Last Wednesday, I received an email from a retired Certified Financial Planner with 23 years of experience from the trusted Midwest firm of Waddell & Reed. The inquisitive gentleman has been successfully using covered calls for years and has decided to integrate selling puts into his overall income strategy as well.
After reading a previous article on selling puts on Apple, the retired professional wanted to know exactly how to use Relative Strength Indicator RSI to create a high-probability put-selling strategy for extra income.
RSI, developed by J. Welles Wilder, Jr. is an overbought/oversold oscillator that compares the performance of an equity – in our case a highly liquid ETF – to itself over a period of time. It should not be confused with the term “relative strength,” which is the comparison of one entity’s performance to another.
Basically, the relative strength index allows me to gauge the probability of a short- to intermediate-term reversal. It does not tell me the exact entry or exit point, but it helps me to be aware that a reversal is on the horizon.
To start off, I think it is awesome that so many of you are beginning to see the value that selling puts creates for your portfolio. From creating a steady stream of extra income with far less capital required, to buying stocks or ETFs at the price YOU want, selling puts should be a important part of every investor’s investment strategy.
But for some reason, many investors seem to have an extreme aversion to selling puts.
American investors have “heard” that selling puts is inherently risky. And this belief has been reinforced by the mainstream financial media. Simply put: Most “experts” in the financial media portray this kind of strategy as too complicated for the average investor.
They want you to buy the next hot stock.
For whatever reason, there’s no doubt that this fear of selling puts exists. The fear is real. But the evidence to support this fear is scant.
And yes, selling puts can be dangerous – but only if you use them in incredibly stupid ways.
But I can guarantee that once you learn how to use this type of investment, you will immediately begin to see the whole world of finance in a different light. Instead of “paying” people to invest your hard-earned money, you learn to get paid to invest. I know it sounds like a strange concept, but hear me out because it’s a strategy that professionals have used successfully for years.
The first key to selling puts safely and profitably is knowing the real risks in owning an asset’s shares. We need to assure ourselves the assets on which we sell puts are fundamentally sound.
For instance, take silver.
Silver is a commodity that most investors feel comfortable owning for the long haul, mostly due to the ongoing uncertainty in the global economy.
Over the past month silver has charged over 12% higher and is currently making lots of headlines. But, before you go out and immediately buy the commodity, take a quick look at the chart below.
This is where RSI comes in. RSI gives us the ability to tell whether a stock, or in this case an ETF, is overbought or oversold. Basically, RSI allows me to gauge the probability of a short- to intermediate-term reversal. It does not tell me the exact entry or exit point, but it helps me to be aware that a reversal is on the horizon.
Of course, other factors must come into play before I decide to invest, but I do know that, in most cases, when an index reaches an extreme state, like what we are currently witnessing in silver, a short-term reversal is imminent.
The silver ETF, Silver Trust (NYSEARCA:SLV), is currently trading for $20.27.
For example’s sake let’s say I prefer to pay $19.50, or 3.8% less than the current price.
Remember when I said we want to get paid to be investors?
Well, given our desire to own silver at $19.50 – we can get paid. Think about that: We can get PAID to agree to buy a silver ETF at a lower price…a price we prefer.
I don’t want to get into the details in this short column, but we can sell one put contract that gives us the ability to buy 100 shares of SLV at $19.50 a share – and collect an immediate $28.
And no matter what happens, we get to keep that $28. If SLV stays above $19.50, the $28 we collected is ours. Best of all, we can do this roughly every 45 days for a 1.5% return or roughly 12% annually in extra income.
But for the sake of understanding, we should examine the alternative – SLV closing below $19.50 by option expiration in roughly 45 days.
In that case, we’d keep the $28 and be forced to buy the silver ETF at $19.50 per share.
In this case, we’d actually own the silver ETF for $19.22 per share – that’s the $19.50 strike price minus the $0.28 premium. That 5.2% less than SLV’s current market price.
The important thing to remember is that if the stock trades below $19.50 by option expiration in July, you become a shareholder just like everyone else . . . but at a discount.
One way to think about it is that you’d receive roughly $228 on a $1,950 investment. This works out to 11.7% annually on your money.
To me, this safe 11.7% return is superb given the current yields on bonds and other safe investments.
Simply, selling puts is not inherently dangerous. If used correctly, it’s no more dangerous than buying a blue-chip, dividend-paying stock.
And if you’re interested in extra income, it’s something you owe to yourself to look into.
This article is brought to you courtesy of Andy Crowder from Wyatt Investment Research.