#1 What Worked in 2012

Posted on January 23rd, 2013

Finally, after 2 weeks of posting what worked and what didn’t in 2012, we’re at the #1 tactic that worked in 2012; which was selling puts.
 
Put selling is a bullish strategy, so naturally in a year where the market was up, selling puts worked. But selling puts worked where many other bullish strategies fell short.
 
By far the most successful strategy we ran this year was selling deep out-of-the-money high probability credit put spreads. That’s a mouthful. This is the strategy we wrote about all year which sold puts far away from the market and buys puts even farther away to create a spread.  Spreads have a reduced the maintenance cost and allowed the tactic to benefit from leverage. In doing, so we generate small monthly percentages that range from 1-4% gains that have a high probability of succeeding. This strategy proved successful 11 times out of 12 for 2012 and produced roughly a 40% return for anyone following it. Here’s a snapshot of the strategy run for the year.
The best description of the strategy can be found in our article published in Stocks Futures and Options magazine on March 1st titled: Take Steps to Generate Income with Credit Spreads.
 
Of course selling deep-out-of-the-money spreads is nothing new to the world of options trading. It has been around for years. But what we preached and preached about was understanding the risk. The golden rule of this strategy has always been to get more reward than the risk you are taking. This guideline kept us out of trouble most of the year and had us trade out of positions that could have catastrophic results. As spread traders know, all the money put up for the trade is at risk, so avoiding that at all cost is paramount.  You can’t make 40% without taking substantial risk, so understanding where that risk comes from needs to be job #1 with this tactic. Typically, we would use this tactic on a portion of a portfolio and not on the entire balance, but if you have the stomach and the emotional discipline to follow the rules, then based on history, it will outperform.
 
The second was using short puts as a means of entering into new positions. You’ve all probably heard this before, but selling puts has been equated to getting paid for using limit orders for new positions. In 2012, this held true. Selling a put as a means to enter a new stock or ETF position provided a successful way of picking up bargains in a disciplined way. See our article from September 21st titled Forcing yourself to be a bargain investor.
 
This tactic does two things, one, it will allow entry into positions at levels you want with less emotional stress. And the second is it allows a premium to be generated while you wait for the stock to dip down to your entry level.  Despite the year having low volatility, there were plenty of buying opportunities as the market dips occurred.
 
 
The third way selling puts worked in 2012 was as a means of generating income to help pay for hedging costs. In our June 26th article titled: Generating a little extra premium when your hedges expire, we explain how selling puts against a hedged position is a disciplined way to dollar cost average and generate extra premium in the process
 
The high level explanation is that if you’re going to be disciplined about using the profits from hedges that go in-the-money to add to an underlying position, then you should be disciplined about selling puts that would execute that strategy for you. Selling puts at a level below your hedge would lower your position’s cost basis if you got assigned or generate small credits through the year. Both of those things are good for a portfolio. The trick is the size of the short put compared to the overall position. Typically, we would look for a put to represent 10-20% of the underlying position, but this will vary based on how far from you hedge you sold the puts.
 
All in all, selling puts worked for hedgers in 2012 and we expect it to continue into 2013 as the market outlook is to the bullish side. Using these strategies appropriately should help produce higher returns as well as lowering hedging costs. 


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