Pro Tips for Buying Options Premium

Find out how our Weekend Trader team drills down on option-buying opportunities

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The final stretch of 2017 started with a bang for our Weekend Trader options recommendation services, as traders closed out three winners in three days. First, our Dollar Tree (DLTR) call option was closed out at a 102% gain on Nov. 29, less than two months after it was initially recommended. Then, on Nov. 30, a Kroger (KR) call option hit its target for a 104% return in a little over two weeks, while a Progressive (PGR) call rounded out the trifecta on Dec. 1 by doubling in value in just under six weeks.

These three trades were spread across our Weekend Trader Series and Weekend Trader Alert subscriptions, which follow an identical methodology -- find intermediate-term option-buying opportunities that are set to deliver 100% returns within one to four months. This approach typically (but not always!) leads our traders toward in-the-money calls and puts, which provide leverage on directional moves while offering comparably lesser risk of a total loss relative to an out-of-the-money alternative.

With two more trades closed out at target profits within the past week, as of this writing, there's clearly something going right with this strategy. To find out more, we sat down with the experts behind Weekend Trader: Schaeffer's Senior VP of Research Todd Salamone, Senior Quantitative Analyst Rocky White, and Quantitative Analyst Chris Prybal.

It was obviously a good year for the stock market in 2017, but what kind of environment was it for the Weekend Trader strategy? What were the advantages and disadvantages?

Todd Salamone: In most instances, implied volatility on equity options was relatively low, which means option prices were cheap, and gives the option buyer more profit potential on directional moves in his favor.

It would be easy to say the strategy did well because the market was higher, but that isn’t necessarily true. The strategy focuses on three- to six-month options, three- to four-month options, and nothing more expensive than one-year options. There were 2 two-month stretches where the S&P 500 Index (SPX) did very little on a net basis -- late February through late April, and mid-June through August. However, there was enough rotation in the market where the analysts here were able to find hot stocks and sectors throughout the year, as well as "cold" sectors and stocks on a few put plays -- which paved the way to a successful 2017.

Did you find you had to adjust your usual approach to fit the market environment -- playing more calls than puts, for example? 

TS: Naturally, in a market that grinded higher with little downside, we found more call opportunities. But we did find some stocks that were major underperformers and carried more downside risk, in our assessment, so we tried our best to take advantage of such opportunities as they arose. However, there were a few occasions during the year when we carried no puts, which is not something we are entirely comfortable doing.    

What kinds of "dealbreakers" have iced otherwise-appealing trade setups?   

TS: Frequently, we would see underperforming stocks that were potentially ripe for a put play, but we found the chart was too choppy for a two- to four-month option premium -- meaning we didn’t see enough reward for the risk we would be advising our subscribers to take. Sometimes, such opportunities were better suited for one of the real-time trading recommendation programs that we offer with much shorter holding periods, such as Overnight Trader or Weekly Options Trader.

Another deal-breaker on occasion was a major event around the corner, such as earnings, which made the options more expensive than usual. 

Which indicator or signal might tip the scales in favor of a particular stock? 

TS: If we're weighing several candidates, it might be the underlying with the most favorable options pricing or a higher Schaeffer's Volatility Scorecard (SVS) rating. The SVS is a proprietary scoring system that we use internally to rate the historical tendency of an underlying to produce favorable returns for option buyers.

DLTR call was recommended on Oct. 13 -- the same day the stock was downgraded. Did this impact your recommendation at all?    

TS: We actually noted that the stock was holding above the critical $90 level despite the bearish analyst note, which is pretty much the perfect microcosm of a contrarian bullish setup -- strong price action in the face of pessimism. This was an encouraging sign that definitely played into our ultimate decision to play Dollar Tree calls.

The KR call was recommended on Nov. 19 after a lengthy slide related to pessimism over Amazon's buyout of Whole Foods (and subsequent slashing of prices). The option was recommended two weeks ahead of earnings, after which KR gapped higher. Did you change your approach at all to manage the event-related risk?

Chris Prybal: Heading into the trade, we felt KR was oversold by a variety of measures, even as it was rebounding from support around $20 -- a crucial level that corresponds with a $20 billion market cap, roughly half the all-time high, double the 2009-2012 trading range, and peak put open interest at the time of the recommendation. Due to the earnings being two weeks out, though, our strategy was to select an option deeper in-the-money (ITM) and buy more time than usual. 

PGR was recommended on Oct. 22, with high short interest being one of the key factors behind the trade. Obviously, there are a lot of heavily shorted stocks out there at any given time -- what made the case for PGR so compelling?

Rocky White: For most of the year, short interest had been rising, and the stock was up quite a bit. Specifically, from February until the trade was put on, short interest had nearly doubled and PGR was up 25%. Therefore, the chances of a short covering rally were higher than usual.

Just before the trade was put on, short interest had declined from the highs, which we took as a sign that shorts were beginning to lose faith in their positions. Fortunately, that turned out to be the case, as short interest fell further from there -- which was probably key in driving the rally that led to our position hitting targets.

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