There's No Edge In Stock Picking

Those that subscribe to the efficient market hypothesis believe that there’s no edge or advantage when it comes to picking stocks. Thus, stock-picking is a binary event and boils down to a 50/50 probability or simply chance. Everything that can be possibly known about a stock is known, and all the available information, technical analysis, and fundamental analysis is priced into the underlying stock price. The efficient market theory may be the Achilles heel of professional money managers’ performance and their inability to outperform their benchmarks. A staggering 92% of actively managed funds do not outperform their benchmark hence the massive inflows into passive index investing and ETFs.

Furthermore, when looking at The Russell 3000 Index over a 26-year timeframe (1983 to 2006) which comprises the largest 3000 U.S. companies, 39% of stocks were unprofitable investments, 64% of stocks underperformed the Russell 3000 and 25% of stocks were responsible for all the market’s gains. Taken together, only 36% of stocks outperformed the Russell 3000 index. If the efficient market theory is correct, is stock picking a useless endeavor? If stock-picking boils down to chance, is there a strategy that places the statistical odds of success in one’s favor?

Efficient Market Hypothesis

Markets aren’t always functioning efficiently. Markets can be irrational and become overbought or oversold. Outside of these extremes, however, markets are efficient, and over the long-term the vast majority of actively managed funds are unsuccessful at beating their benchmarks. Everything that can possibly be known about a stock is known, and there’s no edge in stock picking. As of Q1 2019, for the ninth consecutive year, the majority (64.5%) of large-cap funds lagged the S&P 500 last year. The longer the timeframe, the weaker the performance, after 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92% are underperforming the index (Figures 1 and 2). These dismal results hold true across large-cap, mid-cap, and small-cap funds. Even if these actively managed funds happen to outperform their index, it’s due to chance, and this margin of outperformance is primarily negated by hefty management fees, rendering stock-picking useless. To further emphasize this point, for the Russell 3000, 39% of stocks were unprofitable investments, 64% of stocks underperformed the index, and 25% of stocks were responsible for all the market’s gains. Taken together, only 36% of stocks outperformed the Russell 3000 index.

Stock Picking

Stock Picking

Figures 1 and 2 – Time based underperformance of actively managed funds relative to the S&P 500 (Active Fund Managers Trail S&P 500)

Stock Picking

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Figures 3 and 4 – Data summarizing the performance of individual stocks relative to the Russell 3000 index. Highlighting the fact that only 36% of stocks had a higher return than the index and 25% of stocks accounted for all of the market’s gains. (The_Capitalism_Distribution)

Even Distribution of Returns

If the fact that 92% of actively managed funds do not outperform their index and that only 25% of stocks accounted for all the market’s gains wasn’t compelling enough, the distribution of returns also supports the efficient market hypothesis. The S&P 500 moves in a standard distribution over time, the number of daily moves is evenly distributed. There’s an equal and even number of days where the market moved up 0.6% as it moved down 0.6% (Figure 5). The market has fluctuated between a 2% loss and a 2% gain 94% of the time. Markets move in a standard distribution over time; there is no pattern or predicable cycles over the long-term which renders stock picking to random chance or a 50/50 probability. Interestingly, the market does move up over time due to positive skew in these data attributable to the fact that indexes are capitalization-weighted. This means that successful companies receive larger weightings in the index. Conversely, unsuccessful companies receive smaller weightings and are inevitably removed from the index. This disproportionally favors successful, growing companies hence the fact that only 25% of companies account for all the market gains.

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Figure 5 – Standard distribution of daily market moves of the S&P 500 for 65 years

Options Provide Statistical Edge

The only way to consistently and reliably profit from this even distribution and market behavior is via options trading. Options trading allows one to profit without predicting which way the stock will move. Options trading isn’t about whether or not the stock will move up or down; it’s about the probability of the stock not moving up or down more than a specified amount. Options allow your portfolio to generate smooth and consistent income month after month without predicting which way the stock market will move. Options are betting on where stocks won’t go, not where they will go. Running an option-based portfolio offers a superior risk profile relative to a stock-based portfolio while providing a statistical edge to optimize favorable trade outcomes. Options trading is a long-term game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. Put simply; an options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates.

