Red Hat Inc Using Put Spreads To Outperform The Stock

Red Hat Inc Using Put Spreads to Outperform the Stock

Red Hat Inc (NYSE:RHT) : Using Put Spreads to Outperform the Stock

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Selling puts is a common option strategy during a bull market, but it turns out that looking at a lower risk put spread, and being rather clever in how we treat earnings, yields powerful results in Red Hat Inc (NYSE:RHT) . More urgently, if we do not look at this approach, we would likely miss some worthy short put spread opportunities and incorrectly identify them as losers. This is one of those cases.

There is a lot less 'luck' involved in successful option trading than many people know, and it's not about guessing stock price direction. Let's review this phenomenon right now for RHT. Let's first examine a one-year back-test of a short put spread strategy implementing these rules:

* Trade monthly options (roll the trade every 30-days).
* Avoid earnings
* Test short put spreads for one-year

Here's how to implement this quickly in the back-tester:

put spread avoid earnings set up

If we do this test, we find that the best short put spread to employ is the 40 delta, 10 delta put spread.

If we do a short put spread in Red Hat Inc (NYSE:RHT) over the last one-year but always avoid earnings we get these results:

Sell 40 Delta Put, Buy 10 Delta Put
* Trade Frequency: 30 Days
* Always Avoid Earnings

Gross Gain: $826
Gross Loss: -$138
Put Spread Return:  135.7% 
Stock Return: 32.0%

Out-performance:  103.7% 

The results above reveal two critical pieces of information. First, we see a strong performing short put spread with a 135.7% return. But, just as important, we also see that the 135.7% return in the short put spread considerably out-performs Red Hat Inc stock over the last two-years, which hit 32.0%.

Altogether we're looking at a 103.7% out-performance while taking less risk than owning the stock outright and always avoiding earnings risk.

While out-performing the stock and avoiding the risk of earnings is a powerful implementation of a short put spread, there's even more going on here. We can repeat this back-test but this time examine only trading earnings. Specifically, we open our short put spread two-days before earnings, let the earnings event occur, and then close the position two-days after earnings.

Here's how easy the test is. We simply click the appropriate buttons.:

put spread earnings only set up

Now we examine the results for that same 40, 10 delta short put spread.

Sell 40 Delta Put, Buy 10 Delta Put
* Trade Frequency: 30 Days
* Only Trade Earnings

Gross Gain: $356
Gross Loss: -$540
Put Spread Return:  -13.1% 

Now we see explicitly the impact of avoiding earnings. Holding the short put spread position in Red Hat Inc (NYSE:RHT) through earnings under-performed the stock and certainly under-performed a short put spread that avoided this risk. In fact, our strategy to avoid earnings beat the strategy held only during earnings by a whopping 148.8%. The reality is that it's remarkably easy to overlook this implementation without diving just a little deeper than the standard option analysis.

For an explicit demonstration we chart the stock returns, the short put strategy with earnings and the one that avoids earnings, below.

Red Hat Inc Stock
and short Put Spread Returns %

We can explicitly see the out-performance in Red Hat Inc by being methodical in our approach and in this case avoiding the risk of earnings.

When we take the time to go through this analysis, which really isn't very hard with the right tools, this approach with Red Hat Inc (NYSE:RHT) reveals that this ethereal concept of 'options expert' has been made far too complicated and even intangible. Below, we go the final step (with a video).

When we wrote that there's actually a lot less 'luck' and a lot more planning in successful option trading than many people know, this is what we meant.

It's not about trying to guess which stocks will go up or down.

What the back-tester allows us to do is find calm, low stress stocks or ETFs (like SPY, QQQ, etc) and find the option strategies that have created a high percentage of winning trades, gaining profitability slowly, while avoiding unnecessary risks -- specifically, avoiding earnings.

In a five minute video, your entire view of the options world and what people mean when they say 'expert trader' will be turned upside down - to your advantage.
Tap here to see the CML Pro option back-tester.

Thanks for reading, friends.

Risk Disclosure
Trading futures and options involves the risk of loss. Please consider carefully whether futures or options are appropriate to your financial situation. Only risk capital should be used when trading futures or options. Investors could lose more than their initial investment.

Past results are not necessarily indicative of future results. The risk of loss in trading can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition.