Giving Away the 'Secret Sauce' to Successful Option Trades

What type of patient are you?

During my days in the clinic seeing patients, I quickly discovered I could group patients into two types.

One was the silent type. They usually held to a more paternalistic view of our relationship. When I ordered a test or prescribed a medication, they responded with, "OK, Doc." No questions. No discussion. For this patient, I was the all-knowing parent while they were the child.

The other type has questions... Often, a lot of them. They want to know the risks of different tests, the odds of a diagnosis, the mechanism of a drug... Anything they can think to ask, they want to know.

Though they take more time, I'd always prefer the patients who ask questions. And I hope that's the type of patient you are, too...

After all, this is your health and your life. Nothing is more important. You can't sit back and let someone make big decisions without asking for an explanation. That's not to say you can't trust your doctor. But you'll feel better if you work together and understand the details of your care.

Of course, people approach their finances the same way.

When you ask someone about his or her retirement, many people respond by saying, "I don't know. My adviser got me into some things, and we're doing fine."

Some folks just don't care for finance and investments. They don't want to know the "secret sauce." But putting your hard-earned money at stake without understanding what's happening with it is a huge risk.

That leads me to today... I want to have a conversation. I'm going to reveal more about how our options-trading strategy works. In fact, I worry we may be giving away too much of our tactics and strategies all at once.

I don't expect you to put your money on the line without understanding exactly what we're doing.

It's the way I'd want to be treated if things were reversed. So it's the way that we'll treat you. Now, let's go over how we pinpoint which options to trade...

A while ago, we received a question from a subscriber:

I just subscribed to Retirement Trader and hope for many great opportunities. Can you give more detail on how you choose the exact contract you recommend? For instance, [why a particular expiration and strike]? I would love to understand better. – B.G.

This is exactly the type of "patient" that we want. To fully understand what you're doing with your money, you need to know why we do what we do... so we're going to tell you.

The first part of our process – and the one we spend the most time on – is the selection of the stocks we use. We like quality companies at fair prices. And those companies must have options that will pay us a significant amount up front (called the "premium") to justify the trade...

That's the challenging part. The market is always changing, but our team's cumulative experience navigating the market spans decades. We're constantly on the lookout for great trades.

After we select the stock, we need to pick the type of option. If you recall, an option is simply a contract between two people.

In Retirement Trader, we tend to focus on a type of options trade known as "selling covered calls" (and we show folks how to sell naked puts, too).

Typically, we choose to sell "at the money" options with an expiration around two months away. As a refresher, at-the-money means that the options we sell have a strike price that's nearly the same as the share price of the underlying stocks. (The strike price is simply the price at which a trader can exercise an option.)

Sometimes we may vary that a little bit, but that's the framework. And there's a key reason why we focus on at-the-money options that are about two months away from expiration.

Again, to be clear, we should probably keep this to ourselves. It gives away too much of what makes our options strategy so profitable. And some may view it as information overload. But it's the only way to help our readers be fully comfortable with our trades.

To understand why we've settled on that as the winning trade, you have to understand how options make money in the first place...

As option sellers, we don't just earn money from stocks that rise. We also earn money from something called "time value."

It's an entirely new source of returns that's diversified from the rest of our portfolios. It doesn't depend on the economy, the business cycle, or political policy. It moves in its own way.

And it's a source of returns that few investors know about... let alone use.

Everyone has heard the fundamental investing concept "buy low and sell high." With options selling – both calls and puts – we turn that around. We want to first "sell high," then "buy low" at the end. So we want option prices to go down.

If you sell an option and everything "stays the same," over time, the value of the option will slowly "decay." If things like the underlying stock price and volatility levels don't change, we can still harvest our extra profits with this strategy.

In other words, we make money simply by watching time pass.

To see how this value changes, we need to separate an option into two parts. The "intrinsic value" measures the unquestioned value of an option based on the difference between the strike price and the stock's price.

If you hold a call with a strike price of $15 and the stock is trading at $20, you can know immediately that the option has at least a $5 value. By exercising the call to buy at $15 a share and then selling the stock in the market at $20 a share, you'd get at least $5 a share. That $5 is called the intrinsic value.

Whatever's left of the price that the call trades for in the market is called "extrinsic value" or "time value." For example, if the call option with the $15 strike is trading in the market at a price of $6, it would still have $5 of intrinsic value since the stock is at $20, while the remaining $1 in the call's price is time value.

As the stock moves up and down, the intrinsic value may change, but the time value only moves in one direction... down.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig

Editor's note: Trading options isn't just for experts. Anyone can learn to do it. In fact, Doc recently sat down with a retired police chief who had almost no financial experience... and walked him through a specific kind of options trade, step by step. We got the whole thing on film so you can see how it's done. Check it out – and learn how this strategy could help you make thousands in extra income every month – right here.

Further Reading

"If you and your friend have been accused of a crime," Doc says, "the most rational thing for you to do is betray your friend." Recently, major brokerages have been thrust into this same situation, called the "Prisoner's Dilemma." And that's great news for options traders... Read more here.

"If an option is going to become less valuable every day, why on earth would you ever buy one?" Jeff Havenstein writes. Most novice investors either avoid options altogether or dive in without learning what they're doing. But thanks to Doc's newest strategy, profiting from options has never been easier. Learn more here.

Market Notes
THE 'MELT DOWN' WON'T KILL EVERY BUSINESS

Today, we’re looking at a business model that’s great at withstanding market shocks…

As you know, we’re in the late stages of the Melt Up. But the “Melt Down” is coming, too… And many companies will be in trouble when it strikes. Others, though, are “recession proof” – folks will still need them no matter what’s happening in the economy. Just look at this resilient business…

AutoZone (AZO) is America’s largest auto-parts retailer, with 5,790 U.S. stores. It also sells parts online to both car owners and professional mechanics. Even in a recession, folks still need spark plugs, batteries, and oil filters… And if they’re keeping an old car alive rather than splurging on a new one, they’ll buy more car parts than ever. Sales are rising today, too… AutoZone’s net sales hit $2.8 billion in the most recent quarter, up nearly 6% year over year.

AZO shares have risen 75% over the past two years, and they just hit new all-time highs. People need auto parts during the Melt Up… And they’ll still need them during the Melt Down…