Life Insurance Parallels

Insurance companies sell policies based on risk factors, then price these policies to their advantage. Insurance companies are betting on probabilities and sell overpriced policies above their expected losses. The insurer agrees to pay out a specific amount of money for a specific loss (i.e. death). In return, the insurance company is paid monthly premiums based on this risk-based revenue model. Insurance companies sell policies with a premium cost level that maximizes a statistical edge to the insurance company’s benefit. The goal is to collect premiums over the course of the policy and never payout on the policies they sell. So, the probability of paying out on the policy is very low while the premiums received, over the policy lifespan will exceed your total benefit. In terms of life insurance, it’s the probability that you won’t die before your predicted lifespan so the insurance won’t have to pay. In order to spread the potential payout risk, the insurance company will sell as many policies as possible to collect as much premium income as possible.

Options trading is much like insurance. I receive premium payments (policy payments) in exchange for selling options (insurance). I sell these options with a statistical edge (underwriting) and a high-probability of winning the trade (insurance won’t have to pay). Occasionally, options move against you (death occurred) and you’re assigned stock (insurance is paid out) however in order to spread the risk of being assigned shares, options (insurance) are sold across a diversity of tickers that include both stocks and ETFs with varying expiration dates and optimal sector exposure. Additionally, risk is mitigated by appropriate capital allocation, position-sizing, and holding cash reserves in the portfolio.

Results

Sticking to a set of fundamentals, this approach can provide long-term, high-probability win rates to generate consistent income while circumventing drastic market moves. Over the previous 11 months through both bull and bear markets, the win rate percentage was 84% (231/262). Over the previous 11 months, the options-based portfolio outperformed the S&P 500 over the same period by producing a 0.9% return against 0.4% for the S&P 500 (Figures 6-8).

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Figure 6 – Options based portfolio return (0.90%) in comparison to the S&P 500 return (0.43%)

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Figure 7 – Comprehensive options metrics over the previous 11 months

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Figure 8 – Dot plot summarizing ~260 trades over the previous 11 month period

Conclusion

Markets are efficient, and over the long-term the vast majority of actively managed funds are unsuccessful at beating their benchmarks. A staggering 92% of actively managed funds do not outperform their benchmark. Furthermore, when looking at The Russell 3000 Index over a 26-year timeframe (1983 to 2006) which comprises the largest 3000 U.S. companies, 39% of stocks were unprofitable investments, 64% of stocks underperformed the Russell 3000 and 25% of stocks were responsible for all the market’s gains. Taken together, only 36% of stocks outperformed the Russell 3000 index. Everything that can possibly be known about a stock is known, and there’s no edge in stock picking, hence the efficient market hypothesis. The only way to profit from this even distribution and market behavior is via options trading. Options trading allow one to profit without predicting which way the stock will move. Options allow your portfolio to generate smooth and consistent income month after month without predicting which way the stock market will move. Options are betting on where stocks won’t go, not where they will go and provide a statistical advantage.

An options-based portfolio has allowed me to do something 92% of actively managed funds haven’t been able to accomplish and that outperforms the broader index consistently despite the volatility and the month of August negatively impacting my portfolio in a disproportional manner. Selling options with a favorable risk profile and a high probability of success is the key. Options fundamentals provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. I’ve demonstrated an 84% options win rate over the previous 11 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 0.9% return against a 0.3% for the S&P 500 with a lower risk profile. Taken together, options trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions with the probability of success in your favor.

Noah Kiedrowski
INO.com Contributor

Disclosure: The author holds shares in AAL, BAC, C, CVS, GPS, GE, HLF, KSS, SLB, TRIP, URBN, USO, WBA, and X. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.

What Does Life Insurance Have To Do With Options Trading?

Generating smooth and consistent income month after month without predicting which way the stock market will move is the objective of options trading. Running an option-based portfolio offers a superior risk profile relative to a stock-based portfolio while providing a statistical edge to optimize favorable trade outcomes. Options trading is a long-term game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. Put simply; an options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates. Essentially, options are a bet on where stocks won’t go, not where they will go. Sticking to a set of fundamentals, this approach can provide long-term, high-probability win rates to generate consistent income while circumventing drastic market moves. In July, I posted a 96% (24/25) options win rate, and over the previous 10 months through both bull and bear markets that win rate percentage was 87% (199/230). Over the previous 10 months, the options-based portfolio outperformed the S&P 500 over the same period by a significant margin producing a 6.1% return against a 2.3% for the S&P 500.

What Does Life Insurance Have To Do With Options Trading?

