Seven ‘Rules’ for Earning Safe Income in Volatile Markets

May 20, 2022

There’s no sugarcoating it… It’s getting ugly out there.

Inflation has been a serious problem for months, recession fears are on the rise, and the stock market is looking shakier than it’s been in years.

Given these risks, it’s more important than ever to protect your hard-earned savings. So, for the past several weeks, I’ve been doing my best to help Money Talks readers do just that.

I’ve shared strategies to help you navigate inflation, weather a recession, and protect your investment portfolio from a bear market in stocks.

One of the strategies I’ve also discussed before is utilizing options.

Selling puts is the safest and simplest way I know of to earn consistent monthly (or even weekly) income payments. Over the past couple years, it’s become my absolute favorite way to make money in the stock market.

This strategy does carry some risks, but there are a handful of simple guidelines that can dramatically reduce these risks and help you safely trade options no matter what the markets throw at us.

Let’s get right to them.

1. Stick to Healthy Stocks

When selling put options for income, it’s generally a good idea to choose “healthy” stocks (those that are in an uptrend with positive momentum). If you’re a TradeSmith subscriber, these are stocks in the Health Indicator Green Zone.

These stocks are more predictable and less likely to experience a “downside surprise” than those in the Yellow Zone or Red Zone. As a result, selling put options on these stocks is generally much less risky, all else being equal.

At a minimum, I would urge you to avoid selling put options on any stocks in the Red Zone right now.

2. Focus on High-Quality Stocks You Would Be Happy to Own

You can reduce your risk even more by going a step further and selling puts on only the highest-quality stocks that you would be happy to own outright. I’m referring to “forever”-type stocks that have strong “moats” and typically pay a consistent dividend.

Selling puts on these stocks will further increase your chances of a profitable trade. However, it has an additional benefit as well.

In the worst-case scenario – where your trade goes against you, and you get put the stock – you’ll end up owning a high-quality company for less than you would’ve paid to buy it directly. (I explained how this works in detail in TradeSmith Daily earlier this year.)

You can then sell covered call options against this stock to collect additional income until the trade is profitable or you otherwise decide to close the position.

3. Trade the Same Stocks Again and Again

Individual stocks often have their own “personalities.”

By selling options on the same handful of high-quality stocks over time, you can become familiar with their individual movements, which in turn can allow you to choose lower-risk and more profitable trades.

4. Don’t Chase Premium

It’s always tempting to choose trades with higher premiums. After all, who doesn’t want to make more money?

But it’s important to remember that higher-premium options generally have a lower probability of profit (POP), meaning you’re much more likely to be put the stock.

Over the long run, you’ll generally be far more successful selling lower-premium put options (further out of the money) with a very high POP than trying to earn more money on riskier trades. And that’s particularly true when overall market risks are high like they are today.

5. Consider Using Smaller Position Sizes

One of simplest ways to reduce your risk in any investment is to reduce your position size.

A single option contract controls 100 shares of an underlying stock, so options don’t offer the same degree of position-sizing flexibility as stocks. But trading options can still be a useful strategy on lower-priced stocks, or for traders with larger account sizes.

In short, if you would typically sell multiple options on a particular stock, you could consider reducing that number by one-fourth to one-half while market risk remains elevated.

6. Use Credit Spreads To Minimize Risk Further

Selling a credit spread in place of a single, cash-secured put is another great way to reduce your risk.

This involves selling a put option while also buying a put with a lower strike price at the same time.

Buying the lower-priced put will obviously reduce the total premium you collect upfront.

However, it will also dramatically reduce your maximum risk if the trade goes against you. And in many cases, credit spreads will produce a higher return on capital at risk than you can get selling the same put option alone.

(I also wrote about options spreads in more detail in TradeSmith Daily for those who would like to learn more right here.)

7. Avoid Trading Around Earnings

Finally, it’s always a good rule of thumb to avoid selling options around a company’s quarterly earnings announcement.

Earnings reports can trigger significant short-term moves in even the highest-quality stocks. But that’s particularly true when market volatility is high.

This week was a great example… Walmart Inc. (WMT) is a quintessential “forever stock.” Yet it plunged more than 20% following a less-than-stellar earnings report on Tuesday.

I have no doubt Walmart will continue to do just fine over the long run. But if you had sold puts expiring in the next few weeks, you’d be sitting on an unnecessary – and largely avoidable – loss today.