Selectivity has always been a part of my professional life. Whether it was during my time in the military or in my career as a trader, I quickly realized how important this skill is in determining success or failure.
From my time in the Army, I can say with authority that the military is a highly selective group.
I spent some time as a recruiter and learned how to evaluate potential recruits. When considering someone for life in the Army, we looked at their test scores (intellectual ability), physical fitness, their height and weight, their character (community involvement and criminal history) and medical history. Each factor was important and well defined.
The military lifestyle is a demanding one. Work is often physically and mentally exhausting. Instead of going home to your family at the end of the day to recharge, you push apart the flaps of a large tent and try to relax on a cot. It's a different way of life than most are used to, and the Army screens potential recruits to be sure they will be able to meet the standards.
Screening potential job candidates is not unique to the military, though. Every company in the private sector does this as well. The cost of a mistake -- in the Army and in the private sector -- is high. If you hire the wrong candidate, they might quit after a short time, and then you have wasted time and money on training. Time spent hiring a replacement takes more away from productivity and represents another loss to the company.
In the Army, we wanted to be sure we took a "whole person" view to avoid surprises after a new recruit enlisted. I use a similar approach when it comes to investing. This is especially important when it comes to screening potential options trades for my premium newsletter, Income Trader.
A well-defined approach, where each factor is carefully considered, is essential to getting a view of the "whole trade." The goal is the same -- no surprises that could later result in large losses of valuable resources.
I've narrowed my approach down with options to three key traits that make for a profitable trade. Every trade I make in Income Trader must meet these three criteria...
1. I want stocks that offer value, and that value must be defined in advance.
For example, Twitter (NYSE: TWTR) is a stock that is difficult to value. The company lost money last year (the loss was $0.18 per share), and Twitter is expected to report earnings per share (EPS) of only $0.01 this year. I'm not sure any stock is worth buying when the price-to-earnings (P/E) ratio based on next year's estimated earnings is more than 122.
Clearly, some investors believe that Twitter's technology, business operations or future growth prospects are valuable. They may be right, but we don't have methods to value the unknown acquisitions or new technologies that are in development. Therefore, I would not call Twitter an investment. Buyers are speculating, in my opinion, about a future that is both unknown and unknowable.
I only consider stocks trading below price targets I can find with fundamental investment analysis techniques. I don't adopt new ideas like the price-to-eyeballs ratio that some analysts used to justify sky-high valuations during the "dot-com" bubble.
2. I want an option on a stock that provides sufficient income.
In Income Trader, I look for a minimum annualized return on investment of at least 15%. The average annual return for our trades has been about 50%. I look for consistent, low-risk trades rather than trying to knock the cover off the ball with each trade.
3. When selling puts, I want to see a high probability that the option will expire worthless.
After thoroughly screening the best option trades available and researching the company involved, I think about the potential problems the trade could face, and make sure that even under "worst case" scenario, the trade should still be successful.
With that in mind, I only sell puts on truly undervalued companies worth holding. When I sell the put, I collect a "premium" upfront -- that's income right off the bat.
From there, if the stock rises in price and the option expires worthless (usually after a month or so) I get to keep that upfront income as pure profit.
If the stock were to fall (worst-case scenario), I get to buy the stock I wanted to own anyway at a deep discount.
Often, my first trade idea gets discarded because I see something I don't like in the company's financial statement. When that happens, I start over and follow the same process until all three requirements that I mentioned above have been met.
I am confident that these three rules will be an important factor in our success in the future. Sticking to a defined, quantitative checklist is the answer to minimizing risk, eliminating ego and therefore biased opinions from trading. In the end, making money is more important to me than being right.
If you don't have a process or rules that you follow for every trade, I strongly urge you to create one... today. It can be the difference between succeeding or failing in the market.
P.S. -- These rules have led me to tremendous success. Since launching my Income Trader advisory in February 2013, we've made 53 trades -- and all 53 have been profitable. And today I'd like to show you exactly how I've done it. That's why I recently created a "behind-the-scenes" presentation detailing exactly how my readers have made money from every single trade. Simply follow this link to learn more.