Insurance companies sell policies based on actuaries and risk factors, then price these polices to their advantage. Insurance companies are betting on probabilities across insurance products and sell overpriced policies above their expected losses. The insurer agrees to pay out a specific amount of money for a specific loss (i.e., death). In return, the insurance company is paid monthly premiums, and based on this risk-based revenue model; it’s a very profitable business. Insurance companies sell policies with a premium cost level that maximizes a statistical edge to the insurance company’s benefit. The goal is to collect premiums over the course of the policy and never payout on the policies they sell to you. So, the probability of paying out on the policy is very low while the premiums received, over the policy lifespan will exceed your total benefit. Continue reading "What Does Life Insurance Have To Do With Options Trading?"

Options: Long-Term Game of Discipline and Outperformance

Options trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. To this end, an options-based portfolio requires discipline and time to materialize in order to reach its full benefits when benchmarked to a broader index. An options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates. An options centric portfolio ebbs and flows just like any portfolio as various types of trades are executed, management of trades are carried out and the inevitability of assignment of occurs. Over the long-term, this approach provides smooth portfolio appreciation while generating consistent income. Since options are a bet on where stocks won’t go, not where they will go, this is accomplished without predicting which way the market will move. When adhering to options trading fundamentals, this approach can provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. Following these option trading fundamentals, I’ve demonstrated an 85% (175/205) options win rate over the previous 9 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 4.51% return against a 0.95% for the S&P 500.

Results

The broader market has been tumultuous over the past 9 months, to say the least. In Q4 2018, the S&P 500 posted one of its worst quarters and since the Great Depression with the index selling off 14% and erasing all of its gains for the year. 2019 started off on a high note for the S&P 500 with January posting a 7.9% gain, logging its best January in over 30 years. This was followed by continued strength in February, putting the index on its best footing since 1991 with a cumulative return of 11% through the first two months and rounding out Q1 2019 up just over a 13% return. May witnessed a market sell-off which saw a decline of -5.8%. June 2019 was the best June for the Dow since 1938 whereas the S&P 500 posted its best first half of a year since 1997, notching a 17.3% gain. Sticking to a set of disciplined fundamentals through this volatile market over the previous 9 months generated superior returns relative to the historic run by the S&P 500 (Figures 1-4).

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Figure 1 – Options based portfolio return (4.51%) in comparison to the S&P 500 return (0.95%)

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Figure 2 – Comprehensive options metrics over the previous 9 months

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Figure 3 – Dot plot summarizing ~225 trades over the previous 9 month period

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Figure 4 – Additional, comprehensive options metrics over the previous 9 months

Difficult Market Conditions Resulted In Mixed Results For Q2 2019

The options based portfolio did not perform as well as the broader index during Q2 2019 due to specific sector exposure weighing on performance.

  • Oil and oil-related stocks sold-off (i.e., USO and SLB)
  • Retail stocks tumbled double digits (i.e., GPS, URBN, LOW, KSS, and CPRI)
  • Pharmaceutical supply chain stocks continued to be pressured (CVS and WBA)
  • Financials couldn’t seem to get much traction (i.e., BAC and C)
  • Steel stocks plummeted (i.e., X)
  • Airlines were pushed lower (i.e., AAL)

A series of buy-to-close trades at a loss and a few assignments (KSS and X) largely negated premium income gains throughout the second quarter. Previously assigned positions from past quarters continued to weigh on performance (GE, SLB and USO) as well. Overall portfolio performance for Q2 2019 was anemic and slightly positive at 0.32%. Despite these mixed results, continuing to trade through all market conditions is essential to long-term options success.

Portfolio Approach

For the past 9 months, I’ve managed an options-based portfolio where I predominately leverage cash to sell options and collect premium income. The goal in options trading is to leverage cash and/or stock and sell options using the underlying cash and/or stock to collect premium income. This can be performed in a high-probability manner where a statistical edge goes to the option seller’s advantage.

The vast majority of my trades are cash covered puts. Thus I am not buying the underlying stock. However, I’m leveraging/earmarking cash and agreeing to buy shares at an agreed upon price by an agreed upon date. For example, if a stock sells for $50 per share now, I may elect to sell an option for $0.75 per share and agree to buy the shares for $45 one month into the future in exchange for $75 (since options trade in blocks of 100). When selling an option, one collects premium income ($75) in exchange for taking on the obligation/risk to buy the shares at the agreed upon price. I contractually agree to buy shares with a high probability that the shares will not trade lower than $45 before expiration. Thus, I’ll capture the premium income of $75 and re-purpose the cash that was earmarked upon expiration of the contract.

