermine trust in the company (e.g., CEO/CFO selling large blocks of shares).
Rule 3 – Take advantage of opportunities
The rationale is that whenever you enter into short- or long-term trades, you must carefully consider the timing. You’ll want to sell a put option when there’s an unexpected opportunity for a strong short-term stock price rebound. You don’t want to do this when technical analysis suggests a short-term decline in stock price.
- Seize opportunities: Analysing upcoming events will help you identify those that could have an immediate and significant impact on the stock price (e.g., data release dates, market regulator decisions, procedural, government, banking, and tax information, rating changes, etc.).
- Momentum: The results of technical analysis will help you determine the timing of your trade. Identify the trend and support and resistance lines across various timeframes. Evaluate the trading time indicators (e.g., overbought/oversold), the relationship between moving averages and the 200, 50, and 20 windows, Bollinger Bands, etc. Determine whether it’s a good time to sell a put option and which strike price increases the return-to-risk ratio.
Rule 4 – Volatility and liquidity are your friends
Justification: Your goal is to capture and retain as much of the option premium as possible. The amount of this premium (the option price) depends primarily on the stock price’s volatility. Equally important are the contract’s term and the stock price’s ratio to the option’s strike price on the trade date. Low liquidity (a shallow options market) poses a threat to the controlled closing of the trade.
- Liquidity: Remember that you may want to buy back a sold option, which is difficult in a shallow market. Therefore, it’s worth analysing the number of active call/put contracts, the LCALL/LPUT contract ratio, and the number of contracts offered at various prices and expiration dates.
- Volatility: High stock price volatility, preferably rising just before the trade, will ensure a high option premium. Therefore, monitor stock price volatility indicators, both historical and implied.
Rule 5 – check what the willows are whispering about, but only respect your own opinion
Justification: Fundamental and technical analysis can prove ineffective in the face of the investing crowd’s incomprehensible behaviour. That’s why analysing investment sentiment, especially its dynamics and recent changes, is so important. However, don’t let the crowd’s opinion sway you. It hurts most when we abandon a decision we’ve prepared, driven by some opinion from our environment, only to later discover we were right.
- Take into account an investment sentiment: It is measured by analysing the content of blogs and social media posts, now often done with AI.
- See pervasive disinformation: It is the essence of our times. The rapid flow of information can lead the mind astray. We must read and actively seek information, but with a huge dose of criticism and the assumption that each message was created for a specific purpose.
- Think contrary to popular belief: Some unexpected events can trigger an overreaction and a sharp sell-off of stocks. When falling prices are amplified by automated trading systems, an opportunity for short-term speculation on short puts arises. In a few hours, the dust will settle, prices will rebound, and we will collect a premium and forget about it.
Sometimes we choose a financially weak company with a volatility of around 70%. It’s fun to speculate on something like Coinbase (at the time of writing this article). In this case, we’re breaking a few rules, but you also have to have a little fun. I like the roughly $600 premium on the two-week MAR 13 26 170 SPUT contract. It’s worth signing it on Friday because time flies on Saturday and Sunday, and the stock market is dormant. But don’t consider this investment advice. I have no right to advise anyone, and I take no responsibility for any stupid things you do under the influence of this article, nor for your losses.
