Once you’ve settled on a lousy company or market segment to short, how do you pick the perfect put option?
An OptionsZone.com survey showed that options traders typically think it is easier to pick the underlying stock for an options trade than it is to choose the correct option once they’ve decided on the stock. So, I’m here to help.
I’m going to teach you the ground rules of picking put options, the technical indicators to pay attention to, and how to select the right put option.
The Ground Rules
The Company: Remember, you are buying a put, but the underlying driver is a lousy company that will disappoint investors and that, in turn, will drive the stock price down.
Repeat after me: “Fundamentals, not charts.”
For example, you know a big drug company faces a patent expiration in two years on a drug that accounts for 25% of revenue and 50% of profits. Generic competition will hit it hard and the dividend is way too high — a simple story that is not yet built into the stock price.
More Ground Rules
The Stock: Take a hard look at the relevant stock and pick a target price — i.e., what you think the stock price will be in three to six months, independent of the market.
I know that seems difficult, but you do it on the long side all the time. Occasionally the market moves all stocks one way or another, and that is why you are looking three to six months out, after one or two more earnings announcements and other bad news has had time to materialize.
Patience: Ask yourself if you have the patience to wait out a put on this stock. If not, move on.
Identifying the Appropriate Technical Indicators
Keep your technical analysis simple — this is about longer-term puts and fundamentals, not day trading and impressing people with big words like stochastic or terms like “iron butterfly.”
What you should concern yourself with are the basics like moving averages, liquidity, money flow and put/call ratios.
Moving Averages
I like to use the 50-day and 200-day moving averages. The best underlying stocks for put option positions have sliced through these as support levels, or hit these as ceilings and bounced back down.
Also, look at the moving averages of a fund that represents the market segment your underlying stock falls in. Ideally, you want to buy a put on a stock that you think is headed off a cliff that is also in a falling market segment.
Liquidity
Liquidity is an issue for small- and mid-cap stocks.
When I plan on buying a put, I like to see at least 5,000 open put contracts on a company, with at least 1,000-2,000 in the target expiration month and 500-1,000 for a specific contract.
The less liquid the put, the larger the spreads, and the less room for error when buying or selling the puts. And if you subscribe to a trading service, remember that others are trying to get into the same trade at the same time.
Money Flow
You should see if money is flowing in or out of the stock and compare that to money flows for the entire segment as represented by an exchange-traded fund (ETF) for that segment.
For example, if you were thinking of shorting a big pharma company, be sure to check out the Pharmaceutical HOLDRs first.
Put/Call Ratios
The put/call ratio is a ratio of the trading volume of put options to call options, which serves an indicator of investor sentiment.
Several Web sites can help you determine what the put/call ratio is, and whether it is increasing or decreasing. Sites like Yahoo Finance can help with the overall number, while changes in the ratio are the province of some fee-based services.
If the number of puts is rising compared to calls, no time to be a contrarian, this is a good sign.
Picking the Right Put
Now that you understand the ground rules and have a handle on what technical indicators to pay attention to, it’s time select your put option.
I have five guidelines to help ensure that you pick that perfect put.
Buy Yourself Enough Time
Pick a put three to six months out. Strange things happen in markets, and in a bear market there are many bull rallies that fade away.
Stick to a simple rule: Play defense first.
Shoot for a Double
Given the risks associated with options, shoot to double your initial capital and use this as framework for picking the right put. This will determine what you are willing to pay for the put and a target price for selling it.
A word of warning: Do not get seduced by the actual price of the contract. A $5 put that is sold for $10 produces the same return as a 50-cent put that is sold for a dollar. Many traders love those little guys, but stick with math, not emotion.
Use Limit Orders
Stick to your target entry price by using limit orders.
Never, ever use a market order to open a position. Market orders negate all of the hard work you put into finding the right entry price. Do not chase a position — it’s better to have it run away from you then to get caught chasing it.
Be Willing to Walk Away
Remember, there is always another trade. I have spent hours looking at a company, then the stock, but walked away from a trade because I couldn’t find the right put.