I like this type of trade when coupled with a high implied volatility rank (IV Rank) value because there’s a high probability that the shares will not be as volatile as the market is predicting as measured by IV Rank. Historically, predicted volatility is nearly always overestimated; hence, the stock will be less volatile than predicted. Meanwhile, a healthy margin of safety to the downside is built into the trade, and in this case, it’s a 10% cushion to the downside. Taken together, these types of trades are placed 1 standard deviation out-of-the-money to yield ~85% probability of winning the trade at expiration. These probabilities of success are based on past volatility moves over a given timeframe of the underlying security. Using past volatility moves, the market can use this to predict future stock volatility and probability of success. When IV Rank values are high, rich premiums are paid out at any given strike price since market participants are predicting a high level of volatility. If the shares break below the strike of $45, then your effective purchase price would be $44.25 per share since $0.75 per share was received upfront in the form of premium income. Best case scenario, premium is collected, and cash is re-purposed for future trades while worst case scenario is an assignment at $44.25 (which is 10% lower than the stock traded at the time of the initial trade).

The 7 Essentials for Effective Options Trading

Let’s review these 7 essentials that provide long-term options trading success for durable portfolio appreciation.

  • 1. Be an overall options seller
  • 2. Sell options in high IV Rank scenarios
  • 3. Sell options that possess liquidity in the options market
  • 4. Set an appropriate probability of success using Delta as a proxy
  • 5. Manage winning trades
  • 6. Maximize the number of trades
  • 7. Limit position sizing/allocation

Mitigating Risk

This outperformance is due in part by proactively addressing losing trades to manage the overall risk profile. When engaging in options trading, losing trades are inevitable however managing these trades via risk-defined trades, position sizing, diverse sector allocation, buying-to-close for a gain or loss, allowing assignment to occur at expiration, selling covered calls on the assigned stock and rolling the trade out to a different strike level can mitigate risk and enhance long-term successful options trading. In the end, following a set of options, trading fundamentals will enable your portfolio to appreciate steadily month after month for consistent portfolio appreciation.

Managing Trades and Optimizing Outcomes

A variety of actions can be deployed in a losing trade situation to mitigate risk and optimize portfolio performance. A rule of thumb that I generally stand by is limiting myself to selling options on underlying dividend-paying stocks in the large-cap space thus an event I’m assigned, I’ll own shares of the underlying company at a significant discount (since I always sell options out-of-the-money in high IV Rank situations) and a dividend to reinforce the position. There are four actions that I usually employ to manage trades:

  • 1. Take the assignment and sell covered calls against your long position
  • 2. Buy-to-close at a loss to avoid assignment altogether prior to expiration
  • 3. Buy-to-close at a loss and sell a new further out-of-the-money option to reset your positioning
  • 4. Sell option spreads to define your risk (sell a put and buy a further out-of-the-money put)

Upon assignment, selling covered calls is a great way to extract additional value while waiting for the underlying assigned position to recover or appreciate beyond your assigned price. If an option is near expiration and has already broken through my strike price, then I often buy-to-close at a loss, especially if earnings are due prior to expiration. If this situation presents itself, buying-to-close and taking the loss may be the superior route since the odds are not in your favor moving into earnings/expiration. If the underlying stock has already broken through the strike, then upon earnings, the stock may sink lower and result in a huge loss upon assignment. After buying-to-close at a loss (if that was the best action to take) then selling a further out-of-the-money option will offset the loss and reset the odds of being in your favor.

In order to define your risk, you can sell an option spread, which is when an option is sold, and another option is purchased further out-of-the-money. In this situation, you receive premium income for selling the option, and you use part of that income to buy protection via buying a further out-of-the-money option. If you sell a put at a strike of $65 and receive $100 in premium income, you can buy a further out-of-the-money put strike at $60 for $40 in debt. The net premium income would be $60 ($100 - $40), and the max loss would be $500 ($65 strike - $60 strike) if the stock broke through the $60 level. If the stock breaks through $60, you have the right to sell shares at $60 since you bought the put option as well for protection. So, the ideal scenario is the income of $60 at expiration, and the worst case scenario is a max loss of $500. This can be modulated to define risk and optimize net premium income.

