My Three Rules for Making 67% a Year with Options
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Longtime TradeSmith readers know I’m a huge fan of options.
In fact, going into 2023 I said that if I had just $5,000 to invest in the markets for the year, I wouldn’t have invested it at all.
Rather, I’d have used options-trading strategies to generate consistent gains of around 1% on that money each week.
As I mentioned, those kinds of returns don’t sound particularly exciting… until you consider they can add up to compounded gains of about 67% a year.
Yes… by earning 1% on your $5,000 each week and compounding it, using the options strategy I’ll lay out here today, you’d have wound up with $8,350 at year-end. That’s more than double the 24% you’d have gotten riding out 2023 in an S&P 500 index fund.
Not to mention that, when you compare that to a longer-term annualized return, 67% with options is more five times better than just holding stocks.
Best of all, it’s possible to earn these returns in any market environment. The best options strategies work in bull markets, bear markets, and everything in between.
So, today I want to share three rules I’ve found to be critical for consistent options-trading success.
Rule 1: Focus on selling rather than buying options
The vast majority of options end up expiring worthless. That means the odds of success are generally tilted overwhelmingly in favor of options sellers versus buyers.
You can think of the options market as a casino.
Folks who buy options are like gamblers. They might get lucky and hit it big occasionally, but most people end up losing most of the time.
On the other hand, folks who sell options are like the house. The casino is mathematically guaranteed to come out ahead in the long run.
That means you’re much more likely to be successful using strategies such as selling covered calls or cash-secured puts than you are simply buying calls and puts.
With these strategies, you’re selling other investors the right to buy or sell stocks at certain prices by certain dates. Since a big chunk of options expire worthless, the odds are much more on your side as a seller than a buyer.
That’s not to say you can’t make money as a buyer… just that it’s statistically less likely.
Rule 2: Aim for singles, not homeruns
Of course, even casinos lose money occasionally. And sometimes those losses can be significant.
The same thing applies to selling options.
So, I generally like to reduce my risk even further by selling short-term options – those expiring within a week to a month – with a very high probability of expiring worthless. This happens when the options contract is out of the money (OTM).
To use a baseball analogy, this approach aims to hit singles rather than doubles, triples, or home runs. Your potential returns will be smaller, but your chances of success will be much higher. That’s Rule 2.
That is one of the areas where Options360 – our powerful suite of options-trading tools – really shines. Specifically, Options360’s proprietary Probability of Profit (POP) metric provides the most accurate assessment of how likely a trade is to succeed that I’ve ever come across.
When selling options, the POP indicates the probability that a particular option will expire OTM (worthless).
Here’s an example of an option with a high Probability of Profit and a 2% potential return found by our algorithm. (Note that this isn’t a recommendation, just an example.)
For this example, Petco (WOOF) stock is trading at about $4 as I write, and the strike price of this put option is $2.50. As long as WOOF stays above $2.50 through expiration on June 21, this put option would indeed expire out of the money, and therefore worthless.
If you were a seller of this option, that means you would keep the $5 in premium for selling the option, then move on to the next trade. And Options360 sees a 99% probability that it’ll work out like this.
I generally look for trades with at least an 80% POP, but 90% or greater is ideal.
However, if you’re not an Options360 subscriber, you’re not entirely out of luck. You can use an option’s “delta” in a pinch.
If you’re unfamiliar, delta is one of the five so-called “greeks” – along with theta, gamma, vega, and rho – that measure various aspects of an option’s price.
Delta measures how sensitive an option is to changes in the price of its underlying stock. However, you can also use it to estimate a short-term option’s probability of expiring in the money.
Specifically, you’ll generally want to target short-term options with deltas between 0 and 0.10 when selling covered calls, and 0 and -0.10 when selling puts.
It’s not perfect, but these ranges should roughly equate to a POP of 80% or better in our system in most cases.
Rule 3: Stick to high-quality companies for an extra measure of safety
However, even if you strictly follow the first two rules, there is always a tiny chance the option you sell will expire in the money.
If you were selling covered calls instead, this isn’t necessarily a problem. It just means the underlying stock may be called away from you, and you’ll be forced to sell.
But when selling put options, you may be put (required to buy) shares of the underlying stock.
So, my third rule is to sell options on high-quality companies that you would be happy to own for a time if necessary.
These stocks tend to perform better and be less volatile, which means you’re less likely to suffer a significant, permanent loss of capital even if you’re required to buy shares for more than their current price.
I hope this breakdown helped show you how powerful an options-selling strategy can be in the right hands.
So long as you put the odds on your side by being a seller, targeting high-probability trades, and sticking to quality businesses, then you’re trading options far better than the 99% of traders who simply use them to speculate.
Like I said, you can study all about delta and the other greeks if you want to start doing this yourself. But before you do, I recommend checking out what our comprehensive options-analysis software, Options360, has to offer.
This software helps you create that 1%-per-week trading plan that can outperform the market even in hugely positive years like 2023 and what 2024 is shaping up to be.
My recent strategy session really demonstrates why this tool is such a great way for any investor to get started with this strategy. Take a few minutes and check it out here – I’m sure you’ll learn something valuable.
All the best,
Keith Kaplan
CEO, TradeSmith