Lessons Learned

Everything that could’ve gone wrong in May 2019 went wrong. Airlines, banks, retail, oil, pharmaceutical supply chain, and trade war sensitive stocks all disproportionally impacted my portfolio. Despite the diversity of tickers across sectors, occasionally trades go horribly bad even in large-cap, dividend-paying stocks that are ostensibly lower risk equities. CVS Health (CVS), American Airlines (AAL), Bank of America (BAC), General Electric (GE), Kohl’s (KSS), Schlumberger (SLB), US Oil ETF (USO) and US Steel (X) were all assigned and have weighed heavily on my overall portfolio throughout the past 8 months. All of these assignments were down double digits (~-20%) from the assigned purchase price at one point. These stocks have been dead weight, especially the stocks in the oil space and the middle of the trade war crossfire such as US Steel, General Electric, and Kohl’s. Case in point, CVS fell from $70 to $53 per share, dropping 24% in one week and Kohl’s dropped from $72 to $51, dropping 29% in a single week. These drastic market moves are unpredictable; thus, managing risk is essential. These unrealized losses could have easily been avoided had I executed a buy-to-close at a loss prior to earnings being announced for both Kohl’s and CVS and/or sold an option spread to define my risk.

Conclusion

This comprehensive options strategy provides key fundamentals for long-term successful options trading. These fundamentals allow your portfolio to appreciate steadily since options are a bet on where stocks won’t go, not where they will go, without predicting which way the market will move. These fundamentals provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. I’ve demonstrated an 85% options win rate over the previous 9 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 4.51% return against a 0.95% for the S&P 500 with a lower risk profile. However, unrealized losses can pile up and negate these performance metrics if proactive management isn’t utilized. This includes a variety of techniques that can be deployed to mitigate unrealized losses and/or assignment altogether. Taken together, options trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. When adhering to options trading fundamentals, this approach can provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves.

Noah Kiedrowski
INO.com Contributor

Disclosure:The author holds shares in AAL, BAC, C, CVS, GPS, GE, KSS, SLB, USO, and X. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.

Options: How About Those Losing Trades and Managing Risk Profile?

Let’s discuss losers and managing options trades that move against you despite the high probability of winning the trade at the onset. When engaging in options trading, losing trades are inevitable however managing these trades via risk-defined trades, position sizing, diverse sector allocation, buying-to-close for a gain or loss, allowing assignment to occur at expiration, selling covered calls on the assigned stock and rolling the trade out to a different strike level can mitigate risk and allow long-term successful options trading. In the end, following a set of options, trading fundamentals will enable your portfolio to appreciate steadily month after month for consistent portfolio appreciation. Since options are a bet on where stocks won’t go, not where they will go, this is accomplished without predicting which way the market will move. These fundamentals provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. Following these option trading fundamentals, I’ve demonstrated an 86% options win rate over the previous 8 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a -0.1% return against a -5.6% for the S&P 500. This outperformance is due in part by proactively addressing losing trades to manage the overall risk profile.

Losers Negate Winners

The goal in options trading is to leverage cash and/or stock and sell options using the underlying cash and/or stock to collect premium income. This can be performed in a high-probability manner where a statistical edge is to the options trader’s advantage. Despite the odds being in your favor, occasionally trades can move against you in a major way and negate a large swath of winning trades. Let’s say 12 trades were placed and closed with an average income per trade of $65, translating into $780 in income. If one trade goes south and assignment occurs at $8 below the strike, then this would more than wipe out the $780 in profit and result in an overall loss on the portfolio, translating into a net $20 loss over these 13 trades since options trade in blocks of 100 shares. The onus is on the trader to circumvent this situation and manage these trades before this huge loss in relation to all the option-income received. The example used above is the primary rebuttal from cynics when it comes to an exclusive portfolio driven by options trading. Even if this assignment occurs, the stock was purchased at a substantial discount relative to where the stock traded when the option was placed. Additionally, the assignment can be held until the underlying stock recovers beyond the assigned strike price. Continue reading "Options: How About Those Losing Trades and Managing Risk Profile?"

7 Essentials For Effective Options Trading

I’ll be discussing a comprehensive options strategy and key fundamentals for long-term successful options trading. These essentials will enable your portfolio to appreciate steadily month after month for consistent portfolio appreciation. Since options are a bet on where stocks won’t go, not where they will go, this is accomplished without predicting which way the market will move. These fundamentals provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. Following these option trading essentials, I’ve demonstrated an 87% options win rate over the previous 7 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 6.4% return against a 1.0% for the S&P 500.

Empirical Application

Applying these 7 essentials, long-term options trading success can be achieved to generate consistent income and mitigate risk in a high-probability manner. I was able to win 87% of my options trades while capturing 59% of premium income (Figure 1). This was achieved by trading options in a diversity of tickers for a total of 66 stock and ETFs. These essentials resulted in a wide outperformance relative to the S&P 500, posting a 6.4% return compared to a 1% return for the S&P 500 (Figure 2).

Options Trading
Figure 1 – Metrics across the options based strategy over the previous 7 months Continue reading "7 Essentials For Effective Options Trading"